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May 11, 2009

Economist's View - 7 new articles

Fed Watch: Turning Which Corner?

Tim Duy:

Turning Which Corner, by Tim Duy: Is the economy turning a corner? And, if so, which corner is it turning? In my view, economic activity has been influenced by two separate trends since 2007. One is the structural response to an over-leveraged household sector that pushed the US economy into what was initially a mild recession. The second trend is the sharp cyclical recession that began in earnest in the second half of 2008 as the commodity price shock decimated already weakened households and the deepening credit crunch cut financing for a broad swath of firms. Excess capacity emerged throughout the economy, triggering the familiar phenomenon of rising unemployment. Difficult though they may be, the cyclical dynamics do not last indefinitely - generally speaking, output declines stop well short of zero GDP and unemployment will not rise to 100%. Market participants are rightly anticipating the economy is turning the corner on the cyclical trend. But I suspect we have a long path ahead of us on the structural challenge poised by overleveraged households - suggesting that the green shoots we hear so much about will yield little more than stunted growth. This is why Bernanke and Co. are more likely to fertilize the fields than plan for the next harvest.

If there is one picture that sums up the cyclical story of the past year, it is the path of real consumption:


The sharp deceleration has come to an end, of that there can be little doubt. Nor should there be much surprise. The collapse in commodity prices, lower interest rates to allow mortgage refinancing for those homeowners still above water, and tax cuts all joined to provide powerful support for household budgets allowing consumption to stabilize despite the massive job losses experienced in recent months. The stabilization in consumer demand will eventually slow the pace of job cuts. Indeed, this is already evident in the data - analysts have pointed topeak of initial claims as a key hurdle in the race to recovery. To be sure, it is difficult if not impossible to characterize the data flow as "good." But it is certainly less "bad." The path to Great Depression II has hit something of a speedbump. And seeing that, market participants have priced out some of the most cataclysmic scenarios, supporting equities and commodities while pushing bond yields higher.

There will be more opportunities for euphoria - do not underestimate the power of pent-up demand to trigger bursts of positive data. There is a portion of the population who are not credit constrained, biding their time for the perfect moment to buy a new car or schedule a vacation. Indeed, such bursts of data are more likely than not following a sharp decline in activity (the 2.2% gain in consumption spending in 1Q09 is such an example). I believe, however, that those bursts of data will not be sustainable. Far from it - at a minimum, the ability of households to carry activity forward is at its end, which by itself would leave the economy floundering .

I think it is difficult to ignore the implications of the growth of consumer dominance in defining patterns of economic activity:


The story of the last 25 years has been an increasing role for household spending, rising to perhaps a peak of conspicuous consumption, with the motto "a filet mignon in every stainless steel oven, a RV in every garage." Patterns of economic development - more to the point, capital formation - have favored taking advantage of this trend. Countless business plans are based on the expectation that this trend will continue. The baby boomers have endless wealth (not so anymore, if it ever was), there is a never ending supply of equity rich Californians to support our [insert locality] housing market, etc. Those plans will be stressed, to say the least, if the trend stalls. The implications for a reversal are even more significant. And for those that believe reversal is necessary, note that the reversal has really not even begun. What took 25 years to build may take another 25 years to destroy.

How sure are we that the trend is at an end? My thought is that the factors that supported the trend - a steady march down in the saving rate to zero and a steady march up in household debt, coupled with monetary policy that had room to go from 15% short rates to zero over nearly three decades, are at an end. Even if you believe that savings rates will not rise to 12%, the inability to sustain below zero rates puts a limit on household spending growth (as well as debt accumulation). And with underwriting conditions tightening - a permanent tightening, given the changing regulatory environment - the role of debt financing in the life of the consumer is sure to stagnate.

The challenge then is to transition the economy away from the debt-supported consumption trend that looks no longer viable to a trend more reliant on investment and external spending. This, however, is easier said then done. How quickly can 25 years of growth directed at consumer spending be reversed? And reversed to what, especially if the rest of the world continues to struggle? I see little hope of an "immaculate conception" of a fresh, sustainable pattern of economic activity. Until the transition path reveals itself, fiscal policy will be necessary to fill the economic hole likely to exist if the savings proclivities of households continue to exceed the investment intentions of firms.

Ironically, the "best" road to growth is also the riskiest from a policy perspective - a rapid expansion of emerging market activity. Such an expansion, however, would once again place the US in competition for global resources, and threaten a reversal of the commodity and interest rate trends that have been so important to supporting US consumers. Indeed, just the whiff of recovery has supported oil prices, promising an abrupt end to one of the factors supporting US consumers. In the worst case scenario, a flight of capital away from the Dollar (in response to more promising investments abroad) would generate an inflationary and structural shock that would leave the Fed juggling between renewed recession and higher inflation. In short, the optimal external shock would be one only partially supportive; anything more would push the globe to a revisiting of the commodity price surge of early 2008. Looking for a decoupling story now, however, seems like almost a naïve dream.

