The Lessons of Black Monday


February 13, 2018

The Lessons of Black Monday

by Barry Eichengreen

https://www.project-syndicate.org/commentary/stock-market-lessons-of-black-monday-by-barry-eichengreen-2018-02

“Will Trump respond like FDR in 1933, reassuring the public that the only thing we have to fear is fear itself? Or will he look for someone to blame for the collapse in his favorite economic indicator and lash out at the Democrats, foreign governments, and the Fed? A president who plays the blame game would only further aggravate the problem.”-Barry Eichengreen
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When interpreting sharp drops  in stock prices and their impact, many will think back to 2008 and the market turbulence surrounding Lehman Brothers’ bankruptcy filing. But a better historical precedent for current conditions is the huge one-day drop on October 19, 1987.

 

BERKELEY – US President Donald Trump has regularly pointed to the stock market as a source of validation of his administration’s economic program. But, while the Dow Jones Industrial Average (DJIA) has risen by roughly 30% since Trump’s inauguration, the extent to which the market’s rise was due to the president’s policies is uncertain. What is certain, as we have recently been reminded, is that what goes up can come down.

When interpreting sharp drops in stock prices and their impact, many will think back to 2008 and the market turbulence surrounding Lehman Brothers’ bankruptcy filing. But a better historical precedent for current conditions is Black Monday: October 19, 1987.

Black Monday was a big deal: the 22.6% price collapse is still the largest one-day percentage drop in the DJIA on record. The equivalent today would be – wait for it – 6,000 points on the Dow.

In addition, the 1987 crash occurred against the backdrop of monetary-policy tightening by the US Federal Reserve. Between January and October 1987, the Fed pushed up the effective federal funds rate by nearly 100 basis points, making it more expensive to borrow and purchase shares. In the run-up to October 2008, by contrast, interest rates fell sharply, reflecting a deteriorating economy. That is hardly the case now, of course, which makes 1987 the better analogy.

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Treasury Secretary Steven Mnuchin

The 1987 crash also occurred in a period of dollar weakness. Late in the preceding week, Treasury Secretary James Baker made some remarks that were interpreted as a threat to devalue the dollar. Like current Treasury Secretary Steven Mnuchin at Davos this year, Baker could complain that his comments were taken out of context. But it is revealing that the sell-off on Black Monday began overseas, in countries likely to be adversely affected by a weak dollar, before spreading to the US.

Finally, algorithmic trading played a role. The algorithms in question, developed at the University of California, Berkeley, were known as “portfolio insurance.” Using computer modeling to optimize stock-to-cash ratios, portfolio insurance told investors to reduce the weight on stocks in falling markets as a way of limiting downside risk. These models thus encouraged investors to sell into a weak market, amplifying price swings.

Although the role of portfolio insurance is disputed, it’s hard to see how the market could have fallen by such a large amount without its influence. Twenty-first-century algorithmic trading may be more complex, but it, too, has unintended consequences, and it, too, can amplify volatility.

Despite all the drama on Wall Street in 1987, the impact on economic activity was muted. Consumer spending dropped sharply in October, owing to negative wealth effects and heightened uncertainty, but it quickly stabilized and recovered, while investment spending remained essentially unchanged.

What accounted for the limited fallout? First, the Fed, under its brand-new chairman, Alan Greenspan, loosened monetary policy, reassuring investors that the crash would not create serious liquidity problems. Market volatility declined, as did the associated uncertainty, buttressing consumer confidence.

Second, the crash did not destabilize systemically important financial institutions. The big money-center banks had used the five years since the outbreak of the Latin American debt crisis to strengthen their balance sheets. Although the Savings & Loan crisis continued to simmer, S&Ls were too small, even as a group, for their troubles to impact the economy significantly.

What, then, would be the effects of an analogous crash today? Currently, the US banking system looks sufficiently robust to absorb the strain. But we know that banks that are healthy when the market is rising can quickly fall sick when it reverses. Congressional moves to weaken the Dodd-Frank Act, relieving many banks of the requirement to undergo regular stress testing, suggest that this robust health shouldn’t be taken for granted.

