At the end of the summer there was some hope for a rapid economic recovery, but that has faded. Recovery from a recession or depression precipitated by a collapse of the banking industry secondary to a housing collapse tends to be slow. Weakened banks are hesitant to lend, and because housing is a big part of household wealth a collapse of housing prices tends to inhibit spending, or alter spending patterns, and especially to inhibit borrowing: debt is a fixed cost, so when household wealth declines people find themselves overindebted. With the supply of and demand for credit weak, economic activity slows. The banks' reluctance to lend, which expresses itself in stricter credit standards, is especially hard on small business, which depends on bank loans for credit; small businesses unlike big cannot finance themselves by issuing bonds or commercial paper or using retained earnings in lieu of credit. And small businesses in the aggregate are big employers. The Administration's ambitious health-care reform is inhibiting hiring by small business by creating uncertainty about the health-insurance costs that employers will bear. Mounting concern with our rapidly growing national debt is a further damper on investment and hence employment.

There is even concern that we may be in a trap in which rising unemployment feeds on itself. Credit defaults are highly correlated with the unemployment rate, so as unemployment rises, defaults rise, and defaults impair bank capital, causing a further tightening of credit, which by hurting small business pushes unemployment up.

All this is speculation and for all I know the unemployment rate will start falling soon and rapidly. But most forecasters think not, and so it is understandable that the Administration would like to do more than it is doing to curb unemployment. But what is there to do? In part because of mistakes in the design, implementation, and explanation of the $787 billion stimulus program enacted last February, and in part because of concern with the rapidly growing federal deficit, the stimulus has become extremely (I think undeservedly) unpopular, and Congress will not enact another stimulus program as urged by left-wing economists.

What then can be done? One possibility, which has been tried in Europe recently, apparently with some success, is to pay employers, through tax credits or otherwise, to hire workers. This is fiscal stimulus--Keynesian deficit financing--by another name. It is like the government's paying a construction company to build a highway, which will require the company to enlarge its workforce. All that might seem to distinguish the job subsidy is that the link between funding and jobs is more direct, which increases its political appeal.

A common objection is that it will encourage fraud--employers will fire workers and then rehire them, to obtain the subsidy. Or, less transparently, it will fire workers and hire replacements, again in order to obtain the subsidy. But a bigger objection, which is also an objection to the original stimulus program, is that it's not targeted on industries or areas of above-average unemployment. Even in an area of low unemployment. an employer will have an incentive to hire workers in order to obtain the subsidy, but he may do this by hiring workers who already have a job, and the net effect on unemployment will therefore depend on what the hired worker's former employer does--maybe just pay him to stay.

There are other ways of stimulating employment, at lower cost and probably with greater impact. One would be to reduce the federal minimum wage, which over a three-year period beginning in 2007 will have risen from $5.15 to $7.25 an hour--a 40 percent increase. As time passes, unemployment becomes less a matter of layoffs and more a matter of failing to provide jobs for new entrants to the workforce, and a reduction in minimum wage would make these new entrants--inexperienced workers with modest wage expectations--far more employable.

Another way to reduce unemployment would be to amend the stimulus law to redirect the remaining unspent funds to areas and industries of high unemployment. Another would be to reduce payroll taxes, including the unemployment-insurance tax and the employer's share of the social security tax; for payroll taxes are part of the cost of labor. The effect on the employer would be similar to that of a wage cut, and would increase the demand for labor. Since social security and unemployment benefits (as opposed to taxes) would be unaffected, the reduction in the taxes would not reduce the employees' full wages and so induce a demand for higher wages. So the employer's net labor cost would fall and his demand for labor rise. The problem is that the government's deficit would increase, but that would also be true of a subsidy for hiring, though it would not be true of a reduction in the minimum wage.

Posner correctly indicates that the unemployment rate understates the employment problem since some men and women have left the labor force after giving up finding work, or they are working part time when they would like to work full time. The so-called "underemployment" rate is estimated to be 17.5%, much higher than the unemployment rate. Note, however, that the underemployment rate is far harder to estimate accurately than is the unemployment rate, which itself is difficult to measure.

I have responded to Posner's emphasis on the underemployment rate in previous posts that apples have to be compared with apples. If the underemployment rate, not the unemployment rate, is used to measure the severity of this recession, than the underemployment rate also has to be used for past recessions. Not surprisingly, underemployment was also considerably higher in these recessions than was unemployment. The underemployment rate for December of 1982 is estimated at about 17.1%, also much above the high unemployment rate at that time. Yet while the unemployment rate has not yet reached the rate obtained in 1982, for the first time the estimated underemployment rate has slightly surpassed the rate for that earlier recession.

In addition, while this recession ended during the third quarter (I believe), unemployment usually lags any pickup in the overall economy, so that the unemployment rate is likely to continue to rise further. However, there are signs of a pickup beginning in the labor market: hours worked of those working have been rising, and wage rates rose by about 2% during the past year. The rise in wages-which is uncommon during recessions- also casts doubt on claims of extensive wage cutting during this recession. Yet it is an unusual combination: workers who still have a job are doing better than in other serious recessions, but the underemployment rate has grown to its highest level since the Great Depression.

Keynes and many earlier economists emphasized that unemployment rises during recessions because nominal wage rates tend to be inflexible in the downward direction. The natural way that markets usually eliminate insufficient demand for a good or service, such as labor, is for the price of this good or service to fall. A fall in price stimulates demand and reduces supply until they are brought back to rough equality. Downward inflexible wages prevents that from happening quickly when there is insufficient demand for workers.

The usual suggested remedies are either to stimulate demand for labor, or to reduce the real cost of workers to employers. The stimulus package has tried to stimulate demand. While I believe this package has failed to stimulate demand to any significant degree (see the discussion my earlier posts on January 11, 18, and November 1, 2009), and that the claimed employment effects of the stimulus are vastly overstated, I concentrate my discussion, as Posner does, on reducing the real cost of labor to employers.

