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January 18, 2008

Economist's View - 7 new articles

Selling American Banks to Sovereign Wealth Funds

Joe Stiglitz and Jamie Galbraith on selling off American banks to sovereign wealth funds: Link to audio file.

Countercyclical Fiscal Policy

One of the big economic stories today is, of course, Ben Bernanke's support of fiscal policy measures. Most commentary I have seen has focused on Bernanke's remarks that fiscal policy should, among other things, be targeted and temporary, and has noted that this is an implicit argument against Republican style permanent tax cuts (policies to stimulate growth such as investment tax credits or accelerated depreciation are not the optimal policies for stimulating the economy in the short-run; in general optimal growth policies are different than optimal stabilization policies).

knzn has another warning - Democrats shouldn't use this to push through large spending projects where the payoffs in terms of stimulating the economy are not immediate, or that are sure to get vetoed on ideological grounds:

Note to Congressional Democrats, by knzn: (This means you, Senators Edwards and Clinton.)

If Congress passes a stimulus package full of new programs and all sorts of bells and whistles and tinsel and lights and stars and angels and golden balls with glitter on them, one that President Bush is almost certain to veto, and one that he, given his ideological preferences, could very easily justify vetoing, and indeed would have a hard time justifying singing signing, then it will be your fault, not his fault, if the recession turns out more severe than expected. I will hold you responsible. I suspect that voters will hold you responsible too.

If, on the other hand, Congress passes a simple if imperfect stimulus program that works on the revenue side -- say an across-the-board one-time tax rebate -- one that President Bush may not be happy with but will have a hard time justifying a veto, then if he does end up vetoing it, that will be his fault -- and all the more reason to elect a Democratic president. And if he signs it, well, I guess you'll just have to take the risk that the stimulus will actually work and that it will make things look a little better on election day than they otherwise would. A non-recessionary economy in 2008 -- seems to me that's a risk worth taking.

[Update: I should proofread these posts better. I don't think we're going to be seeing "Recession -- The Musical" any time soon.]

Michael Woodford: Forward Guidance for Monetary Policy: Is it Still Possible?

Michael Woodford continues his discussion of monetary policy. Here, he discusses how Central Banks use "forward guidance", code words in communications signaling expected future policy, to stabilize inflation expectations over medium to long-run horizons.

Is the Fed's decision to "step back from this practice over the past year" a good choice, particularly since the effects of monetary policy depend largely upon expected future policy actions? The Fed is worried about committing to policies that it may not be able to pursue if conditions change leading to problems of credibility, but if the Fed communicates the full range of forecasts rather than the single most likely path, and also communicates its decision-making framework so agents understand how it will interpret and react to new developments, that danger can be minimized:

Forward guidance for monetary policy: Is it still possible?, by Michael Woodford, Vox EU: "Forward guidance" is communication by a central bank aimed at signalling the likely future path of policy rates. All of the big-3 central banks (the Fed, Bank of Japan and the ECB) have experimented over recent years with more explicit forward guidance through their official communications. Generally it is through the use of "code words," such as removal of policy accommodation at a "measured pace," or the exercise of "strong vigilance" toward inflation risks.

At the Fed, at least, there has been a step back from this practice over the past year, with recent FOMC post-meeting statements no longer containing the explicit signals about future policy that had become routine --- and the subject of much scrutiny by market commentators --- in the period between 2003 and 2006. The Bank of Japan (BOJ) has also stopped making definite commitments about future interest rates, since the end of its 'zero interest-rate policy' in July 2006. I suspect that other central banks are becoming more cautious as well about the use of code words that are taken to directly indicate future interest-rate decisions, under the current rapidly changeable conditions in financial markets.

The value of talking about the future

Is it in fact appropriate for central banks to try to communicate about future interest rates, or is this a point on which they are better advised to say as little as possible? I think that talking about the likely future course of rates can be quite valuable, at least at certain times. The economic effects of monetary policy depend almost entirely on the anticipated future path of the policy rate, rather than on the current level itself of a rate such as the federal funds rate; announced changes, or non-changes, in the funds rate operating target matter only to the extent that they also often imply changes in the expected path of the funds rate months or even years into the future. Hence it is certainly relevant to a central bank's stabilization objectives what the private sector understands about the likely forward path of the policy rate; and when the central bank perceives that the private sector has not reached a correct understanding on its own, there is reason for it to seek to clarify matters.

