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January 23, 2008

Economist's View - 5 new articles

Quasi-Experimental Evidence on the Neutrality of Money

Arindrajit Dube of the Institute for Research on Labor and Employment at UC Berkeley looks at how recession probabilities on Intrade changed immediately following the Fed's announcement of an emergency rate cut:

Market based evidence on the non-neutrality of monetary policy, by Arindrajit Dube: Ahem… we have for the first time used quasi-experimental evidence to estimate the impact of a large (and surprising) reduction in the federal funds rate on the probability of a recession. Recent financial innovations allow us to use the market for "recession futures" to estimate impact of policy on implied probabilities in an event study framework. Using hourly trading data from Intrade.com over a 48 hour period, we find that a 0.75 percentage point reduction in the federal funds rate on the morning of January 22 led almost instantaneously to a reduction in the implied probability of recession from 77% to 68%, and to around 70% after 24 hours of the announcement.

Neutrality Please click here for larger version

We find the elasticity of recession odds to policy [d(probability of a recession)/ d(percentage point reduction in rate)] to be between 9.3 and 12. This suggests that at best, a 400 basis point (4 percentage point) reduction in the federal funds rate can hope to reduce the odds of a looming recession by around 50%. Our identification assumes that this was both unanticipated in terms of timing, and represents a net reduction in the medium term as compared to the forecasted path of the federal funds rate. If the surprise reduction in federal funds rate is partly substituting for a (now foregone) reduction in the future, the true effects of a medium-term reduction may be understated by our estimates. Overall, our results suggest that rational expectations are inconsistent with the theory of monetary policy neutrality.

"Capitalism's Enemies Within"

Robert Samuelson says there's something wrong with the markets that determine pay on Wall Street that causes pay to be too high and encourages excessive risk-taking:

Capitalism's Enemies Within, by Robert J. Samuelson, Commentary, Washington Post: Amid the mayhem on world financial markets, it is becoming clear that capitalism's most dangerous enemies are capitalists. No one can have watched the "subprime mortgage" debacle without noticing the absurd contrast between the magnitude of the failure and the lavish rewards heaped on those who presided over it. At Merrill Lynch and Citigroup, large losses on subprime securities cost chief executives their jobs -- and they left with multimillion-dollar pay packages. Stanley O'Neal, the ex-head of Merrill, received an estimated $161 million.

Everyday Americans will conclude (rightly) that this brand of capitalism is rigged in favor of the privileged few. ... If you leave your company a shambles -- with losses to be absorbed by lower-level employees, some of whom will be fired, and shareholders -- do you deserve a gold-plated send-off? Still, the more serious problem transcends the high pay itself and goes to the wider consequences for the economy.

Wall Street's pay practices perversely encourage extreme risk-taking that can destabilize the economy. Subprime mortgage losses may simply be chapter one. ... If banks and investment houses sustain more losses, the nation's credit system will be further wounded and so will the economy. ...

By "Wall Street," I mean all the commercial banks, investment banks, mutual funds, hedge funds and the like..., but particularly investment banks. Pay is eye-popping. In 2007, Lloyd Blankfein, chief executive of Goldman Sachs, received compensation estimated at $68 million. ... Just why investment bankers and traders out-earn, say, doctors or computer engineers is a question I've never heard convincingly answered. Are they smarter? Unlikely. Do they contribute more to the economy? Questionable. True, Wall Street often performs a vital function. ...

But Wall Street also frequently misallocates capital and credit. The "tech bubble" of the late 1990s was one episode. Now we have subprime mortgages. Why? Well, the herd mentality of financial crazes has a long history. But compensation practices skewed so heavily toward bonuses based on annual profits make matters worse. ...

To be fair, the real estate bubble had many causes, including low interest rates, the political popularity of homeownership and the (mistaken) belief that housing prices could never fall. This may explain why, so far, the backlash against Wall Street has been muted.

But if the subprime failure turns out to be a preamble to a larger financial breakdown, flowing from the creation of new securities that offered short-term trading possibilities but whose long-run risks were underestimated, then the mood could turn uglier. Indeed, many Americans may conclude that capitalism has run amok.

