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December 15, 2007

Economist's View - 9 new articles

"Time to Reexamine Time"

Taking a momentary break from the subprime crisis, the fall in the dollar, the distribution of income and wealth, the Fed, tax cuts, and so on, here's something on the nature of time:

Making Space for Time, by Scott Dodd, Scientific American: ...Many of the world's top theoretical physicists and cosmologists gathered ... to grapple with the mystery of how time works. New telescope observations and novel thinking about quantum gravity have convinced them that it is time to reexamine time. ...

On the face of it, time seems pretty simple, like a one-way street: eggs don't unscramble, ... and your grandparents will never be younger than you. But the universe's basic laws appear to be time-symmetrical, meaning they are unaffected by the direction of time. From the point of view of physics, the past, present and future exist simultaneously.

For more than a century, physicists have proposed any number of explanations for this apparent contradiction, from the psychological (the flow of time is an illusion) to the physical (some unknown property of quantum mechanics reconciles the contradiction). None has proved satisfactory. In 1927 astrophysicist Sir Arthur Eddington coined the term "time's arrow" for the phenomenon and linked it to entropy: as the universe gets older, it becomes more disordered, following the second law of thermodynamics. But scientists cannot explain why order lies in the past and disorder in the future. ...

Laura Mersini-Houghton, a physicist at the University of North Carolina at Chapel Hill [says]... "It's been very difficult to make progress over the past 20 years, because there hasn't been much new to say." That is all changing thanks to stronger instruments for probing the heavens. The cosmic microwave background radiation, a remnant of the big bang, shows that 380,000 years after its birth, the universe was filled with hot gas, all evenly distributed and highly ordered. Eventually the early cosmos underwent inflation and began to coalesce into the disordered universe of stars and atoms we know today.

What remains puzzling, though, is why the early universe was so orderly—a condition that physicists consider highly improbable—and what caused it to swell so rapidly. "The arrow-of-time problem, once you get down to the nitty-gritty of it, is, Why was the early universe the way it was?" says Sean Carroll, a cosmologist at the California Institute of Technology. ...

Prominent physicists ... invoked string theory, black hole equations and the idea that we live in one of many parallel universes as possible explanations.

The multiverse concept emerged as one of the more favored—or at least frequently talked about—theories for the strange tidiness of the early cosmos. "If you accept the idea that this might be only one of many possible universes, then that makes it more plausible," Mersini- Houghton says. Universes that started out more chaotic might not have survived or evolved to support intelligent life. So one-way time—and our entire existence, for that matter—could be just a happenstance. ...

FRB Minneapolis: Interview with Eugene Fama

Eugene Fama on ratings agencies and problems in mortgage markets:

Interview with Eugene Fama, by Douglas Clement, The Region. FRB Minneapolis: ... Region: Some observers have suggested that regulators and others have put too much reliance on ratings agencies to determine the risk of mortgage-backed securities and that even financially sophisticated parties "didn't really know what they were buying." Is this evidence that credit markets are inefficient?

Fama: That story just doesn't appeal to me. First of all, it's well known that rating agencies tend to lag actual changes in credit worthiness. For example, stock prices predict changes in ratings better. The best models of credit quality are basically options pricing models that work off the stock price. So I'm very skeptical of these stories. The bond market is a simpler market than the stock market. Bonds are simpler to evaluate than stocks, because there's downside risk, but you don't have to worry much about the upside: They're not going to pay you more than they promised. So bonds are much simpler to deal with. Now bond products have become more complicated because of the securitization of that market, but still not that big a deal. [entire interview]

FRB Dallas: National Economic Outlook

John V. Duca and Jessica J. Renier of the Dallas Fed with the outlook for the national economy:

National Economic Update: Economy Slowing After a Strong Third Quarter, FRB Dallas: Third Quarter GDP Revised Upward Real GDP growth in the third quarter was revised up from 3.9 to 4.9 percent, with 0.6 and 0.4 percentage points of the improvement owing to upward revisions in inventory investment and net exports, respectively. All major categories posted gains, with the exception of residential investment, whose declines intensified and cut more than 1 percentage point from overall GDP growth (Chart 1).