If rigid nominal wages were the culprit, inflation would reduce the real value of labor costs, and hence stimulate demand by companies for workers. But deflation rather than inflation is the greater worry now, so this approach does not seem feasible at this time. The alternative is to cut the cost of labor to employers. A frequent suggestion by economists and others is to give employers subsidies for each unemployed person that they hire, but I believe this approach has many problems of implementation. Clearly, companies would have an incentive to fire some employees and replace them with subsidized unemployed workers.

Moreover, if the unemployed hired under the subsidy program received higher pay because companies compete for the subsidy, some workers might remain unemployed rather than accepting jobs now because they expect to do better when the subsidy program is introduced. Others might even quit to become unemployed, so that they can then become employed at better wages through this program. Many other adjustments would make such a subsidy program both extremely difficult to enforce in a net job-creating way, and highly intrusive into the employment decisions of companies as the government tries to close various loopholes that are bound to be discovered.

It is wiser to cut labor costs in other ways. I fully endorse Posner's suggestions to cut the minimum wage, but I do not see that happening with the present Congress. My favorite approach it to try to stimulate the economy by cutting income taxes, especially corporate income taxes and other taxes on capital, both physical and human capital. Such tax cuts will stimulate investments in the economy, and in this way increase the demand for workers.

Of course, tax cuts at this moment would add to the deficit and increase the size of the government debt at a time when the debt has already grown rapidly. Tax cuts may also take time before they raise investments and jobs. On the other hand, tax cuts that add significantly to the growth rate of GDP will have only modest, and possibly even negative, effects on the ratio of the debt to GDP while they increase investments and the demand for workers. This seems to me to be an attractive way to approach solutions to the unemployment problem at the jobs summit this Thursday.

The Chinese central bank held the value of the renminbi fixed relative to the US dollar at a little over 8 renminbi per dollar during the 1990s, and until 2005. It then allowed the renminbi to appreciate gradually to less than 7 per dollar until 2008, when it again fixed the rate of exchange between these currencies at about 6.9 renminbi per dollar. This exchange rate is considerably above a free market rate that would be determined in a regime of flexible exchange rates. So there is no doubt that China is intentionally holding the value of its currency below the rate that would equate supply and demand.

The dollar has depreciated substantially relative to other currencies since May of 2009. Since the renminbi is tied again to the dollar, the renminbi has depreciated by the same amounts, including 16% against the euro, 34 % against the Australian dollar, 25% against the Korean won, and 10 % against the Japanese yen. This substantially depreciation of the Chinese currency has made many other countries angry at China's policy of locking it to the US dollar.

President Obama apparently complained to Hu Jintao, President of the People's Republic of China, about the low value of the renminbi, and urged China to allow it to appreciate substantially. The US and other countries worry that the undervaluation of the Chinese currencyi increases the demand for Chinese exports, and reduces China's demand for imports from countries like the US because China keeps the dollar and the currencies of other countries artificially expensive relative to their currency. America and other countries hope that greater demand from China for their exports resulting from a higher value of the renminbi will help these countries resume sizable economic growth as they recover from this severe recession. They especially want to help reduce the high levels of unemployment found in many of these nations.

Indeed, in good part due to the low value of its currency, China has run substantial surpluses on its current trade account as it imports fewer goods and services than it exports. The result is that China has accumulated enormous reserves of assets in foreign currencies, especially in the form of US government assets denominated in dollars. As of September of this year, China had the incredible sum of over 2 trillion dollars in foreign currency reserves, such as US Treasury bills. This is by far the highest reserve in the world, and it amounts to the enormous ratio of more than one quarter of China's GDP of about $8 trillion (purchasing power parity adjusted).

I am dubious about the wisdom of both America's complaints about China's currency policy and of China's responses. On the whole, I believe that most Americans benefit rather than are hurt by China's long standing policy of keeping the renminbi at an artificially low exchange value. For that policy makes the various goods imported from China, such as clothing, furniture, and small electronic devices, much cheaper than they would be if China allowed its currency to appreciate substantially in value. The main beneficiaries of this policy are the poor and lower middle class Americans and those elsewhere who buy Chinese made goods at remarkably cheap prices in stores like Wal-Mart's that cater to families who are cost conscious.

To be sure, US companies that would like to export more to China are hurt by the maintenance of the Chinese currency at an artificially low value relative to the dollar. As a result, employment by these companies is lower than it would be, so that this may contribute a little to the high rate of US unemployment. But I believe the benefits to American consumers far outweigh any loses in jobs, particularly as the US economy continues its recovery, and unemployment rates come back to more normal levels.

Since the opposite effects hold for China, I cannot justify their policies from the viewpoint of their interests. Their consumers and importers are hurt because the cost of foreign goods to them is kept artificially high. Their exporters gain, but as in the US, that gain is likely to be considerably smaller than the negative effects on the wellbeing of the average Chinese family.

I reach similar conclusions about China's accumulation of their excessive reserves. The US has little to complain if China wants to hold such high levels of low interest-bearing US government assets in exchange for selling goods cheaply to the US and other countries. China's willingness to save so much reduces the need for Americans and others to save more, but is not differences in savings rates also part of the international specialization that global markets encourage? To be sure, why China is willing to do this is difficult to understand since they are giving away goods made with hard work and capital for paper assets that carry little returns.

One common answer is that China hopes to increase its influence over economic and geo-political policies by holding so many foreign assets. Yet it seems to me just the opposite is true, that China's huge levels of foreign assets puts China more at the mercy of US and other policies than visa versa. China can threaten to sell large quantities of its US Treasury bills and other US assets, but what will they buy instead? Presumably, they would buy EU or Japanese government bills and bonds. That will put a little upward pressure on interest rates on US governments, but to a considerable extent, the main effect in our integrated world capital market is that sellers to China of euro and yen denominated assets would then hold the US Treasuries sold by China.