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Donald Trump’s cameo in the new movie Wall Street: Money Never Sleeps

Moreover, there is less room to cut interest rates today than in 1987, when the fed funds rate exceeded 6% and the prime rate charged by big banks was above 9%. To be sure, if the market fell sharply, the Fed would activate the “Greenspan-Bernanke Put,” providing large amounts of liquidity to distressed intermediaries. But whether Jay Powell’s Fed would respond as creatively as Bernanke’s in 2008 – providing “back-to-back” loans to non-member banks in distress, for example – is an open question.

Much will hinge, finally, on the president’s reaction. Will Trump respond like FDR in 1933, reassuring the public that the only thing we have to fear is fear itself? Or will he look for someone to blame for the collapse in his favorite economic indicator and lash out at the Democrats, foreign governments, and the Fed? A president who plays the blame game would only further aggravate the problem.

 

America’s extraordinary economic gamble –The Economist


February 13, 2018

The Economist

Souped up growth

America’s extraordinary economic gamble

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The mood of fiscal insouciance in Washington, DC, is troubling. Add the extra spending to rising pension and health-care costs, and America is set to run deficits above 5% of GDP for the foreseeable future. Excluding the deep recessions of the early 1980s and 2008, the United States is being more profligate than at any time since 1945.–The Economist

Fiscal policy is adding to demand even as the economy is running hot

Print edition | Leaders

Feb 8th 2018

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VOLATILITY is back. A long spell of calm, in which America’s stockmarket rose steadily without a big sell-off, ended abruptly this week. The catalyst was a report released on February 2nd showing that wage growth in America had accelerated. The S&P 500 fell by a bit that day, and by a lot on the next trading day. The Vix, an index that reflects how changeable investors expect equity markets to be, spiked from a sleepy 14 at the start of the month to an alarmed 37. In other parts of the world nerves frayed.

Markets later regained some of their composure (see article). But more adrenalin-fuelled sessions lie ahead. That is because a transition is under way in which buoyant global growth causes inflation to replace stagnation as investors’ biggest fear. And that long-awaited shift is being complicated by an extraordinary gamble in the world’s biggest economy. Thanks to the recently enacted tax cuts, America is adding a hefty fiscal boost to juice up an expansion that is already mature. Public borrowing is set to double to $1 trillion, or 5% of GDP, in the next fiscal year. What is more, the team that is steering this experiment, both in the White House and the Federal Reserve, is the most inexperienced in recent memory. Whether the outcome is boom or bust, it is going to be a wild ride.

Fire your engines

The recent equity-market gyrations by themselves give little cause for concern. The world economy remains in fine fettle, buoyed by a synchronised acceleration in America, Europe and Asia. The violence of the repricing was because of newfangled vehicles that had been caught out betting on low volatility. However, even as they scrambled to react to its re-emergence, the collateral damage to other markets, such as corporate bonds and foreign exchange, was limited. Despite the plunge, American stock prices have fallen back only to where they were at the beginning of the year.

Yet this episode does signal just what may lie ahead. After years in which investors could rely on central banks for support, the safety net of extraordinarily loose monetary policy is slowly being dismantled. America’s Federal Reserve has raised interest rates five times already since late 2015 and is set to do so again next month. Ten-year Treasury-bond yields have risen from below 2.1% in September to 2.8%. Stock markets are in a tug-of-war between stronger profits, which warrant higher share prices, and higher bond yields, which depress the present value of those earnings and make eye-watering valuations harder to justify.

This tension is an inevitable part of the return of monetary policy to more normal conditions. What is not inevitable is the scale of America’s impending fiscal bet. Economists reckon that Mr Trump’s tax reform, which lowers bills for firms and wealthy Americans—and to a lesser extent for ordinary workers—will jolt consumption and investment to boost growth by around 0.3% this year. And Congress is about to boost government spending, if a budget deal announced this week holds up. Democrats are to get more funds for child care and other goodies; hawks in both parties have won more money for the defence budget. Mr Trump, meanwhile, still wants his border wall and an infrastructure plan. The mood of fiscal insouciance in Washington, DC, is troubling. Add the extra spending to rising pension and health-care costs, and America is set to run deficits above 5% of GDP for the foreseeable future. Excluding the deep recessions of the early 1980s and 2008, the United States is being more profligate than at any time since 1945.

