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December 5, 2007

Economist's View - 6 new articles

Stepping in Fertilizer

I meant to note this earlier, but didn't and Felix beat me to it. After I posted a recent article about the use of fertilizer in Malawi with the lead in of "This is very Rodrikian. It's also Sachsian", I wondered, on second thought, if the either statement was true (Felix says it's 50% correct). I assumed that if it wasn't, Dani Rodrik would say so - he hasn't been shy about things like that - and today a response of sorts appeared on his blog. This isn't his post, it's by a guest blogger (Maggie McMillan), but since I made the assertion I thought I should also run this response to the NY Times article:

Ending famine, by ignoring the experts?, by Maggie McMillan: According to the NYT, the experts (aka the World Bank) have been pressing African governments to get rid of fertilizer subsidies. This, the article claims, has been a big mistake. The experience of Malawi proves it: farmers in Malawi experienced record harvests as a result of subsidized fertilizer use, and this could be replicated elsewhere to fight hunger across Africa. ...

Low fertilizer use is indeed one of the Africa's most vexing challenges. But subsidizing is only a band-aid, masking its high cost and low productivity without sustaining growth. Such band-aids can be useful, but they can also be a distraction, drawing attention away from the interventions needed for large-scale improvements.

Much can be learned from looking across African countries. In a recent study, economists at Michigan State University found that between 1980 and 2000 fertilizer use increased in a number of African countries, and was stagnant or declined in others. Overall use is low, but variability in fertilizer use is driven by local factors more than blanket World Bank policy.

Will Masters explains fertilizer use in terms of both prices and productivity. His survey paper points to Africa's relatively high cost of transport to farms, high cost of capital over the growing season, plus low and variable physical productivity due to poorly-adapted seed varieties in the context of low and variable rainfall.

Dr. Masters and his colleagues at Purdue University did one of the first studies of Malawi's fertilizer subsidy program, when it was first introduced. They predicted the high payoff reported in the NYT article, but found that it had little to do with the fertilizer subsidy as such. Most of the effect comes from the improved seed that accompanied the fertilizer, and from overcoming Malawian farmers' credit constraints.

Without underlying change, warns Dr. Dick Sserunkuuma, an economist at Makerere University in Kampala, farmers do not benefit enough from the fertilizer to make the subsidy an effective development strategy. The article makes it sound like farmers in Malawi can achieve international levels of competitiveness simply by applying fertilizer. This is simply not true. Adding fertilizer without improved seed may increase yields, but at a high cost.

The World Bank has given out lots of loans to African governments for fertilizer and it has good reason to be cautious. For example, in an effort to stave off famine and reduce Ethiopia's dependence on food aid, in 1995 the World Bank gave two loans to the government of Ethiopia totaling $164 million to support fertilizer use. Fertilizer use increased quite a bit, and with good rains in 2000/2001 there was a record harvest and maize prices plummeted. I was there that year and the sad joke was that farmers had come all the way to Addis to beg on the streets for money to repay their fertilizer loans. Inputs can be productive without being profitable. In Ethiopia the government tried to force farmers to repay their loans, causing enormous hardship.

Fertilizer use would be more productive if infrastructure was better, and transport costs were lower. Improvements in infrastructure are very expensive, however, and there is already a high level of investment so marginal returns are low. The highest marginal returns are almost certainly to increased investment in crop genetic improvement, which raises the payoff to everything else.

More fertilizer use is clearly an important part of poverty-alleviation success stories around the world, driven by the spread of improved seed and favorable market conditions. Subsidized fertilizer can raise output only temporarily. So there is certainly scope for increased fertilizer use in Africa, but it is not the magic bullet that the NYT headline would have us believe.

Rogoff: Dog Days for the Super Dollar

Kenneth Rogoff on a popular topic recently, the dollar, where it's headed, and whether we are going with it. His conclusion is that unless "the US gets its act together soon," there could be trouble ahead:

Dog days for the super dollar, by Kenneth Rogoff, Project Syndicate: Is the United States' position as the world's dominant superpower at risk if the dollar loses its super-currency status? Maybe not, but Americans will certainly find global hegemony a lot more expensive if the dollar falls off its perch.

Until now, Americans have been raking in profits by borrowing cheaply from pliant foreigners and investing the money in high-yield foreign equities, land, and bonds. Counting capital gains, Americans have profited to the tune of $300bn to $400bn annually in many recent years...

[T]he really big bucks come from the fact that places like the People's Bank of China and the Bank of Japan passively hold enormous volumes of low-interest US debt, while Americans romp around the world with venture capital, private equity, and investment banks, reaping huge gains.