On the other hand, the US can threaten to inflate away some of the real value of its dollar denominated assets-not an empty threat because of the large US government fiscal deficits, and the sizable growth in US bank excess reserves. Inflation would lower the exchange value of the dollar, and also of the renminbi, as long as China keeps it tied to the dollar. That would further increase the current account surpluses of China, and thereby induce China to hold more US and other foreign assets, not a very attractive scenario to China.

So my conclusion is that the US in its own interest should not be urging China to appreciate its currency- countries like India have a much greater potential gain from such an appreciation. On the other hand, I see very little sense at this stage of China's development in maintaining a very low value of its currency, and accumulating large quantities of reserves. Paradoxically, President Obama and President Jintao should each have been arguing the others positions on these economic issues.

Could China have sensible reasons for such an odd, old-fashioned policy ("mercantilism"--the maximization of a nation's cash or cash-equivalent reserves--famously attacked by Adam Smith more than two hundred years ago)? It could. The immense exports that China's skewed exchange policy has fostered provide employment for a large number of Chinese. Their wages are low, but at least they have jobs. Of course they might have jobs if the dollar were cheaper relative to Chinese currency. China would import more and export less. It would manufacture less, because many workers would be required for the expanded system of domestic distribution that would be necessary if domestic consumption (both of Chinese manufactures diverted from export to internal markets and of imported goods). It would manufacture a different mixture of goods, because of competition from imported goods, but above all it would need a much more elaborate system of wholesale and retail distribution, and perhaps a different commercial culture. The transition to a modern consumer society with its credit cards and product warranties and malls and the rest would be difficult. In the interim there might be widespread unemployment; shifting employees from manufacturing to distribution, or from one type of manufacturing to another, doesn't happen overnight. And China doesn't have the kind of social safety net that we do, to catch the unemployed before they reach the bottom. Because of the limitations of domestic consumption, Chinese are great savers, and this relieves the pressure the government would otherwise feel to provide social services. That provision might strain the government's administrative abilities.

China has a long history of political instability, and there is tension between its dictatorial communist government and its largely free-enterprise economy. It is naturally reluctant to take chances on changing its economy from one of producing manufactured goods for export to one of manufacture and distribution primarily for domestic consumption.

And there is value to China in those trillions in foreign reserves that it has accumulated. They magnify its global power. China is our major creditor. It finances our deficit. Like any dependent debtor, we must be very careful not to offend our major creditor. It is true that our relation with China is one of bilateral monopoly: if we devalue the dollar (which we may be doing) in order to lighten our debt burden, we hurt China; but if China in retaliation stops buying our Treasury bonds, we are badly hurt.

For all these reasons, while China is likely to abandon mercantilism in the long run, it probably is sensible for it to do so gradually.

Would we benefit from China's abandoning mercantilism? As Becker points out, our consumers benefit from the artificially low prices at which Chinese goods are sold in this country. At the same time, our dependence on China's financing our public debt weakens our ability to influence Chinese policy on issues of urgent concern to us, such as the threat of nuclear proliferation posed by North Korea, Iran, and Pakistan, and the need to take effective steps to limit global warming.

Then too it seems that the only way in which we can buy those cheap goods from China is to borrow from China. We buy more from China than we sell to it and so China accumulates dollars to bridge the gap, dollars that it then lends to the U.S. Treasury. The effect is to reduce pressure on our government to pay down our immense and growing public debt either by raising taxes or by cutting spending. We cannot continue along the path of ever-growing debt unless our economy grows very rapidly, which is not assured. So I am not sure that I agree with Becker that China's policy is good for us and bad for it. The reverse may be truer.

Japan was hard hit by the current economic crisis, in part because of its dependence on exports. It responded with aggressive monetary and fiscal measures, as before--with what appear to be potentially disastrous results, if one may judge from data in a recent article in the Wall Street Journal (Richard Barley, "Japan: The Land of the Rising CDS," Nov. 11, 2009, p. C20). The International Monetary Fund predicts that next year Japan's ratio of national debt to GDP will be an astronomical 2.27, forcing Japan to continue borrowing heavily abroad. Interest rates remain very low, in part because Japan is again experiencing deflation. Rating agencies have reduced Japan's bond rating to AA-, yet the government, lulled by low interest rates, apparently has no sense of urgency about the country's mounting debt burden, a burden aggravated by the rapid aging of Japan's population. International financial markets believe that there is some probability that Japan will default on its debt. The "CDS spread" (the percentage of a debt that someone desiring insurance against the debt's defaulting must pay for the insurance) on Japanese government debt is almost 1 percent (.75 percent).

The United States differs in many respects from Japan, but is beginning to look more and more like it. We too experienced a banking collapse in the wake of the bursting of a housing bubble, and our monetary and fiscal responses, though aggressive, may not have been highly effective. The fiscal stimulus--the $787 billion federal spending program enacted in February--was enacted late and is poorly designed, and some think too small. And there is concern that, like Japan, we are babying our weak banks by allowing them to overvalue the assets and underestimate the liabilities on their balance sheets. The stress tests conducted last spring, for example, both underestimated the stress the banks were under (by assuming an unemployment rate--unemployment being highly correlated with bank-loan defaults--substantially lower than it became within a couple of months after the tests) and disregarded likely defaults of bank loans that will mature after 2010.

Our government, too, is lulled by low interest rates into believing that we can continue to run huge deficits without raising taxes or cutting spending significantly, simply by borrowing. Our public debt (the amount of federal government debt that is contractually obligated, as distinct from accounting reserves for entitlement programs such as Medicare and social security), of which almost half is owned by foreign governments and other foreign investors, has reached $7.5 trillion, which is more than half our GDP, and is on course to increase by at least a trillion dollars a year for the indefinite future. Like Japan, we have an aging population, which is pushing up entitlement costs. Our government seems not to have any economically realistic or politically feasible plans either to raise revenue or cut spending, but instead plans ambitious new spending programs (notably but not only on revamping health insurance). Proposed economies seem tokens. There is an air of complacency about deficit spending and public debt--again like Japan.