A cocktail of expensive stock markets, a maturing business cycle and fiscal largesse would test the mettle of the most experienced policymakers. Instead, American fiscal policy is being run by people who have bought into the mantra that deficits don’t matter. And the central bank has a brand new boss, Jerome Powell, who, unlike his recent predecessors, has no formal expertise in monetary policy.

Does Powell like fast cars?

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Jerome “Jay” Powell succeeds Janet Yellen as head of the Federal Reserve: To tighten or not to tighten, that is the question for Mr. Powell

What will determine how this gamble turns out? In the medium term, America will have to get to grips with its fiscal deficit. Otherwise interest rates will eventually soar, much as they did in the 1980s. But in the short term most hangs on Mr Powell, who must steer between two opposite dangers. One is that he is too doveish, backing away from the gradual (and fairly modest) tightening in the Fed’s current plans as a salve to jittery financial markets. In effect, he would be creating a “Powell put” which would in time lead to financial bubbles. The other danger is that the Fed tightens too much too fast because it fears the economy is overheating.

On balance, hasty tightening is the greater risk. New to his role, Mr Powell may be tempted to establish his inflation-fighting chops—and his independence from the White House—by pushing for higher rates faster. That would be a mistake, for three reasons.

First, it is far from clear that the economy is at full employment. Policymakers tend to consider those who have dropped out of the jobs market as lost to the economy for good. Yet many have been returning to work, and plenty more may yet follow (see article). Second, the risk of a sudden burst of inflation is limited. Wage growth has picked up only gradually in America. There is little evidence of it in Germany and Japan, which also have low unemployment. The wage-bargaining arrangements behind the explosive wage-price spiral of the early 1970s are long gone. Third, there are sizeable benefits from letting the labour market tighten further. Wages are growing fastest at the bottom of the earnings scale. That not only helps the blue-collar workers who have been hit disproportionately hard by technological change and globalisation. It also prompts firms to invest more in capital equipment, giving a boost to productivity growth.

To be clear, this newspaper would not advise a fiscal stimulus of the scale that America is undertaking. It is poorly designed and recklessly large. It will add to financial-market volatility. But now that this experiment is under way, it is even more important that the Fed does not lose its head.

This article appeared in the Leaders section of the print edition under the headline “Running hot”

The Era of Fiscal Austerity Is Over. Here’s What Big Deficits Mean for the US​ Economy.


February 11, 2018

The Era of Fiscal Austerity Is Over. Here’s What Big Deficits Mean for the US​ Economy.

Has Trumphoria Finally Hit a Wall?


February 6, 2018

Has Trumphoria Hit a Wall?Paul Krugman

When talking about stock markets, there are three rules you have to remember. First, the stock market is not the economy. Second, the stock market is not the economy. Third, the stock market is not the economy.

So the market plunge of the past few days might mean nothing at all. On one side, don’t assume that there was a good reason for the slide (although the fact that the Dow fell 666 points on Friday hints either at satanic forces or at some mystical link with the Kushner family’s bum investment at 666 Fifth Avenue). When stocks crashed in 1987, the economist Robert Shiller carried out a real-time survey of investor motivations; it turned out that the crash was essentially a pure self-fulfilling panic. People weren’t selling because some news item caused them to revise their views about stock values; they sold because they saw that other people were selling.

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And on the other side, don’t assume that the stock price decline tells us much about the economic future, either. The great economist Paul Samuelson famously quipped that the stock market had predicted nine of the past five recessions. That 1987 crash, for example, was followed not by a recession, but by solid growth.

Still, market turmoil should make us take a hard look at the economy’s prospects. And what the data say, I’d argue, is that at the very least America is heading for a downshift in its growth rate; the available evidence suggests that growth over the next decade will be something like 1.5 percent a year, not the 3 percent Donald Trump and his minions keep promising.

There are also suggestions in the data that risky assets in general — stocks, but also long-term bonds and real estate — may be overpriced. Leaving Bitcoin madness aside, we’re not talking dot-coms in 2000 or houses in 2006. But standard indicators are well above historically normal levels, and a reversion toward those norms could be painful.

About that plummet: If there was any news item behind it, it was Friday’s employment report, which showed a significant although not huge rise in wages. Now, rising wages are a good thing. In fact, the failure of wages to rise much until now has been a deeply frustrating deficiency in the otherwise impressively durable economic recovery that began early in the Obama administration.