When I hear about inequality widening, the ultimatum game experiments where people are willing to do things that do not appear to be in their economic interest in order to punish unfairness sometimes come to mind. There is some tipping point - I don't know where it is - but there does come a point where the perception of unfairness causes people to demand change, and they may be willing to do things that appear to be economically irrational in order to bring that change about. Often, it is the threat of taking action, not the action itself, that promotes changes that reduce inequality. On a smaller scale, we see this when workers go out on strike and appear willing to pay a far higher cost than any gain they might eventually reap in order to ensure that pay is fair according to their perceptions of what fair means. And often the threat of a strike is enough to change the outcome of negotiations over who gets what share of the profits, the strike itself is not necessary.

Was the Great Depression such an event, a time where people came to believe that the system did not treat the typical household fairly, and thus demanded change? Some of the policies that came out of the Great Depression to alleviate inequality may have been an attempt to stave off more drastic change - it was either give in to the demand for a reduction in inequality within the capitalist system itself or, some feared anyway, face the possibility the capitalist system itself would be fundamentally altered or even replaced.

If we have a hard landing, a true hard landing where significant numbers of people are thrown out of work for a substantial period of time while those who were rewarded in recent years do not face similar hardship, will that trigger change? I think it might, though it's not exactly comfortable to think that something like universal health care has a better chance of being enacted if we have a severe recession that causes people to demand change, any change that benefits the working class, than if times remain relatively good. But hopefully I'm wrong about that and we'll get the needed change in healthcare and other areas without having to suffer through a long, deep, recession first.

Fed Watch: The Surprises Just Keep Coming

Tim Duy reevaluates after today's surprise move by the Fed:

The Surprises Just Keep Coming, by Tim Duy: One thing is clear – after six months of struggling to learn the policy objectives of the Federal Reserve under Chairman Ben Bernanke, I just am not going to catch a break. Ironically, I sent the following email to Mark Thoma last night, after I saw his lead-in to my last piece:

Funny guy...but truthful. The Fed's been kicking my a** lately. Still can't believe I got December right.

If I listen to Mishkin and his "medium term" outlook, I just know I am going to get burned again.

And there it is. Sigh – some days I wish that Mark had not convinced me to start doing the Fed Watch thing again.

I was referring of course to Federal Reserve Governor Frederick Mishkin's recent comments:

I think there is too much focus on what decision will be made about the federal funds rate target at the next FOMC meeting (Mishkin, 2007e). What is important for pricing most financial assets is the path of monetary policy, not the particular action taken at a single meeting. For these reasons, I hope the recent enhancements to the Federal Reserve's communication strategy--especially the greater prominence of the macroeconomic projections of FOMC participants--will help shift attention toward our medium-term objectives and our approach in meeting these objectives.

I knew that Mishkin was throwing up a false signal, yet Fed policymakers just seem so sincere that they want to pursue greater transparency. Before I got lost in Miskin's preamble, I had titled my last piece "Financial Freefall Put 75bp in Play." Should have stuck with it.

Still, I am not so uncharitable as Wilhelm Butier and Felix Salmon, although I genuinely empathize with their frustration, both of whom express dismay over this "panic" move. Fundamentally, I tend more toward Jim Hamilton's interpretation. But it was a panic move, no question about it. It stinks of the appearance of equity price targeting, and reeks of desperation - especially since each time the Fed cuts rates, they sent a message similar to that of the December 11 statement:

Today's action, combined with the policy actions taken earlier, should help promote moderate growth over time.

Such statements, and the supporting speeches, have pulled me in almost every time. I focused too much on Bernanke's moves toward greater transparency, while neglecting his work on credit markets and, as Paul Krugman reminds us, the experience of the Bank of Japan at the zero-interest rate bound. The transparency/long term forecast story is essentially meaningless in the current environment, and the failure of the Fed to drop references to their long term forecasts earlier is, in my opinion, the most significant failure in the Fed's communication strategy. Indeed, the Fed stepped up those efforts by publishing their forecasts! Thankfully, the most recent Fed statement neglects to include such a forecast.

Still, I am surprised that Fed policymakers are surprised with the flow of current data – they clearly believe they are far behind the curve. What did they expect to see if growth rates were decelerating from the superheated pace of the 3rd quarter to something around 1%? The Fed's own forecasts were bordering on near-recession territory in the near term. And did they honestly expect that the hundreds of billions of dollars that flowed out of housing would suddenly reappear in housing – or some other part of the US economy – within a few months of August's meltdown?