Because of our low inflation rate (it is close to zero) and the Federal Reserve's "easy money" policy (as a result of which our banks are holding a total of $1 trillion in excess reserves), the dollar has now become a favorite currency for the carry trade: dollars exchanged for local currencies earn interest more or less effortlessly, though not without risk. The carry trade may be a factor in the recent rises in commodity prices; indeed there is fear of additional asset-price inflation (bubbles) as a result of all the dollars sloshing around in the world economy.

Should the U.S. economy grow more rapidly than the public debt, we'll be okay. But the government's focus appears to be not on economic growth, but on redistribution (the major goal of health reform) and on creating at least an aura of prosperity, at whatever cost in deficit spending and future inflation, in time for the November 2010 congressional elections.

The danger of any explicit default on this debt is minimal since it is all denominated in the Japanese currency, the yen. Any country can reduce the real value of a debt burden in its own currency by printing money to finance a good chunk of its government spending, and thereby create inflation that destroys part of the real burden of the debt. I do not expect that to happen in Japan unless the debt burden becomes intolerable down the road.

All this is background for comparisons between Japan and the US. As Posner indicates, the American ratio of debt to GDP is now about 50%, where Japan was in 1995. It is also rising rapidly as the government continues to increase its spending on banks, the stimulus package, likely also on health care, maybe subsidizing employment of the unemployed, subsidizing mortgages, and in many other ways. The ratio of federal government spending to American GDP was quite stable at about 20% for about 40 decades, but this ratio has been rising rapidly during the past year, and it is beginning to approach 30%. The government debt is not yet a great burden because, as in Japan, interest rates are low, so that annual interest payments on the debt is not a sizable fraction of total government spending.

It is unlikely that US government spending will decline during the next decade, even though some of the short term spending on banks and stimulating the economy will probably fall sharply. Any spending declines from these directions will be more than replaced by much greater spending on Medicare, Medicaid, and other government financed health programs, on social security, and on various other entitlement programs. The direct impact on the debt burden of such budget deficits can be reduced only by higher taxes or inflation. Eventually, I do expect much greater inflation in the US. The Obama administration has also been vocal about its plan to raise taxes, especially on higher income persons, as soon as the recession is clearly over and the economy is growing again. That would be a serious mistake.

The best solution to reducing the real burden of the public debt is neither inflation nor higher taxes, but more rapid growth of the American economy. This involves lower, not higher, taxes on investments and incomes of small and large businesses. It also requires greater concern about the fact that the US is falling behind many other countries in the proportion of its young population, especially males, who receive a higher education. In addition, much greater attention needs to be paid to correcting the depressing statistic that the fraction of boys who drop out of high school has been stuck at about 25% for several decades, even though the economic and other benefits of finishing high school and going to college have risen dramatically. To its credit, the Obama administration has given high priority to improving the K-12 performance of American students, especially those from minority backgrounds.

In effect, the desirable policies to stimulate growth involve a retreat from the anti-business rhetoric that pervades Congressional Democrats and some of the top players in the executive offices, and a more pro-consumer and pro-business mentality. It is necessary to maintain the minimalist anti-trust policy that developed during the 1980s and 1990s under Democratic as well as Republican administrations, to retreat from the policy that banks and other businesses, such as GM, cannot be allowed to fail when they are mismanaged.

Desirable policies also include the elimination of efforts to restore union power in the private sector, and resistance to the desires of some members of Congress to have the US retreat from a free trade policy> They also want to impose onerous regulations on businesses of all kinds, especially the more successful ones. I am perhaps particularly disturbed by the anti-immigration rhetoric of leading members of Congress since immigrants have contributed so much to the dynamism of the American economy and society.

Sizable advances in productivity and the resulting sharp economic growth can ease the burden of growing government spending, and prevent anything like the expanding debt to GDP ratio and stagnation of the Japanese economy. Can the US do it? Certainly! Will the US do it? Not with the present composition of Congress, and with the tendency of the President to allow some of the more destructive members of his political party to get their way.

The two numbers are closely related because when productivity increases by a lot, that means much more output is being squeezed out of given inputs of labor and capital. Since during the third quarter the growth in productivity-equal to the growth rate in output minus the growth rate in hours of nonfarm workers- was over 9%, it is arithmetically necessary that hours would decline and unemployment increase since output grew "only" by about 4%. Hours worked did decline by about 5%, and unemployment grew by several percentage points. The very rapid increase in productivity during the third quarter followed a sharp growth in productivity during the second quarter of about 7%. The fast growth in American productivity toward the end of this serious recession is quite unusual because measured productivity often falls during recessions as companies are stuck with excess capacity of their capital. Companies also usually decide to hold on to their best employees, even though they are less than fully occupied with work. American productivity never fell during this recession.i

A rapid growth in productivity is generally a good sign since it means that more is being produced with fewer inputs of labor and capital- it is sort of a "free lunch". However, in a period of reduced employment and rising unemployment, many persons begin to fear that companies are advancing productivity only by laying off employees, and that this process cannot be easily reversed. Throughout history there has been a widespread fear that economies with the most rapid rates of technological progress have trouble generating full employment because jobs are lost as economies become more productive. Such an analysis considers economies to have a fixed number of jobs, so that eliminating some of these jobs reduces the number of workers who can be employed. Recall the Luddite textile workers in early 19th century Britain who attempted to destroy the textile machinery that was being introduced into their industry in an effort to protect their jobs.

Yet over periods more than a quarter of a year or a year, even rapid productivity growth has usually gone hand in hand with growing, not declining, employment. The Internet is providing many jobs, some for reporters who formerly worked at newspapers and magazines. The high tech sectors of Silicon Valley and elsewhere have become major employers of programmers, software engineers, salesmen, and many others. Large growth in employment has also occurred in the biotech field, and the health field more generally, and at other new industries. So while productivity of the global economy increased rapidly during the past century, and also during the past 15 years, world employment also rose rapidly during the past century, and during the more recent period, and world unemployment rates declined rather than increased during both periods prior to this worldwide recession. But the effects of the recession is only a temporary reversal of these longer-term trends.