Chart 1: Revisions to third quarter GDP

Slow Start to Fourth Quarter Growth Both forward-looking indicators and early quarter reports suggest that growth slowed considerably in the fourth quarter. The index of leading economic indictors has declined a cumulative 1.3 percent since July (Chart 2), reflecting weakened domestic demand in the wake of the financial and credit market turmoil that erupted in August. Indeed, manufacturing output fell in October, suggesting production cutbacks may have been under way early in the quarter in an effort to reduce excess inventories amid signs of slower gains in consumer spending. Business investment appears to be growing more slowly, as suggested by some softness in October nondefense capital goods orders (excluding aircraft).

Chart 2: Leading indicators suggest slow economic growth so far

Financial Frictions Continue to Emerge Junk, investment-grade, commercial paper and London Interbank Offered Rate (LIBOR) spreads have all risen over recent months. Specifically, both commercial paper and junk bond spreads have jumped sharply in recent weeks, with junk bond spreads surging above their post-1987 averages (Chart 3). Asset-backed commercial paper outstanding has continued to decline, falling by about one-third since midsummer. Additionally, after easing in late October, LIBOR spreads have noticeably widened, implying higher costs for banks to fund loans, especially business loans whose rates are indexed to the LIBOR. Ten-year Treasury bond yields fell further in November, while investment-grade corporate yields and interest rates on conforming 30-year fixed-rate mortgages barely budged.

Chart 3: Spreads between junk and Treasury bond yields jump sharply since 2007

October brought evidence of further tightening of credit standards. While senior loan officers at banks reported tightening credit standards for real estate loans before the late-summer financial turmoil, a notably higher number reported doing so in October. Likewise, whereas few banks reported tightening credit standards for commericial and industrial (C&I) loans and only some for consumer loans over the three months leading into July, a higher number indicated doing so in the October survey. It is unclear whether this result is merely a one-time reaction to financial market turmoil that might unwind quickly or if it will be longer-lasting.

Housing Market Continues to Deteriorate So far, overall weakness in the economy remains concentrated in manufacturing, housing and mortgage-related industries. While new-home sales ticked up 1.7 percent in October, the slight improvement was dwarfed by a 7 percent downward revision to September levels and a sizable downward revision to August as well. Single-family building permits and construction have continued on a steep decline (Chart 4), and multifamily permits have continued to trend lower over the past year. Many housing indicators point to further deterioration in this sector, with increased evidence of home price declines. Outside of housing, indications of declining demand for and tighter credit standards on commercial real estate loans suggest deceleration in the growth of commercial construction may also continue.

Chart 4: Permits point to slowing home construction

Employment Growth Sagged Slightly in November The unemployment rate remained unchanged from September's 4.7 percent, and average hourly wages have continued rising at around a 3.8 percent pace from a year earlier. Recent data on continuing and initial claims for unemployment suggest that firings had not notably increased through late November, but hiring may have slowed some. Payroll employment rose 94,000 in November following an increase of 170,000 in October and a downwardly revised gain of 44,000 in September. Payroll growth has been especially muted in the private sector, where three of the last four months have posted numbers under 100,000 (Chart 5).

Chart 5: Payroll growth sagging below 100k per month

Reflecting further weakness in homebuilding, employment in housing and mortgage-related sectors showed notable declines of about 51,000, with job losses of 20,000 in home construction, 13,000 in credit intermediation, 11,000 in real estate and 7,000 in wood products. Further declines in construction jobs are suggested by the downslide in the number of homes under construction.

Net Exports May Cushion Slowdown Private domestic demand growth has slowed in recent quarters, as reflected in the year-over-year growth of GDP excluding government spending and net exports (Chart 6). On the other hand, one major bright spot for overall GDP growth has been an improvement in the trade balance. Indeed, 0.4 percent of the 1 percent upward revision to real GDP growth in the third quarter was due to a revision in net exports. Nevertheless, it is unclear to what degree net export growth will be able to offset a slowing of private domestic demand in late 2007 and early 2008.