But, here again, I missed something critical РBernanke's blas̩ attitude about global imbalances. From his September 11 speech:

First, these external imbalances are to a significant extent a market phenomenon and, in the case of the U.S. deficit, reflect the attractiveness of both the U.S. economy overall and the depth, liquidity, and legal safeguards associated with its capital markets…

Second, current account imbalances can help reduce tendencies toward recession, on the one hand, or overheating and inflation, on the other…

Third, although the U.S. current account deficit is certainly not sustainable at its current level, U.S. liabilities to foreigners are not, at this point, putting an exceptionally large burden on the American economy..

Bernanke appeared to dismiss, as late as September, the possibility of a sudden stop of capital inflows to the US. But that is in fact exactly what was happening in the mortgage market – a broad global pullback from the asset class sapped households of one source of financing. The imbalance did not "reduce the tendency toward recession" but instead increased it. I thought it was clear that foreign saving was supporting US consumption via the housing market. And I thought it was clear that US consumption would slow measurably as a result.

I still think that the Fed will have only minimal impact supporting the housing market – a bubble once broke cannot be recreated. The vast sums of money available with low underwriting standards simply are not coming back. And we don't know where in the US economy they will show back up – or if in the US at all. Of course, lower rates will provide some supportive effect - eventually, rates will fall enough that those with equity in their homes and good credit ratings can get a refinancing boost. For some that is already happening (I am just 25bp away from making a call to the mortgage broker). Like fiscal stimulus efforts, lower rates soften the transition to a new growth path.

In any event, the Fed has consistently reacted more quickly than I believe implied by their forecasts. What does this mean for future policy? My argument from last week still stands – the Fed needs to continue cutting throughout this period of economic weakness, and now they can do so without playing lip service to their forecast. I can't imagine they believe this week's cut was in lieu of a cut next week as well. Indeed, given their clear concern over the state of equity markets, it seems prudent to bet that they will match market expectations of another 50bp cut (which begs the question – why not due 100bp today?). And assuming the economy remains near or at recession for the first half of the year, expect a minimum of another 75bp. That would bring us down to 2.25%. I had thought the Fed was hoping to anchor expectations to policy fluctuations – hence the whole point of the moves toward inflation targeting – but the policy see-saw continues. Perhaps it is the only policy that works in an asset-bubble driven world.

links for 2008-01-23

Stiglitz: How to Stop the Downturn

Joseph Stiglitz outlines an optimal stimulus package:

How to Stop the Downturn, by Joseph Stiglitz, Commentary, NY Times: America's economy is headed for a major slowdown. Whether there is a recession ... is less important than the fact that the economy will operate well below its potential, and unemployment will grow. The country needs a stimulus, but anything we do will add to our soaring deficit, so it is important to get as much bang for the buck as possible. The optimal package would contain one fast-acting measure along with others that could lead to increased spending if and only if the economy goes into a steep downturn.

We should begin by strengthening the unemployment insurance system, because money received by the unemployed would be spent immediately.

The federal government should also provide some assistance to states and localities, which are already beginning to feel the pinch, as property values have fallen. Typically, they respond by cutting spending, and this acts as an automatic destabilizer. Federal assistance should come in the form of support for rebuilding crucial infrastructure.

More federal support for state education budgets would also strengthen the economy in the short run and promote growth in the long run, as would spending to promote energy conservation and lower emissions. It may take some time to put these kinds of well-designed expenditure programs into place, but this slowdown looks as if it will last longer than some of the other downturns in recent memory. ...

The Bush administration has long taken the view that tax cuts (especially permanent tax cuts for the rich) are the solution to every problem. This is wrong. ... A tax rebate aimed at lower- and middle-income households makes sense, especially since it would be fast-acting.

Something should be done about foreclosures, and appropriately designed legislation allowing those who have been victims of predatory lending to stay in their homes would stimulate the economy. But we should not spend too much on this. If we do, we'll wind up bailing out investors, and they are not the ones who need help from taxpayers.

In 2001, the Bush administration used the impending recession as an excuse to cut taxes for upper-income Americans... The cuts were not intended to stimulate the economy, and they did so only to a limited extent. To keep the economy going, the Federal Reserve was forced to lower interest rates to an unprecedented extent and then look the other way as America engaged in reckless lending. The economy was sustained on borrowed money and borrowed time.

The day of reckoning has come. This time we need a stimulus that stimulates. The question is, will the president and Congress put aside politics to get the job done?

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