It has been a great ride for the US, and America's financial supremacy has certainly eased the burden of being a superpower. But, between the sub-prime US mortgage crisis and the dollar's ongoing decline, America's exorbitant privilege now looks a bit shaky.

The dollar is already down 25% over the past five years, and if the US tips into recession - a 50/50 chance right now - the dollar is going to drop a lot more. Foreign investors are already reshuffling their portfolios, moving into euros, pounds, and even emerging-market currencies... Controversial "sovereign wealth funds" ... are just one manifestation of the search for alternatives to low-yielding, rapidly depreciating, dollar bonds.

Even without any portfolio shift, Americans shouldn't expect their recent luck to hold up in the future. If there is a global downturn, any region that is long stocks and short bonds is going to get burned.

Unfortunately, faced with the growing risks to the dollar's status, ... the ... US government itself has taken advantage by running vast deficits. The Federal Reserve appears to care about exchange rates only to the extent that they affect growth and inflation, and right now the weak dollar is helping US exports. Last but not least, US tax policy hardly encourages private-sector savings...

Professor Maury Obstfeld of the University of California at Berkeley and I have been warning for some time that without pro-active policy adjustments, the dollar is vulnerable to a sharp collapse, with many attendant risks. Unfortunately, that scenario now seems to be unfolding.

This year alone, the dollar's value has fallen by another 10% in purchasing power terms against America's major trading partners, and it could fall at the same rate in 2008 - or faster if global investors decide to cut and run. ...

The good news for Americans is that there is enormous inertia in the world trading and financial system. It took many decades and two world wars before the British pound lost its super-currency status. Nor is there any obvious successor to the dollar yet. Indeed, the sub-prime crisis has made the European financial system look just as vulnerable as that of the US. ...

But danger signs abound. Unless the US gets its act together soon, it may find the value of its super-currency franchise much diminished. ...

Is it Moral to Knowingly Send Borrowers into Default?

I have a question. Suppose you are a mortgage loan officer, and you have been assigned to the subprime loan division.

You look through the statistics and find that, using your firm's criteria, if you loan to people who are subprime 15% are going to have serious troubles and default, but 85% will not. Fortunately, even with a 15% default rate, with the interest rate you are charging on these loans, the loans are still profitable to the firm (but wouldn't be if the default rate went up, but we'll hold the default rate constant for this exercise). If you could sort people into those who will default and those who won't you would, but a priori, given the information at your disposal, there's no way to do that.

So here's the situation. If you make the loans - which is profitable for both you and the firm since you are on commission - you will be sending 15% of your customers into a troubled situation, but 85% will do just fine.

If we take an asymmetrical information approach, as is common, i.e. that borrowers know more about their ability to repay then lenders, then some of these loans that go into default are due to borrowers knowingly getting in over their heads. But that won't be true in every case, perhaps not even in most cases, so there are quite a few loan customers who will find themselves, unexpectedly, in serious trouble.

Should you feel guilty about making these loans? Is it ethical to make them at all, i.e. to knowingly send 15% of your customers into foreclosure (even though you don't know for sure who it will be)? It's hard to imagine the government allowing any other product to be sold that would, upon bringing it home, cause serious difficulty in the lives of 15% of the customers, so why is this different? If you think it's okay to make these loans, would your answer change if, say, the chances of repaying/defaulting were 50-50 or worse? Is it okay no matter the default rate so long as it's profitable? I have a feeling that different answers to this question explain a lot about who we think ought to be held accountable for the subprime mess.

I would make the loans even though 15% of them would cause people trouble. So long as the loans remains profitable, and they are not sold fraudulently so that people enter willingly and with full knowledge of the probability of default, I would accept an even higher default rate. Does that make me a bad person? I get the feeling some people think loan officers should only make loans when there is a very high probability of repayment - near 100% - but I can't agree with that as it would prevent an awful lot of people from purchasing a home. But it does seem like as the default rate increases, there comes a point when the default rate is sufficiently high so as to make one wonder about the morality of making the loans even if they remain profitable. If two-thirds of my customers would be completely ruined from purchasing my product, I might wonder about that. So why is 15% okay? Is it because the 85% of the customers who benefit more than compensate for the 15% who do not? That's my answer.

What do you think? [Update: Mostly, so far, you think I missed the boat, in particular that the real question is the morality of steering people into loans that are more profitable for the firm, but are not as good for the borrower, something that relies on asymmetric information, but here it's the lender who has superior information about loan products, loan risks, and eligibility (is this like steering a customer to purchase a sports car that is more profitable for the firm even though another, safer, lower monthly payment model fits the customer better, or is it fundamentally different?).]