Chart 6: Domestic private GDP grown has moderated mor than overall GDP growth

Core and Trimmed Mean Inflation Steadied Near 2 Percent While overall PCE and CPI year-over-year inflation rates surged in October, core and trimmed mean inflation rates appear to have steadied near 2 percent in recent months. Although there has been some recovery in productivity growth, it is unclear whether further progress in reducing inflation in the near term will be possible in the face of higher commodity and oil prices coupled with downward pressure on the dollar (Chart 7). Various measures consistently indicate that expected long-term inflation remains in a range between 2 and 2.5 percent.

Chart 7: Overall PCE & CPI inflation rise with oil prices again

Is Stephen Moore "That Stupid"?

I'm very pleased that the press seems to finally be getting it: tax cuts have not paid for themselves. Politicians too, for the most part anyway, but there is one notable exception noted below. Justin Fox has a nice write-up, as does Avi Zenilman at Politico who summarizes the positions of Republican candidates on the "tax cuts pay for themselves"claim and reviews academic work on this issue:

Continuing with the 'shameless commie propaganda' on tax cuts and revenues, by Justin Fox: The comment screening software here seems to have gone hyperactive in the past few days... I will try to fish regularly in the junkpile, where I find gems like this comment to one of my Arthur Laffer posts from alex:

Shameless Commie Propaganda (I simply refuse to believe that you are that stupid)

1. Mr. Laffer did state the evident and nothing else: (1) if government will collect 100% nobody will show up for work, (2) if government won't collect nothing it will have no revenues and (3) there is a maximum somewhere in between.

2. So "diminishing returns" is far from being the biggest danger of raising taxes, the biggest dangers is sliding into area of negative impact on Laffer's curve.

3. Tax cuts did paid for themselves: e.g. in 1984 federal revenue were greater than in 1982 and grew up until 2001 and again after tax cut of 2003, revenues in 2004 were greater than in 2002 and are growing ever since

http://www.irs.ustreas.gov/pub/irs-soi/table_6_2006_dp.xls

Now I simply refuse to believe that alex, or WSJ editorialista Stephen Moore, who makes similar claims to #3 all the time, is that stupid. So what does that make them? Definitely disingenuous, maybe something worse.

If you take the very simple step of adjusting for inflation, you'll find that real federal revenues were lower in 1984 than in 1982, and lower in 2004 than in 2002. So alex's claim #3 is, on its face, false. But that's not really the issue: Eventually, tax revenues did come to surpass their 1982 and 2002 levels in real terms. Which proves absolutely nothing about the efficacy of tax cuts. The U.S. economy has a tendency to grow, whether or not Congress is cutting taxes. And over time, that tendency will produce higher government revenues, whether or not Congress is cutting taxes.

Now I'd like to believe that well-designed tax cuts can make the economy grow faster. But would any non-charlatan want to argue that all of the economic growth post-1982 and post-2002 was tax-cut-induced? Of course not. Arthur Laffer certainly didn't when I quizzed him on it. So the question becomes a far more complex one of separating the tax-cut-induced growth from the rest. Now I'm pretty sure alex and Stephen Moore are too stupid to figure out answers to that. I know I am. So I rely on the verdict of economists who study tax matters, who are pretty much unanimous in concluding that the Reagan tax cuts were, taken in their entirety, a big money loser for the federal government and that the Bush tax cuts will turn out the same way.

The final refuge of the tax-obfuscation scoundrel is usually to point out that those pointy headed economists at the Congressional Budget Office and elsewhere are often way off in their projections of future tax revenue. It's true: Since 2003, revenues have risen faster than anyone at the CBO or even the White House projected. But it's not like they're biased toward the downside: The fall in tax revenues between 2001 and 2003 was also much sharper than any of the pointy heads projected.

The main reason for this inaccuracy is that any such projection depends heavily on forecasts of future economic growth. Economists really aren't any good at forecasting recessions and recoveries, so what the CBOers and their ilk usually do is plug in numbers based mostly on estimates of long-run growth, which will inevitably be undershot during downturns and overshot during booms. Lately this undershooting and overshooting has grown more pronounced. My guess is that it's a result of increased income inequality: An ever bigger share of government revenue is coming from a small group of high-end taxpayers (not because their tax rates are higher than they used to be, but because they're making much more money than they used to), and those high-end incomes include a lot of stock option gains, performance bonuses, and the like that are extremely sensitive to even slight changes in economic growth.