But we’re now seeing fairly strong evidence that the U.S. economy is nearing full employment. The low measured unemployment rate is only part of the story. There’s also the growing willingness of workers to quit their jobs, something they don’t do unless they’re confident of finding new employment. And now wages are finally rising, suggesting that workers are gaining bargaining power, too.

Again, this is all good news. But it does mean that future U.S. growth can’t come from putting the unemployed back to work. It has to come either from growth in the pool of potential workers or from rising productivity, that is, more output per worker.

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Did the markets believe Trump? At the very least, they’ve been acting as if the U.S. economy still had lots of room to run; throwing cold water on that belief should mean both higher interest rates and lower stock prices, which is what we’re seeing.

But should we be worried about something worse than a mere downshift in growth? Well, asset prices do look high: A widely used gauge of stock valuations puts them at a 15-year high, while a conceptually similar measure says that housing prices have retraced a bit less than half the rise that culminated in the great housing bust.

Individually, these numbers aren’t that alarming: Stocks, as I said, don’t look nearly as overvalued as they did in 2000, housing not nearly as overvalued as it was in 2006. On the other hand, this time both markets look overvalued at the same time, at least raising the possibility of a double-bubble burst like the one that hit Japan at the end of the 1980s.

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Fed Chairman Jerome ‘Jay’ Powell– How well he would handle a crisis if one developed, asks Dr. Krugman

And if asset prices take a hit, we might expect consumers — who have been spending heavily and saving very little — to pull back. Still, all of this would be manageable if key policymakers could be counted on to act effectively. Which is where I get worried.

It’s surely not a good thing that Trump got rid of one of the most distinguished Federal Reserve chairs in history just before markets started to flash some warning signs. Jerome Powell, Janet Yellen’s replacement, seems like a reasonable guy. But we have no idea how well he would handle a crisis if one developed.

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Secretary of the Treasury–Steven Mnuchin

Meanwhile, the current Secretary of the Treasury — who declared of Davos, “I don’t think it’s a hangout for globalists” — may be the least distinguished, least informed individual ever to hold that position.

So are we heading for trouble? Too soon to tell. But if we are, rest assured that we’ll have the worst possible people on the case.

Image result for Paul KrugmanDr. Paul Krugman

 

John Cassidy on Janet Yellen’s Legacy–A Robust US Economy


February 2, 2017

John Cassidy on Janet Yellen’s Legacy–A Robust US Economy

by John Cassidy@www.newyorker.com

 

Dr. Janet Yellen, the Federal Reserve Board chair, is responsible for the economic success that Trump is taking credit for, but her successor will have to make some tricky calls.

During his State of the Union speech, on Tuesday night, Donald Trump took credit for the country’s strong rate of job creation, its rising wages, and the lowest unemployment rate in many years. Meanwhile, Janet Yellen, the person primarily responsible for these things, was preparing to leave her post as the chair of the Federal Reserve Board. On Wednesday, she chaired her final meeting of the central bank’s policy-making arm, and Friday will be her last day at the Fed.

On Monday morning, Jay Powell—a Republican, investment banker, and current member of the Fed’s board—will be sworn in as her successor. In a more just world, Yellen would have been given a second four-year term, as most of her (male) predecessors were. But late last year Trump decided to replace her with Powell.

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Jay Powell– an Investment Bank and Federal Reserve Board Member

Having spent fourteen years at the Fed, and having been the first woman to lead it in its hundred-and-five-year history, Yellen is leaving with a record of high achievement. A fiercely smart academic economist—she holds a Ph.D. from Yale—she served as a loyal and able deputy to her predecessor at the Fed, Ben Bernanke.

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Paul Volcker,  Alan Greenspan, Ben Bernanke and Janet Yellen

Upon taking the top job, she quickly demonstrated a mastery of the communicative and political skills that are necessary to run a large institution like the Fed. In speeches and at press conferences, she explained the Fed’s thinking clearly and carefully, doing her best not to lapse into the technical jargon beloved by economists. Her colleagues liked and respected her, and she charmed some key Republicans on Capitol Hill. (That helped to head off recent calls, emanating from some corners of the G.O.P., for an inquisitional audit of the Fed.)