Feldstein: How to Avert a Recession

Marty Feldstein says it's time to use both monetary and fiscal policy to deal with the weakness in the economy:

How to Avert Recession, by Martin Feldstein, Commentary, WSJ: The American economy is now very weak and could get substantially weaker. Current economic conditions call for lowering interest rates and for enacting a tax cut now that is conditioned on economic developments in 2008. More generally, fiscal policy should be considered in the future whenever there is a risk that an excessively easy monetary policy could cause an asset-price bubble. ...

Almost every economic indicator -- including credit conditions, housing and consumer sentiment -- has deteriorated significantly since the Federal Reserve's October meeting. In my judgment, the probability of a recession in 2008 has now reached 50%. If it occurs, it could be deeper and longer than the recessions of the recent past.

Further interest-rate cuts can reduce the risk of recession and increase output and employment in 2008 and 2009. The current 4.5% fed-funds rate is essentially neutral... Although there are risks that the rise in oil prices and the falling dollar will raise the inflation rate, the ... Fed should reduce the fed-funds rate at its December meeting and continue cutting toward 3% in 2008, unless there is a clear sign of an economic improvement.

Because of current credit market conditions, there is a risk that interest rate cuts will not be as effective in stimulating the economy as they were in the past. ...

But rate cuts can still help. Lower interest rates will still reduce monthly interest payments for the one-third of homeowners who have adjustable rate mortgages, thus freeing up cash to spend on other things. When banks make new loans, they will do so at lower interest rates, encouraging more business and household borrowing.

Yet more than lower interest rates is needed. Fed Chairman Ben Bernanke signaled a desire for additional policies to reinforce monetary easing when he called for a dramatic temporary rise in the maximum size of eligible Fannie Mae and Freddie Mac mortgages -- to $1 million from the current $417,000. While this would help to stimulate the market for high-priced homes, it would cause these government-sponsored lenders to assume an even greater share of the U.S. housing market when there is a strong fundamental case for reducing their role. And why should American taxpayers provide an implicit guarantee to mortgages of up to $1 million when the average sale price of a home is now less than $250,000?

In a similar attempt to go beyond Fed easing, the head of the FDIC recently proposed that the government impose an across-the-board limit on the mortgage interest increases that are now scheduled to occur. With more than $350 billion of mortgages scheduled to adjust up in 2008, such an imposed limit could no doubt avoid many personal defaults. But arbitrarily changing the terms of mortgages ... would also destroy the credibility of American private debt. Who would invest in U.S. bonds or mortgages if the government could arbitrarily reduce the contracted interest payments?

What's really needed is a fiscal stimulus, enacted now and triggered to take effect if the economy deteriorates substantially in 2008. There are many possible forms of stimulus, including a uniform tax rebate per taxpayer or a percentage reduction in each taxpayer's liability. There are also a variety of possible triggering events. The most suitable of these would be a three-month cumulative decline in payroll employment. The fiscal stimulus would automatically end when employment began to rise or when it reached its pre-downturn level.

Enacting such a conditional stimulus would have two desirable effects. First, it would immediately boost the confidence of households and businesses since they would know that a significant slowdown would be met immediately by a substantial fiscal stimulus. Second, if there is a decline of employment (and therefore of output and incomes), a fiscal stimulus would begin without the usual delays of the legislative process. ....

The excessive asset-price increases caused by some past monetary expansions -- especially the induced rise in the prices of real estate -- provide a further reason to use fiscal as well as monetary policy. By cutting the fed-funds rate to just 1% in 2003 and promising that it would be raised only slowly, the Fed contributed to the sharp rise in house prices and the market's current weakness. A mixed strategy that included a prospective fiscal stimulus would have reduced the Fed's perceived need for a sustained negative real fed-funds rate, and would therefore have produced a more balanced expansion of demand. Now is surely a time for such a two-part strategy of expansion.

If we go the temporary fiscal policy stimulus route, which can occur through either an increase in government spending or a decrease in taxes, there is a reason to prefer increased spending. A tax cut creates an incentive for households to increase consumption, but there is no guarantee that they will, e.g. they could just retire debt instead. This is just the familiar split of a change in taxes and hence disposable income into a change in consumption and a change in saving, and most of the time consumption and hence aggregate demand will increase when taxes are cut, but we can't be sure in advance how a tax cut will be used. In addition, when the tax cut is temporary, as this one would be, the impact on consumption is generally lower than with a permanent change in taxes.

With government spending, however, the impact on aggregate demand is assured. A change in government spending impacts aggregate demand directly on a dollar for dollar basis so there is no uncertainty at all about whether or how much aggregate demand will increase with a change in fiscal policy. And, with all of our infrastructure needs, it's not as though we can't find places where government spending could increase output and employment and also improve our public capital (there are many other ways spending could help as well, infrastructure enhancement is not our only need).