And, from Mathew Yglesias:

Supply-Side Madness, by Mathew Yglesias: Avi Zenilman and the dread Politico put out a solid piece making the point that the central plank of Rudy Giuliani's economic policy outlook is hokum: Tax cuts do not, in fact, increase revenues no matter how many times Giuliani says they do.

Here's more from Zenilman at Politico:

Giuliani consistently echoes President Bush's assertion in February 2006: "You cut taxes and the tax revenues increase."

But there's a growing sentiment among many conservative economists — including those who generally support cutting taxes to spur economic growth and job creation — that Giuliani's statements are simplistic and at worst misleading. ...

While Sen. John McCain, former Gov. Mitt Romney and other GOP presidential contenders have distanced themselves from previous comments supporting the broad claim that reduced tax rates lead to more government revenue, Giuliani has made it central to his economic message. ...

The "On The Issues" section of his website, pointing to his record as New York mayor, says, "City government saw its revenues increase from the lower tax rates." ... But Chris Edwards, tax policy studies director at the libertarian CATO Institute, said: "It sounds like Mr. Giuliani was a little sloppy in his statements there." Giuliani's claim that tax cuts could recoup the trillion or so dollars that the AMT currently collects "seems like a silly argument," Edwards added. ...

"There are circumstances in which lower tax rates can actually increase revenue, but that is not the general result," said Martin Feldstein...

Conservatives have argued that some economic models underestimate the growth effects of tax cuts, and consequently overestimate the lost revenue. But tax reductions actually increase revenue in only very narrow cases, several economists said, such as when the marginal tax rates on capital gains are too high.

Still, Michael Boskin, a Giuliani economic adviser and Stanford professor who chaired the President's Council of Economic Advisers under George H.W. Bush, said that the mayor's claims about revenue and taxes need to be considered in a broader context.

"The mayor has been very clear that he has an aggressive plan to work on both sides of the fiscal equation — both controlling spending and reducing and reforming taxes. All of the elements of the program are designed to reinforce each other and help the economy grow," he said.

I need to break in - that's trying to have it both ways. He's not really lying because he really means you should cut programs too? Of course cutting programs increases revenues improves the fiscal balance (though, like Laffer, I can think of counterexamples at the extremes where that isn't true), but that's not the issue and not what Giuliani is claiming. Continuing:

In December 2005, Congressional Budget Office Director Douglas Holtz-Eakin concluded that a 10 percent reduction in the income tax would spur enough extra economic growth to offset maybe a third of the lost government revenue. Holtz-Eakin ... is now advising McCain.

In 2005, ... Gregory Mankiw co-authored a study that examined "the extent to which a tax cut pays for itself through higher economic growth." The authors concluded that a broad reduction in rates "recoup only about a quarter of the lost revenue through supply-side growth effects"...

Edmund McMahon, the director of Empire Center for New York State Policy at the conservative Manhattan Institute, supported many of the Giuliani tax cuts. "If absolutely no rate cuts had been enacted under Rudy, all else being equal, total revenues might have been $1 billion to $2 billion higher when he left office...

Other campaigns ... have backed off this kind of supply-side rhetoric.

In March, McCain told the National Review, "Tax cuts, starting with Kennedy, as we all know, increase revenues." Two months later at a Fox News debate, he said that the Bush tax cuts "have dramatically increased revenues." Aides to the McCain campaign told Politico that these were oversimplifications, and that he hasn't said anything similar since.

Romney also hit the lower-taxes-higher-revenue gong at an April 2007 speech to the pro-tax cut Club for Growth. But economic observers have noted that he has avoided that tack since, and the campaign has just released a "Conservative Blueprint for Lowering Taxes" that said nothing about increasing government revenue.