A good example is the situation faced by the Fed in the summer of 2003.[1] The funds rate operating target had been reduced to only one percent, and could surely be reduced little further, if at all; market speculation consequently focused on how soon and how sharply rates would be raised again. Indeed, speculation that the Fed would raise rates substantially within a matter of months was already causing long-term interest rates to rise, creating a situation that, it was feared, could actually tip the US economy into deflation. The FOMC could not, or at any rate was certainly reluctant to counter these expectations through any further cut in the current operating target; but instead it was able to calm market fears of an early tightening of rates by explicitly committing to maintain low rates "for a considerable period," beginning with the statement following its August meeting. Somewhat similar considerations had led the Bank of Japan more than two years earlier to commit itself explicitly to maintain its zero-interest-rate policy until deflation had clearly ended, and also in that case the policy signalling facilitated policy objectives by helping to keep long-term interest rates low.[2]

While explicit discussion of the level of interest rates that is expected to be chosen at future meetings can be useful on occasions like those just mentioned, it is clearly not possible under all circumstances to expect that interest-rate decisions will invariably be signalled many months in advance. The events of the past fall, in which central banks have had to keep abreast of rapidly changing market conditions --- and in which they have needed to be free to announce changes in policy, precisely because of their concern to respond to perceived changes in market expectations --- have for obvious reasons made central banks reluctant to announce in advance what they might or might not wish to do even a few weeks later.

Learning from the smaller central banks

Does this mean that there is no useful way for central banks to communicate about future policy? Here as in other respects,[3]

I think that banks like the Fed have much to learn from the communications policies of the forecast-targeting central banks. Banks like the Reserve Bank of New Zealand (for the past decade), joined more recently by the central banks of Norway and Sweden as well, include quantitative projections for the future path of the policy rate along with the projections for inflation and real activity that are discussed in their Monetary Policy Reports. These quantitative projections have a number of advantages over the use of "code words" as practiced by banks like the Fed, the ECB, or the BOJ. One is the simple fact that they are much less ambiguous. But another is that they clearly represent forecasts, conditional on what is known at the time of the forecast, rather than advance commitments of policy --- whereas the code words have frequently been understood as announcements of policy intentions, and have had to be kept ambiguous precisely so as to reduce the extent to which future policy decisions can be regarded as having already been announced. An interest-rate fan chart, of the kind published by the Norges Bank or the Riksbank, does not suggest anything of the kind. It is published alongside similar fan charts for other variables, which clearly represent forecasts rather than promised outcomes. Moreover, these are not single paths; the widening of the probability distributions with the forecast length makes it clear that no specific outcome is being promised in advance.

Would it work in the US?

Could a similar approach be adopted by the Federal Reserve? The FOMC is already publishing a summary of the FOMC members' forecasts for several other variables. And these forecasts are supposed to be made under each member's assessment of "appropriate monetary policy"; conceptually, at least, it would be a relatively small step to ask each member to describe his or her projected path for the federal funds rate under the assumption of "appropriate monetary policy" as well. If, for example, such a procedure had already been in place in the summer of 2003, the publication of projections indicating a substantial degree of unanimity among FOMC members about the judgment that the funds rate would remain at or near one percent through the following summer would have achieved the same end as the commitment to "a considerable period" of accommodation --- and it would likely have been even more effective, as a consequence of its greater precision.

Would this run the risk of requiring FOMC members to commit themselves far in advance to particular interest-rate decisions? I think it could be done in a way that would create little expectation of that kind. Stressing the conditionality of the projections on data available at the time would be important; and over time, as the discussion of reasons for each meeting's projections to differ from those made at the previous meeting become a routine part of each "Summary of Economic Projections," this should become well understood by readers of the Summary. And allowing for changes in policy in response to developments that could not previously be forecasted is as much flexibility as any committee member should seek; in fact, advance commitment of policy, to the extent that things work out in the way that had previously been anticipated, should lead to superior policy decisions, as a decision in advance of this kind leads the policymaker to internalize the consequences of policy anticipations.