So, I agree that we may need to try fiscal policy, but I don't see why temporary tax cuts should be preferred to temporary increases in spending. In fact, here's Greg Mankiw on this point. This is from his textbook Macroeconomics (5th ed., pg. 454) and it explains why temporary changes in taxes are not very useful for stimulating the economy:

The permanent-income hypothesis can help us to interpret how the economy responds to changes in fiscal policy. According to the IS-LM model..., tax cuts stimulate consumption and raise aggregate demand, and tax increases depress consumption and reduce aggregate demand. The permanent-income hypothesis, however, predicts that consumption responds only to changes in permanent income. Therefore, transitory changes in taxes will have only a negligible effect on consumption and aggregate demand. If a change in taxes is to have a large effect on aggregate demand, it must be permanent. ... The lesson to be learned ... is that a full analysis of tax policy must ... take into account the distinction between permanent and transitory income. If consumers expect a tax change to be temporary, it will have a smaller impact on consumption and aggregate demand.

[Update: William Polley continues the discussion. Update: Free Exchange also comments.]

"Why Subprime Auto Loans Default"

This research looks at the reasons for default in the subprime auto loan market:

Why Supbprime Auto Loans Default, by Les Picker, NBER Digest: Access to credit markets is generally considered a hallmark of developed economies. In the United States, most households appear to have substantial ability to borrow. As of September 2007, U.S. households had a total of more than $2.4 trillion in non-mortgage debt. Still, economists often point to limited borrowing opportunities, or liquidity constraints, to explain certain findings about consumption behavior, labor supply, and the demand for credit.

In "Liquidity Constraints and Imperfect Information in Subprime Lending" (NBER WP 13067), authors William Adams, Liran Einav, and Jonathan Levin use unique data from a large U.S. auto sales company to study credit market conditions for precisely the population that is most likely to have a difficult time borrowing: those with low incomes and poor credit histories. These consumers, who typically cannot qualify for regular bank loans, comprise the so-called sub-prime market. The authors combine proprietary data on loan applications, transactions, and repayment records from 2001 to 2004 to provide a snapshot of the market, to analyze consumer borrowing behavior, and to document the informational problems facing sub-prime lenders.

The authors use the data to document two important facts about the market. The first is that this population of consumers appears highly sensitive to cash-on-hand, or liquidity-constrained. The second is that imperfect information substantially constrains lenders in extending credit to this population.

The loan applicants in this dataset fall toward the bottom of both the income distribution and the distribution of credit scores. The U.S. median household income is on the order of $30,000 dollars; less than half of the company's loan applicants have a Fair Isaac (FICO) score above 500, whereas the national median is over 700. These kinds of low credit scores indicate either a sparse or checkered credit record. Nearly a third of the loan applicants have neither a checking nor a savings account.

The company's transaction records indicate a high demand for borrowing. The average purchaser finances around 90 percent of the price of the automobile, with the average loan size being around $11,000. Repayment is highly uncertain: more than half of the loans default, and the majority of these default within the first year of repayment. Interest rates reflect the high probability of default: a typical loan in the authors' dataset has an annual interest rate on the order of 25-30 percent.

The evidence on liquidity constraints comes in two forms. First, the authors document a striking degree of seasonality in purchasing: demand is almost 50 percent higher in February, when consumers receive tax rebate checks, than in other months. This seasonal spike in demand correlates closely with eligibility for the earned income tax credit. Second, the authors estimate that consumers' purchasing decisions are much more sensitive to immediate down payment requirements than to changes in the price of the car, which can be financed. Without liquidity constraints, only an inordinately high degree of impatience would explain these differing sensitivities.

The authors then use the data on borrowing and repayment behavior to estimate the informational problems facing lenders. They estimate that, all else equal, extending a given buyer an additional $1000 in credit increases the default rate on the loan by around 15 percent. This kind of sensitivity of repayment to loan size is the driving force in moral hazard models of credit imperfections. At the same time, a buyer who chooses to finance an extra $1000 of her purchase (that is, who self-selects into a larger loan) has an even greater default rate, around 24 percent higher than a buyer who opts to pay the $1000 dollars upfront. In other words, the decision to finance more heavily reveals additional adverse information about the likelihood of default, as in standard models of adverse selection.

The authors do not provide a welfare analysis or specific evidence on the growth in sub-prime lending that has occurred over the last decade. The last part of their paper finds that modern credit scoring techniques can go a significant distance toward mitigating adverse selection problems in the credit market, which suggests that innovations in this area may be related to the rise in sub-prime lending. Such credit scoring is less likely to mitigate moral hazard problems in repayment, thereby still restricting credit to sub-prime borrowers.

links for 2007-12-05

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