Paul Krugman: After the Money's Gone

Paul Krugman says we shouldn't expect the financial crisis to go away anytime soon:

After the Money's Gone, by Paul Krugman, Commentary, NY Times: On Wednesday, the Federal Reserve announced plans to lend $40 billion to banks. By my count, it's the fourth high-profile attempt to rescue the financial system... Maybe this one will do the trick, but I wouldn't count on it.

In past financial crises — the stock market crash of 1987, the aftermath of Russia's default in 1998 — the Fed has been able to wave its magic wand and make market turmoil disappear. But this time the magic isn't working.

Why not? Because the problem with the markets isn't just a lack of liquidity — there's also a fundamental problem of solvency.

Let me explain... Suppose that there's a nasty rumor about the First Bank of Pottersville: people say that the bank made a huge loan ... on a failed business venture... If everyone, believing that the bank is about to go bust, demands their money out at the same time, the bank would have to raise cash by selling off assets at fire-sale prices — and it may indeed go bust...

But the Fed can come to the rescue. If the rumor is false, the bank has enough assets to cover its debts; all it lacks is liquidity — the ability to raise cash on short notice. And the Fed can solve that problem by giving the bank a temporary loan...

Matters are very different, however, if the rumor is true... Then the problem isn't how to restore confidence; it's how to deal with the fact that the bank is really, truly insolvent, that is, busted.

My story about a ... sound bank ... which can be rescued with a temporary loan from the Fed, is more or less what happened ... in 1998...

In August, the Fed tried again to do what it did in 1998, and at first it seemed to work. But ... banks and ... nonbank financial institutions ... made a lot of loans that are likely to go very, very bad.

It's easy to get lost in the details... But there are two important facts that may give you a sense of just how big the problem is.

First, we had an enormous housing bubble... To restore a historically normal ratio of housing prices to rents or incomes, average home prices would have to fall about 30 percent...

Second... As home prices come back down to earth, many ... borrowers will find themselves with negative equity — owing more than their houses are worth. Negative equity, in turn, often leads to foreclosures and big losses for lenders.

And the numbers are huge. The financial blog Calculated Risk ... estimates that if home prices fall 20 percent there will be 13.7 million homeowners with negative equity. If prices fall 30 percent, that number would rise to more than 20 million.

That translates into a lot of losses, and explains why liquidity has dried up. What's going on ... isn't an irrational panic. It's a wholly rational panic, because there's a lot of bad debt out there, and you don't know how much of that bad debt is held by the guy who wants to borrow your money.

How will it all end? Markets won't start functioning normally until investors are reasonably sure that they know where the bodies — I mean, the bad debts — are buried. And that probably won't happen until house prices have finished falling and financial institutions have come clean about all their losses. All of this will probably take years.

Meanwhile, anyone who expects the Fed or anyone else to come up with a plan that makes this financial crisis just go away will be sorely disappointed.

Should Treasury Discontinue TIPS?

Some questions about TIPS in another simulated Q&A. This is based upon the speech Reflections on the Treasury Inflation-Protected Securities Market by William Dudley of the NY Fed:

If you don't mind, I'd like to ask you a few questions about Treasury Inflation-Protected Securities or TIPS -- the government bonds that are indexed for inflation. There have been questioned raised about whether the TIPS program should continue. Do we have enough information to make such an evaluation?

Now that this market is more than 10 years old, it should be sufficiently mature to permit a fair evaluation of its efficacy as a funding vehicle for the U.S. Treasury.

What are the objections to the TIPS program?

Some research studies have concluded that the incremental financing costs associated with the TIPS program have been substantial, leading some to conclude that the costs may outweigh the benefits. Today I am going to lay out the reasons why I disagree with this conclusion.

I like to ask this of everyone I talk to, so please don't take it personally, but some people won't stick around for the whole interview, so would you mind summarizing your conclusions?

Put simply, I ... praise TIPS… In my opinion, the benefits of the TIPS program significantly exceed the costs of the program.

Okay, now let's backup and fill in some detail. Why does the Treasury issue TIPS?

The logic of issuing inflation-protected securities is straightforward. Wouldn't some investors pay a premium—that is, accept a lower expected return—in exchange for guaranteed, full compensation for inflation? Because the United States and a number of other countries decided that the answer was likely enough to be "yes," they developed an inflation-indexed government debt market.