Nor did the growth in employment come at the expense of earnings since hourly earnings also rose rapidly during the past century along with employment and productivity. This is not at all surprising since higher productivity means that workers and capital tend to produce more output than they did before productivity improved. At the same time that new technologies reduce the demand for worker skills and physical capital made obsolete, the increased productivity of capital raises the supply of other kinds of capital that contributes to a growth in the earnings of workers. The increased productivity of workers also increases their earnings along with their increased employment, although the skill mix of the workers demanded will differ from the mix prior to the growth in productivity.

This is why the rapid growth in American productivity during the past half year is a very good sign for the prospects of the American economy during the next several years. In the very short run, productivity improvements are associated with rising unemployment and reduced employment, but in the somewhat longer run it will raise the demand for workers and earnings. The emphasis on the very short run explains why Friday's unemployment figures received so much more attention than did Thursday's productivity figures, even though the latter are more important for the future prospects of the American economy.

If productivity growth is the result of technological innovation (and "technology" in this context need not be limited to engineering--it could include innovations in management, marketing, inventory control, and so forth), then the effect of greater productivity on economic growth will indeed be positive. But it is unlikely that the productivity spurts in the second and third quarters of this year have been due to innovation. More likely they have been due to old-fashioned cost cutting spurred not by technological advances but by economic distress. The only explanations I have seen offered for the productivity surge is cutting wages and working the workers harder. I have found no suggestion of any technological change that might be responsible for such a large, sudden surge in productivity. Facing declining demand and a frightened work force, a firm is under pressure to reduce its costs and it can do that in a variety of ways, including laying off workers, pushing its remaining workers to work harder, reducing wages and benefits, buying cheaper inputs, slowing delivery, paying its bills more slowly, and responding more slowly to customer complaints. Some cost reductions will not increase productivity, as they will be proportional to reductions in output. But others will, such as laying off the least productive workers, or reducing quality in ways that do not show up in statistics on productivity (as they should--a reduction in quality is a reduction in the value of output).

Productivity gains that are based merely on adaptations to temporarily depressed economic conditions will be lost when conditions improve. As labor markets tighten, a firm will perforce hire workers who are less productive than the workers it had retained in a slimmed-down workforce during the depression; and so productivity will decline.

The productivity gains in the last two quarters could actually signal pessimism about the pace of the recovery. There are costs to reorganizing one's business in order to adapt to a reduction in demand. The shorter the expected reduction, therefore, the less reorganizing a firm will do. Indeed, often during a recession or depression there is the phenomenon of "labor hoarding": if a restoration of normal demand is expected in the near future, a firm may be better off with a workforce larger than it needs to meet the current demand than it would be laying off workers and having to incur the expense of rehiring them, or hiring new workers, when the downturn ends. There has been less labor hoarding in the current downturn than in previous ones, and this may be because employers do not anticipate an early return to normal demand. Their pessimism would be consistent with predictions that unemployment will continue to rise for some months, and thereafter will decline only slowly. For with such a high rate of unemployment (and underemployment--10.2 percent and 17.5 percent at this writing, respectively), demand for goods and services is likely to remain at a low level.

Transfer payments, moreover, are a poor device for fiscal stimulus. The idea of a fiscal stimulus as an anti-depression device is to increase employment and by doing so restore business and consumer confidence; we are seeing today how high and rising unemployment is sapping that confidence and retarding recovery from the current depression (and it is a depression, not the "Great Recession" as some are calling it, though that's an issue for another day).

Transfer payments are at two removes from putting unemployed people to work. The amount of the transfer that is saved by the recipient in a savings account or other safe haven is (by definition) not spent, and so does not increase demand and therefore supply and therefore employment. And the amount of the transfer that is spent is spent at a store or other retail outlet to purchase a good that has already been produced. It is buying from inventory. Only when the store's inventory falls to a level at which the store has to order a new supply of goods from the manufacturer is there any stimulation of production, and thus of hiring; and of course the stimulation may not be of production by an industry, or in an area, of high unemployment. The dive that the economy took in the wake of the September 2008 financial collapse was unanticipated, and as a result sellers found themselves with excess inventories; until they were worked down, production would remain depressed. In sum, the effect of a transfer payment on employment may therefore be nil.

Apart from its inefficiency as a contribution to the recovery, largesse for the elderly--whose medical expenses, paid for largely by the taxpayer under the Medicare program--are threatening to bankrupt the country, sends the wrong signal: the signal of fiscal profligacy.

Lawrence Summers, the brilliant economist who heads the National Economic Council in the White House, has publicly endorsed the $250 dollar gift to social security recipients. He claims that it corrects an "anomaly." The anomaly he points is that social security recipients received only one $250 stimulus check this year and will receive no cost of living increase next year, whereas the tax benefits in the stimulus plan will be paid next year as well as this year. But social security annuitants received a 5.8 percent cost of living increase this year, whereas few workers received as large a wage increase; and they will be receiving a real as distinct from nominal increase in benefits next year. The only "anomaly" in the picture is the cynical provision of a windfall to a group that has suffered less from the depression than persons of working age, a group whose only claim to a $250 Christmas gift paid for by the federal taxpayer is that it votes more heavily than the young.

What's $13 billion at a time when trillions are spent casually? The real significance of the measure is the insight it gives into the Administration's apparent indifference to fiscal prudence. And not just the Administration. The political parties play leapfrog when it comes to spending--each trying to outdo the other in generosity to powerful voting blocs, and specifically to the elderly--the recipients of enormous social security and Medicare benefits, courtesy of the federal taxpayer. The costs of both the Medicare and social security programs are increasing rapidly as the population ages, and as the population ages the voting power of the elderly increases, placing additional pressure on a budget already disproportionately devoted to supporting the least economically productive members of society. (As a septuagenarian, I claim the right to make politically incorrect remarks about the elderly. Moreover, I am speaking of the average; many elderly people are hard-working and productive.)