The risks of misunderstanding would also be reduced if policymakers announced confidence intervals for their projections, rather than point forecasts. This is a weakness of the format currently used for the FOMC's "Survey of Economic Projections," which emphasizes the distribution of views across committee members, but not the degree of uncertainty associated with each of these forecasts. The current questionnaire does, however, solicit rough assessments of uncertainty from each member, and this could be extended and used to present the forecasts in a way that further emphasized their uncertainty.

Even more to the point would be to clarify the contingency of the projections by providing more information about the kind of possible future developments that should be expected to affect future policy. To some extent, this can be achieved by explaining the general framework within which policy decisions are made --- something that forecast-targeting central banks say a good deal about, though the Fed's "enhanced" communication strategy still seeks to avoid any explicit statements about this, as I discussed in first column.

Discussion of alternative scenarios

I believe that it would also be useful to illustrate the general policy strategy by talking through particular alternative scenarios and how the FOMC would expect to respond should they occur. The questionnaire used to solicit the forecasts of FOMC members could be expanded to ask them to comment on a small number of alternative scenarios, and not simply on their view of the most likely evolution given current knowledge. In fact, since the Board staff currently prepares its own projections under several alternative scenarios, and circulates these for discussion prior to each meeting, it would only be necessary to solicit the FOMC members' views of the scenarios that they are already asked to consider. A summary of views of appropriate policy under each of the scenarios could then be included in the "Summary of Economic Projections" in the published minutes of the FOMC meeting.


Extension of the "enhanced projections" in this way would improve the private sector's ability to predict Fed policy, for at least two reasons. First, it should make FOMC members more comfortable talking about the interest-rate paths associated with their projections, by making it clear that several scenarios are possible. And second, discussion of multiple scenarios should also help people in the private sector understand how the outlook for policy should be affected by at least some of the kinds of news that may arrive between publications of the projections. But at the same time, discussion of the appropriate response to alternative scenarios should also help to clarify the nature of the FOMC's longer-run policy objectives. In this way, it should also serve the purpose of stabilizing medium-to-longer run expectations. One hopes that an evolution of the policy along lines of this sort will be considered by the FOMC, as it gains further experience with its new communications policy.

Editors' note: this is the second of 2 columns based on Woodford's comments at the American Economic Association meeting last weekend in New Orleans.


1 For further discussion, see Michael Woodford, "Central-Bank Communication and Policy Effectiveness," in The Greenspan Era: Lessons for the Future, Kansas City: Federal Reserve Bank of Kansas City, 2005. 2 For empirical evidence of the effects of the BOJ's communications policy, see Nobuyuki Oda and Kazuo Ueda, "The Effects of the Bank of Japan's Zero Interest Rate Commitment and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance Approach," Bank of Japan working paper no. 05-E-6, April 2005. 3 For further discussion, see Michael Woodford, "The Case for Forecast Targeting as a Monetary Policy Strategy," Journal of Economic Perspectives, Fall 2007, pp. 3-24, and my previous column, "The Fed's 'Enhanced' Communication Strategy: Stealth Inflation Targeting?," on

Fiscal Policy: The Legacy of the New Deal

This is probably Brad's territory - it's about a professor at Berkeley talking about and documenting the "largely forgotten ... public-works legacy of the FDR era" that is still all around us - but Brad's kind of a blogland wallflower and he may be too shy to promote things related to Berkeley, so I'll note it here:

New life for the New Deal, by By Barry Bergman, Berkeley News: When Gray Brechin set out to document the New Deal's legacy in California, the mission seemed modest enough. Little did he know. What began as a two-person effort — just him and a photographer — has since morphed into a kind of community-based archaeological expedition...

"I liken it to coming across a ruin in a jungle and starting to dig and you find it's not only a building, it's a city, and then you find it's an entire civilization that's been buried and forgotten," says Brechin, a widely known "historical geographer" who earned his bachelor's, master's, and Ph.D. at Berkeley and is now a visiting scholar here. "In this case it's our civilization, it's something that we did."

Just 75 years after Franklin Delano Roosevelt took the oath of office in March 1933, Brechin believes America has largely "buried and forgotten" what the New Deal meant to a nation suffering mightily under the weight of the Great Depression — even though, as he's discovered, we're still reaping the benefits in the form of public art, park trails, golf courses, amphitheaters, school buildings, hospitals, bridges, streets, sewers, and aqueducts. During a 10-year period, millions of out-of-work men helped build physical infrastructure with the federal Civil Works Administration, Public Works Administration, and Works Progress Administration; "boys" age 18 to 25 did their bit for family and country by joining the Civilian Conservation Corps, which was dubbed Roosevelt's "tree army."