Has the program been a good development from the perspective of the U.S. Treasury? What about from the public's perspective?

I think I'm supposed to be the one asking the questions [laughs], but that's where I was headed too, so let's go with those. How can we tell whether or not the program has benefited the Treasury and the public?

A good starting point for answering these questions is to account for the costs and benefits of the program relative to an appropriate counterfactual. For example, we might start by comparing the difference in funding costs to the Treasury of TIPS versus a program of comparable duration nominal Treasuries.

So simply compare the funding costs under TIPS to what the costs would have been if non-TIPS financing had been used?

But we should also be careful not to ignore other potential benefits of the TIPS program.

What are they?

As I see it, these potential benefits include:

  • Greater diversification of the Treasury's funding sources, which presumably has favorable implications for the Treasury's funding costs.
  • The potential for TIPS issuance to reduce the variability of the U.S. government's net financial position.
  • Access to a market-determined measure of inflation expectations that can help inform the conduct of monetary policy.
  • The provision of a virtually risk-free investment that provides value to risk-averse investors.

How do we measure these benefits?

Although it is difficult to quantify these benefits, I will argue that they are considerable and should not be ignored in evaluating the benefits of the TIPS program.

What can we measure, how do we measure it, and what do the results show?

Turning first to the issue of measuring the impact of TIPS issuance on the government's funding costs, this could be done simply by comparing the ex-post costs of a program of TIPS issuance to the costs of a comparable program of nominal Treasury issuance. Studies of this sort have typically shown that TIPS issuance has resulted in a higher net cost to the Treasury. For example, a 2004 paper by Brian Sack and Robert Elsasser found a net cost to the Treasury from the start of the program through early 2004 of slightly less than $3 billion. A more recent paper by Jennifer Roush of the Federal Reserve Board finds that total ex-post costs of TIPS through March 2007 were in the range of $5-8 billion.

Easy enough to do. Is the analysis widely accepted?

Unfortunately, although this methodology is attractive in its simplicity, it has some flaws that undercut its usefulness in reaching conclusions about the attractiveness of the TIPS program.

One of the things that makes the method simple, of course, is the use of "ex-post" real interest rates, i.e. the nominal interest rate minus the actual inflation rate, instead of the "ex-ante" real rate, i.e. the nominal interest rate minus the expected inflation rate. That allows us to use actual inflation rather than expected inflation in the calculations, which is much, much simpler. Unfortunately however, economic decisions are based upon ex-ante rates, not ex-post rates, and the use of the simpler to measure ex-post real rate is generally inappropriate. Is that one of the problems here?

The problem with an ex-post analysis is that it depends critically upon the performance of inflation over the period in question. If inflation turns out to have been meaningfully different than what was expected at the time of TIPS issuance, then this difference—the so-called "inflation surprise"—can be important in affecting the relative costs of TIPS versus nominal Treasury issuance. If inflation turns out to be higher than expected, then TIPS issuance will likely look to have been more expensive than nominal Treasury issuance. If inflation turns out lower, an ex-post analysis will likely show a saving from the TIPS program.

So does that make ex-post analysis invalid?

Over the long run—and I mean the very long run—there should be roughly as many downward surprises in inflation performance as upward surprises. But within any relatively short period, such as the last decade, this certainly does not need to be the case. In other words, over such a short period, the outcome of an ex-post analysis can be heavily influenced by which of the two sides—the Treasury or investors—was the lucky recipient of the net inflation surprise that occurred over the period in question. For example, in countries, such as the United Kingdom, where inflation declined following the inception of an inflation-linked debt program, ex-post studies generally suggest that these programs have reduced financing costs for these countries.

The bottom line, then, for ex-post studies?

The fact that the Treasury saved or lost money ex post is thus not a very reliable guide as to whether the strategic decision to implement a TIPS program has been a good idea. The relevant question is whether the Treasury obtained the financing it needed at a lower ex- ante cost.

How do we answer this question?