She even got along well with Trump, a fellow-New York native. (Yellen grew up in Brooklyn.) Last November, when he announced that he would nominate Powell rather than keep Yellen for a second term, he said, “She’s a wonderful woman who’s done a terrific job.” This statement raised the question of why he didn’t leave Yellen in place. It was widely assumed that partisan politics were responsible: Yellen is a Democrat, and Barack Obama nominated her, in 2013. But there’s also another possibility. Trump may believe that, with Yellen out of the way, it will be easier for him to lay claim to some of her achievements.

These achievements include overseeing a historic period of job creation. “Under Yellen, the U.S. unemployment rate has fallen the most of any Fed chair term in modern history,” the Washington Post’s Heather Long pointed out last month.

In February, 2014, when Yellen took office, the unemployment rate was 6.7 per cent; today, it is 4.1 per cent. And almost three quarters of that decline came before Trump entered office.

It should also be noted that, when Yellen took office, most economists believed that an unemployment rate below five per cent, or thereabouts, would lead to inflation. If the unemployment rate fell below a certain key level, the textbooks said, prices would start rising. To head off an inflationary spiral, the Fed would have to step in and raise interest rates sharply—and such a move would risk a recession.

Yellen disputed this mechanistic view. Citing the fact that millions of people had ceased looking for jobs during and after the Great Recession of 2007-2009, she argued that the headline rate of unemployment was an inadequate measure of the state of the labor market, and that other metrics, such as the labor-force-participation rate, also needed to be taken into account.

More controversially, she also argued that there could be important benefits to the Fed running a “high-pressure economy,” in which the unemployment rate was kept low and new hires were hard to find. In such a situation, Yellen speculated, in a 2016 speech, workers who had dropped out of the labor force could be drawn back in, firms could be incentivized to make capital investments, over-all demand in the economy could be higher, and wages and productivity growth—which were languishing badly—could pick up

This argument harkened back to one made during the nineteen-sixties by an earlier generation of Keynesian economists, including James Tobin, Yellen’s thesis supervisor, and Nicholas Kaldor, the British theorist and policy adviser. With the rise of monetarism, new classical macroeconomics, and so-called New Keynesianism, this type of economics fell out of fashion. But, as Yellen perceived, it could perhaps hold the key to breaking the recent pattern of low growth, low rates of capital investment, and stagnant wages.

The experience of the past eight years shows that it took a big dip in the unemployment rate for median household incomes to recover some of the losses they had suffered during the recession. Only when the jobless rate fell below the level previously considered safe did hourly wages rise by more than the inflation rate. Yellen welcomed these developments and sought to extend them rather than choke off growth prematurely. Even now, in the ninth year of the post-2009 economic recovery, the federal funds rate is only 1.5 per cent. The rate of inflation, as indicated by the Fed’s preferred measure, is also just 1.5 per cent—below the Fed’s official target of two per cent.

It could be argued—and it has been argued—that, with such a low inflation rate, the Fed has no business raising rates, even slowly. However, a case can also be made that the Fed’s expansionary policies are responsible for a stock-market boom that is now turning into a bubble. Sensitive to both of these critiques, Yellen’s Fed has been removing the monetary stimulus slowly, in baby steps.

Thanks to Trump and the Republicans, the Fed now faces another challenge, in the form of an additional boost to the economy provided by a front-loaded tax cut. Should the Fed stick to its current policy stance and accommodate this new stimulus? Or should it perhaps accelerate its interest-rate hikes? Yellen won’t have to make that call. The onus will be on Powell, who must be keenly aware that any hint of the Fed adopting a more hawkish approach will bring down upon him a Presidential Twitter fusillade and more—including the possibility of disruptions in the markets. Yellen certainly deserved another term, but she may be getting out at the right time.

John Cassidy has been a staff writer at The New Yorker since 1995. He also writes a column about politics, economics, and more for newyorker.com

https://www.newyorker.com/news/our-columnists/after-four-years-of-high-achievement-janet-yellen-may-be-leaving-the-fed-at-the-right-time?mbid=nl_Daily 020118 Control&CNDID=49438257&spMailingID=12858345&spUserID=MTg4MDU2MzU5MDA5S0&

The Economics of Dirty Old Men by Paul Krugman


January 26, 2018

The Economics of Dirty Old Men by Paul Krugman

As a candidate, Donald Trump talked incessantly about international trade and how he was going to make America great again by renegotiating trade agreements, forcing foreigners to stop taking away our jobs. But during his first year in office, he did almost nothing on that front — possibly because corporate America managed to inform him that it has invested a lot of money based on the assumption that we would continue to honor Nafta and other trade agreements, and would lose bigly if he broke them.