Much of that infrastructure has fallen into disrepair, and veterans of the CWA, PWA, CCC, WPA, and other alphabet-soup agencies are a rapidly dying breed. Meanwhile, the social safety net created in the wake of the U.S. economy's 1929 collapse has come under increasing fire in what Brechin calls "a long war on the New Deal" dating to the Republican presidency of one-time FDR Democrat Ronald Reagan, and carried on today by proponents of further deregulation and privatization. "The goal was to essentially do away with the last vestiges of the New Deal," he says, "and they've been largely successful."

Enter the Living New Deal Project. ... To Brechin, a California native who's written extensively about the state and its history, the lessons of the New Deal are unmistakable and deeply personal. In the wake of 9/11 and the U.S. invasion of Iraq, he explains, "I was just headed down the road to complete despair. This has really saved me. I want to give that to other people who are involved in the project. Because it gives you a glimpse of an alternate reality.

"It's not utopia," he's quick to add. "We actually achieved this. And it's astounding what we were able to achieve, and what you can achieve when you've got something we've forgotten about, which is compassionate and ingenious leadership. It's been so long since we've had that, and most of the people who've experienced it are dying away."

His lectures, Brechin says, "come as a thunderclap to students," many of whom have grown up with little knowledge of the era or its accomplishments.

In that respect, they're not unlike Brechin himself, who seems just as surprised by the magnitude of his modest dig through the New Deal's bounty. "I've been learning from the moment I got started," he says. "And it's been the most wonderful and overwhelming experience of my life."

To learn more about the Living New Deal Project — or to find the locations of New Deal sites in California — visit the project website at

Misdirecting the Flow of Resources

David Wessel says that excessive expected compensation in the financial industry encourages too many talented resources to flow into the industry, resources that could be put to better use elsewhere:

A Source of Our Bubble Trouble, by David Wessel, Capital, WSJ: First came the bursting of the tech-stock bubble, now the bursting of the housing bubble. The bursting of a bubble in finance -- and the pay of those who helped make the tech and housing bubbles possible -- can't be far behind.

And as painful as that will be for the Bentley/Rolls-Royce/Aston Martin/Ferrari dealership near the railroad station in Greenwich, Conn., the nation's hedge-fund capital, it might be good for the overall economy. ...

Workers in finance are increasingly highly skilled and educated. ... About 15% of men who graduated from Harvard around 1990 were working in finance 15 years after graduation, compared with about 5% of those who graduated around 1970. Among Harvard women, the share employed in finance increased to 3.4% from 2.3%. (Wall Street remains a man's world.)

The trend toward finance appears to be accelerating. ... The lure is obvious. It's the money. Comparing graduates with similar SAT scores, grade-point averages, gender, age, occupation and everything else they can measure, Mr. Katz and Ms. Goldin find Harvard grads who work in finance earn 195% of the pay of those who work elsewhere. That's no typo: Going into finance means making nearly three times as much as your classmates with other careers.

In fact, pay on Wall Street and elsewhere in finance -- even more than those huge salaries of chief executives outside finance -- is a major driver of the widening gap between paychecks of the biggest winners in the economy and the rest of us. ... The top 25 hedge-fund managers combined earned more than CEOs of the Standard & Poor's 500 companies combined in 2004...

Modern finance is, truly, as powerful and innovative as modern science. More people own homes -- many of them still making their mortgage payments -- because mortgages were turned into securities sold around the globe. More workers enjoy stable jobs because finance shields their employers from the ups and downs of commodity prices. More genius inventors see dreams realized because of venture capital. More consumers get better, cheaper insurance or fatter retirement checks because of Wall Street wizardry.

But financial innovation is like splitting the atom: Nuclear power offers energy without greenhouse gases, but nuclear weapons can blow up the planet. It all depends on how wisely it is used. Helping promising companies raise capital? Vital to U.S. prosperity. Devising, selling and trading mortgage-backed securities so complex that no one, even those Harvard grads, can fully understand them? Could be a waste of talent and energy.