The rapidity of the recovery in the US or the world is not yet clear, although many economists who follow short term movements of the economy more closely than I do are predicting a slow and drawn out recovery period in the EU, Japan, and the US. I am not convinced by their forecasts because of the rapid recoveries in Asia, Brazil, and some other countries, and as long as American productivity continues to grow at a rapid rate. To be sure, unemployment is likely to continue to increase for a while since it is what is called a "lagging indicator". However, it almost surely will peak below the 10.8% reached at the end of 1982. During the past couple of years the world went through a severe recession, but it was not appreciably worse in the United States, as measured by the effects on GDP and unemployment, than during some other recession in the past 40 years. Of course, without some of the proactive policies of the Fed and the Treasury, this recession probably would have been deeper and longer.

Not surprisingly, these comments lead me to join Posner in taking a negative view of the plan to pay every social security annuitant a $250 bonus in 2010. The reason given to justify this payment is that the elderly will get no cost of living increase in their social security payments since prices fell rather than rose during the past year. As Posner indicates, this is an illogical and basically nonsensical justification for this bonus to social security recipients. Taxpayers already heavily subsidize the elderly through Medicare and to some extent social security payments, and there is little reason to use spurious arguments to add to that subsidy as part of the stimulus package.

More generally, the $787 billion stimulus-spending package of the Obama administration has made little sense since its inception, as I have argued in several blog posts and elsewhere. Business cycle analysts have long known and documented that fiscal spending programs are not very good at helping to fight recessions since they take a long time to implement. By the time fiscal spending actually occurs. the recessions they were supposed to be combating are usually over. Only about one third of the present stimulus package has yet been spent-and much of it not very well spent. Yet, the recession is already over, although to be sure, the recovery is still at the beginning stages.

I do not believe that inflation due to the Fed's rapid increase in bank reserves is yet a major worry, although it will be in a few years as banks spent these reserves by making additional loans and other investments. Nor do I believe that the huge increase in federal government spending, on the stimulus programs and to help the banks, will be a major cause for concern, as long as American GDP will grow at a much more rapid rate during the next decade than will government spending.

However, the much higher interest payments on the much larger government debt will have to be met either by raising taxes, cutting other government spending, rising tax collections from increased output, or inflation that deflates the real value of these interest payments. I am very much worried that it will be impossible to stop the growth of government spending, so that there will be an enormous, and probably irresistible, temptation to inflate to reduce the real value of the debt, and to raise taxes on higher income persons. Both of these will have negative effects on the growth rate of the American economy.

General controls over wages have frequently been tried in different countries. The usual motivation for wage controls is to reduce inflation by keeping labor costs, and therefore prices, from rising rapidly, although wage controls are invariably combined with general controls over prices as well. Inflationary fears were certainly behind the wage and price controls in almost all countries during World War II, and in the US under President Nixon from 1971-1973. These measures sometimes succeeded in suppressing inflation temporarily, but they also led to rationing of various consumer and producer goods because of weak incentive to produce or work when prices and wages are kept below their market values.

Companies can still compete for employees when higher pay cannot be offered as inducements by increasing fringe benefits to employees, such as longer vacations and subsidized lunches and other meals. US companies began to offer free health insurance to employees during World War II as a way to get around the wartime control over wages. The American health care system has suffered badly since then from this artificially induced connection between employment and subsidized health care.

In some respects, the effects of controls over pay are even more harmful when they apply only to a small subset of all employees, such as the proposed sharp ceilings on management compensation at the seven companies that received the largest amount of government assistance, or the scrutiny of pay of top executives at the thousands of financial institutions under the Fed's supervision. The most talented individuals at these firms will tend to leave because they will receive much higher compensation packages by financial and other companies that do not have their pay set in Washington. So the financial companies that received much government assistance and other banks would lose many of their best people just when they need talented management to help put their companies under a more solid financial foundations. Without the requisite talent, many of these companies may either go under, perhaps not a bad idea, or more likely the government will bail them out once again-not a pleasant prospect.

o prevent an exodus of whatever talent is left and to attract new talent, Feinberg and the Fed may try to differentiate between more and less able executives, and allow much higher pay for the best of them. But can a czar or the Fed perform that task better than the forces of market competition for talent? History indicates that is highly unlikely.

These controls over pay not only will cap salaries, but they would also reduce bonuses and stock options, and prevent the executives affected to cash in options for several years. The reasoning is that this will force executives to take a longer-term view of the risks and other decisions that they take. One irony is that, as pointed out by Yale's Jonathan Macey in a recent Wall Street Journal op-ed piece, Congress in a 1992 Act prevented corporations from deducting as a normal business expense any salaries that exceeded $1 million. As a result, corporations were encouraged to shift their pay to stock options, which received more favorable tax treatment.

I have not seen convincing evidence that either the level or structure of the pay of top financial executives were important causes of this worldwide financial crash. These executives bought large quantities of mortgage-backed securities and other securitized assets because they expected this to increase the average return on their assets without taking on much additional risk through the better risk management offered by derivatives, credit default swaps, and other newer types of securities. They turned out to be badly wrong, but so too were the many financial economists who had no sizable financial stake in these assets, but supported this approach to risk management.

The experience of other financial crashes also does not indicate that either the level or form of compensation of top financial executives were major factors in precipitating these crashes. Thousands of banks failed during the Great Depression, as did hundreds of American savings and loans institutions during the 1980s, without heads of these institutions in either case getting particularly high pay, or pay that was mainly in the form of bonuses and stock options. My impression is that this same conclusion applies to the Mexican bank crisis of the mid 1990s, and the Asian financial crisis at the end of the 1990s.