If the experiment were to be run thousands of times drawing from the underlying distribution of possible inflation outcomes, would Treasury's costs have been lower, on average, with TIPS or with nominal Treasuries? To conclude on the basis of one coin flip or roll of the dice as ex-post analysis essentially does surely is not the best way to evaluate the respective costs of TIPS issuance versus nominal Treasuries.

Obviously, we can't run the economy over and over and then average the outcomes, so what do we do?

To execute an ex-ante analysis, we need a real-time measure of the inflation expectations of TIPS investors that is not contaminated by premiums for inflation risk or liquidity differentials. Unfortunately, we don't have a perfect measure. Nevertheless, we may be able to get close. We do have estimates of expected inflation from other sources—such as the Survey of Professional Forecasters (SPF) conducted by the Federal Reserve Bank of Philadelphia. If such measures do indeed reflect the inflation expectations of investors, then we can conduct a reasonably accurate ex-ante analysis.

Let's get to the actual ex-ante analysis. I've heard about something called the breakeven inflation rate. What is that?

Essentially, this is the realized inflation rate that would cause investors to come out the same in terms of total compensation regardless of whether they had bought TIPS or nominal securities. If inflation comes in above the breakeven rate, the investor who bought TIPS comes out ahead ex post; if inflation comes in below the breakeven rate, the investor who bought nominal securities wins.

What's the breakeven rate right now?

[When I last checked], the breakeven inflation rate at the ten-year maturity point was about 2.4 percent. This compares to the Philadelphia Survey of Professional Forecasters' most recent long-run estimate for CPI inflation of 2.4 percent.

Wow. Right on the money. What does this mean?

If we assume that the SPF fairly represents the expectations of investors, then the current constellation of data indicates that investors are roughly indifferent between the benefit of being protected against inflation risk versus the cost in terms of the greater illiquidity of TIPS relative to on-the-run nominal Treasuries. Thus, on an ex-ante basis, it appears that the cost of issuing TIPS is currently about equal to the cost of issuing nominal Treasuries.

So the cost of TIPS is about the same as other forms of financing?

From this perspective, there appears to be no net benefit or cost from TIPS in terms of expected financing costs.

That does not sound very compelling for TIPS. But I think it is important to emphasize that this standoff is occurring at a time when the preference for liquidity is especially strong. This benefits nominal Treasuries versus TIPS. When market turmoil subsides and this liquidity premium shrinks, one might expect TIPS to move ahead on an ex-ante basis.

Even on an ex-post basis, a detailed analysis of the timing of the net costs of TIPS issuance suggests that continuing a TIPS program makes sense. In her examination of the ex-post costs of the TIPS program, Jennifer Roush finds that the entire cost occurs during the early years of the TIPS program—up until around 2004. Roush's analysis suggests that there were large startup costs associated with the TIPS program. ... Since 2004, TIPS issuance appears to have saved the Treasury money and the program appears likely to be "profitable" from the perspective of the Treasury on an ongoing basis.

So either way you measure it, ex-ante or ex-post, it's a close call with TIPS coming out slightly ahead?

But that's before we have included some of the other considerable—although more difficult to quantify—benefits associated with TIPS issuance.

I see you have a long list detailing those benefits, the ones listed above with bullet points, and also ways to enhance these benefits, but we're running out of time so we'll have to leave that to the written version, apologies.

Hopefully, I have convinced you that the benefits of an ongoing TIPS program exceed its costs.

You've convinced me, you're quite the cheerleader. Do you have any further conclusions to share before we sign off?

Long live TIPS! That's my conclusion.

Yes, well, thanks for talking.

Reading the Dollar Signs

Here's a follow-up to Thomas Palley's argument that the dollar is in no immediate danger of losing its status in the world. This takes a somewhat different position:

Dollar signs, by Howard M. Wachtel, Commentary, LA Times: Has the tipping point arrived when the U.S. dollar ceases to be the preeminent reserve currency in the global economy -- a status it has held for 60 years? Such conjecture has been triggered by the recent dip in the dollar against the euro...

Since World War II, the dollar has been held as reserves by other countries in their financial portfolios because of its universal acceptance in the world economy and its stable value.