What is the Fed's next move? One email crossed my inbox after the April employment report suggested some thinking that the Fed could hike rates as early as November. Such a scenario (absent a stability threatening run on the Dollar) must come from a spectacularly optimistic take on incoming data. Data, I might add, that is a reflection of the massive crutch provided by the Federal Reserve and US Treasury, not necessarily a sea change in the underlying economic environment. Look too how quickly bond rates began to climb after the Fed declined to expand Treasury purchases at the last FOMC meeting. More generally, consider this tidbit on Federal Reserve Chairman Ben Bernanke's thinking back in 2003:

The 2003 FOMC transcripts showed then-Governor Ben Bernanke very tuned into financial markets as he pressed for earlier release of Fed forecasts and a willingness to lower interest rates to zero. From the June 2003 FOMC meeting, when the Fed lowered the target fed funds rate to 1%:

"I wonder if you might give some thought to whether or not it would make sense tactically to say publicly that we are willing to lower the federal funds rate to zero if necessary…I think it would have a beneficial effect on expectations in that there would no longer be a feeling in the market that we had reached the end of our rope."

"It's extremely important that we do what we can to maintain the supportive configuration in financial markets. That means continuing our easy monetary policy and, even more important, using our statement to signal our willingness to keep policy easy so long as there is a risk of further disinflation and continuing economic weakness."

A year and a half after the end of the 2001 recession, Bernanke was looking at the possibility of lowering rates to zero in order to maintain support for financial markets. And comparatively, financial markets were leaps and bounds healthier in 2003 than now. Is a rate hike really feasible this year - or even next - given the current state of dependence of the financial system on government largess? Moreover, consider the disinflation worries in 2003 and fast forward to last week:

Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, implying that the unemployment rate could remain high for a time, even after economic growth resumes.

In this environment, we anticipate that inflation will remain low. Indeed, given the sizable margin of slack in resource utilization and diminished cost pressures from oil and other commodities, inflation is likely to move down some over the next year relative to its pace in 2008. However, inflation expectations, as measured by various household and business surveys, appear to have remained relatively stable, which should limit further declines in inflation.

Now consider the output gap over the last decade:


The current gap already far exceeds that of the last disinflationary scare, and Bernanke expects it to continue to expand further, and then diminish only gradually. As long as the gap continues to expand, Bernanke's bias will be in favor of additional easing. The only question is whether he remains content to allow TALF funds to slowly trickle into the economy, or speeds the pace of policy with expansions of longer dated Treasury purchases. Given Bernanke's past behavior, expecting patience on his part seems unrealistic. Moreover, the last jobs report provides less room for optimism than observers suggest. Importantly, Jim Hamilton notes the decline in hours worked appears unabated; threat of a currency collapse aside, there will be no policy tightening, only easing, until hours worked moves unquestionably and sustainably in a positive trajectory.

Bottom Line: The economy looks to be turning a corner relative to the downward cyclical force of last year. But this is only a partial victory, as the factors that that started us down this path - namely, a debt-supported consumer spending dynamic - remain in play, and will likely remain in play for years, arguing for a long period of slow growth, punctuated by short-lived bursts of positive data. In such an environment, and considering the importance of government support to sustain financial stability, the odds favor continued policy easing. Those looking for a more positive scenario are pinning their hopes on either an unlikely rapid return to past patterns of consumer behavior, an unlikely rapid evolution in patterns of economic activity that are not consumer dependent, or a decoupling of emerging market economic activity from the US (which could pose a different set of policy challenges).

The Ratio of Short-term to Long-Term Unemployment

When this value is high, and the overall level of unemployment is low, I think we can reasonably argue that it is a sign of a healthy, dynamic economy. No surprise, but right now the ratio is at its lowest value since 1980.

How Will the CBO Score Today's Health Care Announcement?

Mathew Yglesias explains that the importance of today's announcement that major health organizations believe it possible to reduce the escalation in health care costs is the effect the announcement may have on how the CBO scores savings from the health care plan:

The Significance of Today's Health Care Announcement, by Mathew Yglesias: Paul Krugman and Jonathan Cohn wax enthusiastic about the news that representatives for the nation's major health care provider organizations ... will come to the White House and announce that they believe it's possible to achieve $2 trillion in cost savings over ten years without compromising patient care. Ezra Klein is more skeptical, worrying that these groups haven't really made any firm commitments to anything in particular.

But the real import of today's event isn't in its signal for what industry insiders may do in the future, it's for the Congressional Budget Office. The main impediment to a health care deal, at this point, is cost. The up-front costs are large. To cover these costs, the Obama administration proposed several exceedingly reasonable tax changes, focused on curbing deductions for high-income taxpayer. This is the most economically efficient possible way of raising revenue, so naturally congressional Democrats rejected it out of hand.

That means that to make the costs work, it's going to be necessary to rely on reform's inherent potential to wring some of the massive waste out of the system. The problem here is that the CBO has been reluctant to "score" such savings in its official account of the bill. As Igor Volsky emphasizes, this industry statement is an important challenge to that CBO reluctance:

Early reports indicate that the signers ... hope to contain costs by implementing "aggressive efforts to prevent obesity, coordinate care, manage chronic illnesses and curtail unnecessary tests and procedures; by standardizing insurance claim forms; and by increasing the use of information technology, like electronic medical records."