The generous bonuses and stock options received by financial executives may often have been unwarranted, but they are being used as a scapegoat for other more crucial factors. Financial institutions underrated the systemic risks of the more exotic assets, and apparently so too did the Fed and other regulators of financial institutions. In addition, large financial institutions may have recognized that they were "too big to fail", and that they would be rescued by taxpayer monies if they were on the verge of bankruptcy because they took on excessively risky assets.

There is a slightly better, though still unconvincing, case for regulating (2) compensation structure, as distinct from the level of compensation, of (2) all financial institutions. Since the market for financiers is global (in part because even a very small country can become a major banking center, given the mobility of capital and of financial personnel and the absence of any need for elaborate infrastructure, physical resources, or a large domestic market), effective regulation of compensation structures would require agreement among all major and many minor nations. If that obstacle to effective regulation could be surmounted, the case for regulation would come down to the fact that front-loaded compensation of financial executives can increase macroeconomic risk.

To explain, the risk of the kind of financial collapse that occurred in 2008 was reasonably perceived as small; had it been perceived as large, the banking industry would have reduced its leverage and other sources of risk. The risk of the kind of financial collapse that occurred in 2008 was reasonably perceived as small; had it been perceived as large, the banking industry would have reduced its leverage and other sources of risk. That small-seeming risk was produced by individual risky transactions, and the object of compensation reform is to discourage such transactions. Suppose the transactions were the purchase of triple-A tranches of mortgage-backed securities at an attractive price, but carried a correlated annual risk of 1 percent that the investments would turn out to be worthless and bring down the firm. A financial executive paid salary or bonus based on the expected profit of such a deal would have an incentive to make it despite the slight chance that it would blow up eventually. Merely requiring, say, that a portion of his salary or bonus be placed in escrow for a few years would not deter him; the reduction in his expected compensation would be too small. Suppose 50 percent of the bonus he received on the deal was placed in escrow and the duration of the escrow was five years. Then he would face a 5 percent chance of losing half his bonus. That would be too small an expected penalty to dissuade him from making the deal. The penalty could not be made sufficiently heavy to disuade him without depriving him of most of his current income.

So I think regulating financial compensation is a mistake. At the same time I think financial executives probably are overpaid from a social perspective. The reason is that their high incomes are generated mainly by speculative trading of stocks and bonds and other financial assets. Speculative profits are not net additions to economic welfare, because they are offset by the losses of the speculators on the other side of successful speculators' trades. That is not to say that speculation has no social value. It generates great social value by bringing about improved matching of prices to values, which encourages investment in productive activities. But the amount of profit that a speculator makes is not the measure of the social value of a successfl speculation. The increase in social value is probably only a small fraction of the speculator's profits.

If financial speculation involved a lot of career risk, in the same way that becoming an actor does, then the high incomes of successful speculators, like those of successful film actors, would be compensation for the risk of failure. But financial executives, while they do sometimes lose their jobs because of bad trades, generally experience a soft landing because their training and experience equip them for a variety of good jobs in business, government, or academia.

Recipients of Harvard Ph.D.'s in physics are said to have two career tracks open to them: academia and Wall Street. No doubt many are attracted to Wall Street by the much higher incomes they can expect there. Yet their social value might well be greater in academia.

Higher marginal income-tax rates, or a stiff tax on financial transactions, might go a slight distance toward correcting the financial brain drain, but probably it is a problem that we shall just have to live with.

Oddly, an interest in organizations is a latecomer to economics, even though most economic activity is conducted through organizations. The standard economic model is of trade between individuals, or firms assumed to behave as individuals. For many purposes the model, despite its extreme simplification, is adequate. If one wants to know how cigarette producers will respond to a rise in cigarette taxes, it is enough to assume unrealistically that a cigarette producer is one person rather than a complex organization. But for other questions the assumption is inadequate--most obviously if the question is why some business firms have steeply hierarchical structures and others rather flat ("M-shaped"--"M" standing for multidivisional) ones (this distinction has been a particular emphasis in Williamson's work). Or why compensation practices within firms (or government agencies) take the form they do. Or--most fundamentally--why there are firms at all--why all economic activity isn't carried on by contracts among individuals. Ronald Coase asked that question in a paper entitled "The Nature of the Firm," published in the 1930s. His answer was that a producer has a choice between contracting with independent contractors for the output of the various inputs into this production of the finished product, and contracting with individual workers--employees--not for their output but for the right to direct their work--and that the employer would choose between forms of contract--the contract with the independent producers or the employment contract--on the basis of which was more efficient, given the nature of his business.

Neither form of organizing production is perfect. The arms' length contract form requires detailed specifications that create inflexibility. The command form--the employer directing the work of employees rather than contracting for their output--creates the well-known principal-agent problem (the problem economists call "agency costs")--the employee is supposed to be working to maximize the firm's profits, but what he wants to maximize is his own utility, so the employer has a control problem.

The modern literature emphasizes the principal-agent problem but also moves beyond it by emphasizing another aspect of control within an organization: the creation, transmission, processing, coordination, and use of information. Because the span of supervision by one person is limited, the more employees a firm has, the more supervisors it requires; and the more supervisors it has, the more supervisors of supervisors it requires because the span of control is limited at every tier of the hierarchy. So as an organization expands, the layers of supervisors multiply, and the consequences ared delay in executing orders, loss of information, attenuation of the directions emanating from the top, and in short a weakening of control and coherence. The larger the organization, moreover, the more difficult it will be to correlate the work of a particular employee with the value of the organization's output, and so the employee's incentives will fall further out of alignment with those of the firm. A partial alternative to hierarchy is to decentralize the organization in imitation of the market, by delegating authority to division heads and requiring them to compete with one another for allocations of capital from central management. That is the essence of the "M-form" of corporate organization ("M" standing for multidivisional).

Organization economics emphasizes the variety of agency costs that flourish in complex organizations, such as "influence activities," by which agents try to influence the decisions of their principals, for example by flattery, by being a "yes man" and not "rocking the boat," by doing personal favors, by making alliances with coworkers, by jockeying for promotion, and by hoarding information to make oneself indispensable and reduce the output of one's competitors in the organization.