This week, however, Trump finally did impose tariffs on washing machines and solar panels. The former tariff was, I think, more about looking tough than about any kind of strategic objective. The latter, however, fits in with an important part of this administration’s general vision. For this is very much an administration of dirty old men.

About washing machines: The legal basis of the new tariff is a finding by the United States International Trade Commission that the industry has been injured by rising imports. The definition of “injury” is a bit peculiar: The commission admitted that the domestic industry “did not suffer a significant idling of productive facilities,” and that “there has been no significant unemployment or underemployment.” Nonetheless, the commission argued that production and employment should have expanded more than it did given the economy’s growth between 2012 and 2016 (you know, the Obama-era boom Trump insisted was fake).

If this seems like a flimsy justification for an action that will significantly raise consumer prices, that’s because it is. But Trump decided to do it anyway.

The solar panel tariff is more interesting, and more disturbing, because it will surely destroy many more jobs than it will create.

The fact is that the U.S. is largely out of the solar panel-producing business, and whatever the reasons for that absence, this policy won’t change it. Like the washing-machine tariff, the solar-panel tariff was imposed using what’s known in trade policy circles as the “escape clause” — rules that allow temporary protection of industries suffering sudden disruption. The operative word here is “temporary”; since we’re not talking about sustained protection, this tariff won’t induce any long-term investments, and therefore won’t bring the U.S. solar panel industry back.

What it will do, however, is put a crimp in one of the U.S. economy’s big success stories, the rapid growth of renewable energy. And here’s the thing: Everything we know about the Trump administration suggests that hurting renewables is actually a good thing from its point of view. As I said, this is an administration of dirty old men.

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House Speaker Paul Ryan

Over the past decade or so there has been a remarkable technological revolution in energy production. Part of that revolution has involved the rise of fracking, which has made natural gas cheap and abundant. But there have also been stunning reductions in the cost of solar and wind power.

Some people still think of these alternative energy sources as hippy-dippy stuff that can’t survive without big government subsidies, but the reality is that they’ve become cost-competitive with conventional energy, and their cost is still falling fast. And they also employ a lot of people: Over all, there are around five times as many people working, in one way or another, for the solar energy sector as there are coal miners.

But solar gets no love from Trump officials, who desperately want the country to stay with dirty old power sources, especially coal. (Wait — when I called them dirty old men, did you think I was talking about payoffs to porn stars? Shame on you.) They’ve even rewritten Energy Department reports in an attempt to make renewable energy look bad.

They’ve tried to turn their preference for dirty energy into concrete policy, too. Last fall, Rick Perry, the energy secretary, tried to impose a rule that would in effect have forced electricity grids to subsidize coal and nuclear plants. The rule was shot down, but it showed what these guys want. From their point of view, destroying solar jobs is probably a good thing.

Why do Trump and company love dirty energy? Partly it’s about the money: what’s good for the Koch brothers may not be good for America (or the world), but it’s good for G.O.P. campaign finance. Partly it’s about blue-collar voters, who still imagine that Trump can bring back coal jobs. (In 2017 the coal industry added 500, that’s right, 500 jobs. That’s 0.0003 percent of total U.S. employment.)

It’s also partly about cultural nostalgia: Trump and others recall the heyday of fossil fuels as a golden age, forgetting how ghastly air and water pollution used to be. But I suspect that it’s also about a kind of machismo, a sense that real men don’t soak up solar energy; they burn stuff instead.

Whatever the specific motivations, the administration’s first significant trade policy move is stunningly boneheaded. You shouldn’t even call it protectionism, since its direct effect will be to destroy far more jobs than it creates. Plus it’s bad for the environment. So much winning!

Image result for The Economics of Dirty Old MenNobel Laureate in Economics–Paul Krugman

 

A version of this op-ed appears in print on January 26, 2018, on Page A23 of the New York edition with the headline: The Economics Of Dirty Old Men.