Yes, the Harvard-trained physician who helps venture capitalists pick among competing cures for cancer may help millions instead of the hundreds of patients he or she might have treated directly. But tens of billions of dollars of losses in new-fangled investments at the largest U.S. financial institutions -- and the belated realization that some of those Ph.D.-wielding, computer-enhanced geniuses were overconfident in the extreme -- strongly suggests some of the brainpower drawn to Wall Street would have been more productively employed elsewhere in the economy.

And it looks like many of those folks will get the chance to find out if that is so. [Video on continuation page]

It's always easy to look at an industry, identify the losers after the fact, and say they would have been better off doing something else. But that doesn't mean the decision to enter the industry was necessarily a bad one, i.e. the ability to identify firms that entered and failed, in and of itself, doesn't prove that resource flows have been distorted. But I don't think it's hard to argue that expected compensation in the industry is excessive and distorts resource flows from other high value areas, though there are those who argue against the idea that hedge fund managers, for example, are paid more than is justified by their contribution.

Losing School Choice

I'm not sure if this will be of general interest, it relates to school choice, but it looks like our local school district is considering restricting the ability of parents to move their kids to the school of their choice. In the past you could move your kids to any school so long as it wasn't full, and most weren't, and that has led to increasing segregation by income within the district:

A step away from choice, Editorial, Register Guard: Choice and equity have been on a collision course in the Eugene School District for years. At its meeting tonight the Eugene School Board will discuss goals and principles that, if they are embraced, imply a painful but necessary move toward equity and away from choice.

Choice means allowing parents to send their children to any school in the district that can accommodate them, including a variety of alternative schools. Equity means providing a high-quality education to all students. Choice has led to a degree of self-segregation that impedes the district's ability to fulfill its commitment to equity. ...

Achieving the goal of narrowing the range of enrollments found in Eugene elementary, middle and high schools would unavoidably mean tightening students' ability to transfer to schools outside their attendance boundaries. Achieving the goal of ensuring that student transfers don't leave neighborhood schools with fewer resources or disproportionate numbers of low-income or minority students also points toward restrictions on school choice.

Such restrictions will be resisted by many parents whose children have been well-served by open enrollment and school choice. These parents pay taxes, vote, volunteer, raise funds and attend meetings — they are a big part of the backbone of the public school system.

But efforts to reconcile equity and choice have not prevented Eugene schools from becoming more economically segregated than ever, with the percentage of students receiving free or reduced-price lunches ranging from 4 percent at Eastside Elementary to 75 percent at River Road Elementary. The demographic trends suggest that segregation will increase if nothing is done.

Widening disparities make it harder for the school district to fulfill its obligation of providing a good education to all students. In his report Russell quotes research by the Piton Foundation that concluded, "when more than 50 percent of students at a school qualify for free and reduced-price lunch, it becomes more difficult for low-income students to excel." To maintain policies that concentrate low-income students in a few schools would require, at best, the acceptance of a double standard, and at worst the abandonment of a segment of the district's student population. ...

The challenge for Russell, the board and the community will be to make these changes into a gain for all students, rather than a loss for some of them.

The schools in Eugene are excellent if you go to the right school, but there are also schools that struggle. Because of that, if choice is restricted, some parents who didn't bother to do so before will move into the more desirable districts. In the past you could move anywhere and keep your kids at the school they were at, or move them pretty much at will, so location didn't close off opportunities. Convenience mattered, and it is easier if kids live near their friends from school, but lots of people chose to send their kids to schools outside of their home district (in my area, 17% of high school students transfer). I'm guessing we will see more segregation in the long-run as these locational choices are expressed.

[What did I do? Initially, my kids went to their neighborhood school, and the elementary school was one of the lowest average income schools in Eugene. I volunteered a lot - e.g. I led science experiments in third and fourth grades - and what I saw was a learning environment was less than optimal. Test scores were awful and many of the higher income families had moved their kids elsewhere. But I believed kids should go to their neighborhood schools, partly for social reasons, so I started them in their neighborhood school. But after a couple of years we moved to a new district and things changed dramatically. You pretty much had to take a number to help in the classes, the parents in the school used fundraisers to hire extra science and music teachers to come in once a week, all sorts of things like that. The state sent the same amount per pupil to both schools by law, but because of the difference in parent involvement and differences in income, and the use of devices like external fundraising and volunteers, the disparities were pretty large. If I had to do it over, I would likely transfer my kids much sooner, i.e. from the start.]

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