The challenge to organizations is to generate cooperation without use of the price system, since the employer does not buy the output of his employees. Instead organizations rely on common norms, understandings, customs, and perspectives that substitute for explicit contracting and thus enable cooperation on dimensions of performance that cannot be prescribed by formal directives. This set of informal binding elements (the organization's "culture") includes codes and other shared specific human capital that facilitates communication and coordination among agents. Unfortunately, an organizational culture that is optimal in its current environment may become suboptimal when the environment changes, yet adaptation to the new environment may be difficult because once information channels and other organizing elements are created, an investment has been sunk that will constrain the organization's reaction to a new environment. Change is especially hard because an organization's culture is diffused throughout the organization rather than concentrated in one place (an employment manual, for example) where it could be changed at a stroke. The result is organizational conservatism or inertia, and explains why innovations tend to come from new firms rather than from existing ones.

An important aspect of organizational culture, one that I have emphasized in my academic work, is the awkwardness of combining different cultures in the same organization. An example is the combination of criminal-investigation and security-intelligence functions in the FBI. The former lend themselves to what are called "high-powered" incentives, which are systems of compensation and promotion that are based on objective performance criteria. In the case of criminal investigation these are number of arrests weighted by convictions and sentence. Intelligence work does not lend itself to such performance criteria, because the effect of surveillance and other intelligence activities in preventing terrorism or subversion is usually very difficult to assess. Hence motivation takes the form of creating a "high commitment" environment in which the organization's leaders try to elicit good performance by getting staff to internalize the organization's goals. The problem is that the absence of objective criteria of performance opens the door to "influence activities" by which members of the organization jockey for advancement.

If both types of task are combined in the same organization--those that can be directed by high-powered incentives and those that require high commitment as their motivator, the best employees will tend to gravitate toward the first type of task because they will be confident that they will do well if their performance is judged according to objective criteria. They will be much less certain how well they will do in a job in which influence activities play a large role in determining success.

The problem of culture clash in an organization is further illustrated by the financial collapse of last year. Banks had traditionally been conservative organizations emphasizing risk avoidance, modest compensation, gradual promotion, and secure tenure. When in the deregulation era they were permitted to expand into riskier and (therefore) more lucrative forms of financial intermediation, they attracted a different kind of employee--smarter, more willing to take career as well as financial risks, more independent, and demanding higher pay. Because they were generating more profits for the bank, their influence grew and placed pressure on the traditional bankers to take more risks in order to hold their own in the struggle to control the organization. So one proposal for preventing a recurrence of the financial crisis, since the crisis was due in part to highly risky lending by banks, is to restore the separation codified in the Glass-Steagall Act of conventional banking from high-risk forms of financial intermediation.

The financial collapse illustrated another facet of organization economics as well. The banking industry expanded very rapidly in the low-interest-rate environment created by Greenspan's monetary policy in the early 2000s, and the expansion took the form largely of the expansion of existing firms rather than the creation of new ones. When an organization expands rapidly, there is a danger of loss of control over subordinate employees. The danger in the case of the banking industry's expansion was increased by the fact that many of the new hires consisted of young risk takers whose attitudes and skills were often quite different from those of the higher tiers of management. Senior managers had difficulty in assessing and limiting the highly risky deals engineered by the young hot shots.

George Stigler argued many years ago in a classic article ("The Economies of Scale", reprinted in his collection of essays called The Organization of Industry) that different types of firms that survive in the competition for profits in very competitive environments must be of rather equal efficiency at producing profits. A corollary is that if a competitive industry were trending over time toward a narrower set of organizational types, this would imply that these types must have become relatively more efficient as the economic and political environments changed over time.

The fact that small supermarkets and large warehouse markets survive the tough competitive pressure of the retail grocery market suggest that both types must be of about the same efficiency in their respective niches of the grocery sector, although the trend seems to be toward larger supermarkets. That steel mills are much larger than textile factories suggest that economies of scale in steel production must be sufficiently larger than the scale economies in the production of textiles to overcome the larger number of command layers and other inefficiencies of a larger production scale in steel but not in textiles.

Also of relevance to understanding the efficiency of different organizational types is that very different types of firms survive in different countries, often even when they are in the same or similar industries. For example, Japan and South Korea (occupied by Japan for about 40 years in the 20th century) have large conglomerates that are active in many different industries, such as Korea's SK company whose products range from an oil refinery to cell phones, whereas Taiwan tends toward smaller firms that are more concentrated in particular sectors (although Taiwan was also occupied by Japan).

Both the inter country and within country evidence indicate that no single organizational form is always the most profitable even in a particular sector of the economy. Different combinations of scale economies, principle-agent problems, compensation practices, thickness of the span of control, and many other variables highlighted in the organizational literature often produce outcomes that are about equally efficient and profitable. The outcome of strong competition is the only really decisive way to determine which are the possibly quite different but about equally efficient combinations of all these different variables.

The major difficulty in evaluating many governmental organizations is that they often do not face such strong competition and they have no simple measure of success, such as profits. These two factors make it difficult to use Stigler's survival test. To take Posner's example, can the criminal catching activities of say the FBI be efficiently combined with a terrorist deterrent function? If this were a competitive industry with many different organizations and good observable measures of success, one could then look at whether such combinations compete successfully in the longer run against more specialized agencies. Lacking either much competition or such measures of success, one has to rely in good part on the insights of analyses of these issues. Similarly, the organization and efficiency of armies is only rarely tested against competition on the battlefield. When so tested, losing armies often try to reorganize so that they can look more like the successful armies, although generals are often accused of reorganizing to fight the last war.

Perhaps then it is best to try to create competition among governmental agencies, such as both the CIA and FBI trying to deter terrorism, and then provide greater resources to the more successful agency. This, however, runs into the difficulty that agencies may withhold information from each other in order to gain an advantage in such competition.