For the country whose currency achieves this status, there are considerable advantages. The United States can run large trade deficits, buying more than it sells in the world, because the selling countries are eager to acquire dollars as reserves. Such trade deficits are in reality debts whose reconciliation can be postponed as long as countries seek dollars as reserves. Political power also derives from this financial reality, as countries become willing to accommodate the reserve currency country in order to gain access to that currency.

The euro's introduction was not unmindful of these political and financial power configurations. Today, Hugo Chavez of Venezuela and Mahmoud Ahmadinejad of Iran have joined a group of Europeans waiting and hoping for the dollar's demise. In the backrooms, where financial-political diplomacy is discussed, similar desiderata are expressed by some influential leaders in Russia, China and the oil-exporting countries of the Middle East.

Countries make decisions to hold their trade surpluses in a reserve currency based on several considerations: the rate of return, degree of risk, relative strength of economies competing for reserve status, and a more subjective determination of the confidence in a country's decision-making. Risk pertains to exchange rate stability. ...

Over the last several years, and especially in the last six months, these factors have turned against the dollar. Exchange rate risk has risen rapidly. The euro zone economies have started to grow faster, restoring confidence in their near-term economic performance. The rate of return has gone against the dollar, with the three interest rate cuts in fall 2007. Finally, there is a general malaise about the solidity of U.S. policymaking. It started after the Iraq war in 2003 and has deepened with each revelation of new problems raised about American governing competence.

Is it any wonder that there would be speculation about the future of the dollar as the dominant reserve currency? Seen from Asia, the Middle East or Russia, those in charge of reserve portfolios must be asking: ...why not place more of our new surpluses into euros? Indeed, the question should be asked: Why haven't major dollar reserve countries diversified more into euros than they have? ...

While there are no clear movements out of dollars, anecdotal musings have surfaced.

For example, Cheng Siwei, ... caused financial markets to tremble when he said that China ... would invest outside the dollar. Cheng's comments were "clarified" a few days later by Chinese financial officials.

The explanation for apparent continuity in holding dollars as reserves can be found in the idea of sunk costs. It is costly to diversify out of the dollar. Any sharp movement would cause the dollar to fall even faster and further, hurting the dollar holders even more than the U.S. ... Some gradual portfolio adjustments at the margin, with more of new dollar surpluses placed in euros, will occur, but this will appear as a continuation of trends and foreshadow a soft landing for the dollar. It could be a hard landing if the Fed continues to cut interest rates.

The U.S. cannot be complacent... Further interest rate reductions will only hasten the dollar's decline as a reserve currency; continuing trade deficits do the same. Restoring confidence in the United States as a 21st century nation is of the highest priority, and not just for global financial reasons. There is a point, we know not where, at which the cost of holding dollars exceeds the cost of jettisoning them.

Myths About Torture

From this Sunday's Washington Post, five myths about torture:

5 Myths About Torture, by Darius Rejali, Commentary, Washington Post: So the CIA did indeed torture Abu Zubaida, the first al-Qaeda terrorist suspect to be waterboarded. So says John Kiriakou, the first former CIA employee directly involved in the questioning of "high-value" al-Qaeda detainees to speak publicly. He minced no words last week in calling the CIA's "enhanced interrogation techniques" what they are.

But did they work? Torture's defenders, including the wannabe tough guys who write Fox's "24," insist that the rough stuff gets results. "It was like flipping a switch," said Kiriakou about Abu Zubaida's response to being waterboarded. But the al-Qaeda operative's confessions -- descriptions of fantastic plots from a man whom journalist Ron Suskind has reported was mentally ill -- probably didn't give the CIA any actionable intelligence. Of course, we may never know the whole truth, since the CIA destroyed the videotapes of Abu Zubaida's interrogation. But here are some other myths that are bound to come up as the debate over torture rages on. ... [...continue...]

Until it actually happened, I never imagined having this debate, I never imagined that the U.S. would be close enough to the line that there would ever be any question whatsoever about whether we torture or not. I still hardly believe that we do, or don't want to believe it. We're supposed to be the good guys.

links for 2007-12-14

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