The industry is suggesting that these cost containment measures — which don't score too well with the Congressional Budget Office — would in fact yield cost savings and help finance health reform. The letter ... takes on the CBO, whose models are likely under-scoring the savings from reforms.

Whatever kind of backstabbing these industry groups may or may not do in the future, they won't be able to take back the fact that once upon a time they stood beside the White House in agreeing that it's possible to achieve massive cost-savings without compromising patient care. That argument may well prove hugely important, politically, to getting a package through congress.

The idea is to pay for reform in part through the CBO scoring procedure, but if CBO won't recognize anticipated savings, then this strategy doesn't work and reform would have to be paid for by raising taxes instead, something congress is reluctant to do. The hope is that today's announcement from health industry representatives that cost savings are possible will change the CBOs willingness to score these cost savings. If the cost savings don't actually materialize later, then some way of making up for the increased costs will have to be found, but for the moment the focus is on getting a bill through congress (this is also the motivation for the administration's recent announcement of the intent to raise 210 billion over 10 years by changing the rules on the use of offshore tax havens, the saving would be used to offset the cost of health care reform).

Update: Ezra Klein:

Is it All about the CBO?, by Ezra Klein: It's true that legislators are very concerned that the Congressional Budget Office won't score likely savings. That will mean the bill's total price tag is higher and the legislation is harder to pay for. But this letter doesn't obviate that problem. It doesn't even change it. The issue isn't that a CBO price tag is credible, and so you need another credible price tag if you want to argue against it. It's that the CBO number is one used by the budget committees, and so if health care is going to pass under pay-go rules -- and my understanding is that it will -- then you have to find revenues that match whatever CBO says the cost is. The revenues can't just match what the industry says the cost is. For much more on the importance of CBO and the price tag it selects, read this piece.

The other option here is something called "directed scoring." Under this scenario, Congress would essentially order the CBO to score health reform in a certain way. I know that some quarters are discussing this possibility, but I don't think most people believe you can get very far with it. More on this later.

Paul Krugman: Harry, Louise and Barack

Paul Krugman is pleased with developments in health care reform:

Harry, Louise and Barack, by Paul Krugman, Commentary, NY Times: Is this the end for Harry and Louise?

Harry and Louise were the fictional couple who appeared in advertisements run by the insurance industry in 1993, fretting about what would happen if "government bureaucrats" started making health care decisions. The ads helped kill the Clinton health care plan, and have stood, ever since, as a symbol of the ability of powerful special interests to block health care reform.

But ... this time the medical-industrial complex ... is offering to be helpful. Six major industry players ... sent a letter to President Obama sketching out a plan to control health care costs. What's more, the letter implicitly endorses much of what administration officials have been saying about health economics.

Are there reasons to be suspicious about this gift? You bet... But ... on the face of it, this is tremendously good news.

The signatories of the letter say that they're developing proposals to help the administration achieve its goal of shaving 1.5 percentage points off the growth rate of health care spending. That may not sound like much, but ... that ... would save $2 trillion over the next decade.

How are costs to be contained? There are few details, but the industry has clearly been reading Peter Orszag, the budget director.

In his previous job,... director of the Congressional Budget Office, Mr. Orszag argued that America spends far too much on some types of health care with little or no medical benefit, even as it spends too little on other types of care, like prevention and treatment of chronic conditions. Putting these together, he concluded that "substantial opportunities exist to reduce costs without harming health over all."

Sure enough, the health industry letter talks of "reducing over-use and under-use of health care by aligning quality and efficiency incentives." It also picks up a related favorite Orszag theme, calling for "adherence to evidence-based best practices and therapies." All in all, it's just what the doctor, er, budget director ordered.

Before we start celebrating, however... Is this gift a Trojan horse? After all, several of the organizations that sent that letter have in the past been major villains when it comes to health care policy. ... Remember that what the rest of us call health care costs, they call income.

What's presumably going on here is that key interest groups have realized that health care reform is going to happen no matter what they do, and that aligning themselves with the Party of No will just deny them a seat at the table. ...

I would strongly urge the Obama administration to hang tough in the bargaining ahead. In particular,... on cost control...: giving Americans the choice of buying into a public insurance plan as an alternative to private insurers. The administration should not give in on this point.

But let me not be too negative. The fact that the medical-industrial complex is trying to shape health care reform rather than block it is a tremendously good omen. It looks as if America may finally get what every other advanced country already has: a system that guarantees essential health care to all its citizens.

And serious cost control would change everything, not just for health care, but for America's fiscal future. As Mr. Orszag has emphasized, rising health care costs are the main reason long-run budget projections look so grim. Slow the rate at which those costs rise, and the future will look far brighter.

I still won't count my health care chickens until they're hatched. But this is some of the best policy news I've heard in a long time.

"Financial Policy: Looking Forward"

Susan Woodward and Robert Hall have advice for policymakers:

Financial policy: Looking forward, by Woodward and Hall: Washington is turning its attention to the future, having put out most of the financial fires. The crisis seems to be over, but questions remain about how to manage under-capitalized banks and, especially, how to design a financial system for the future that is more robust to adverse shocks. With fiscal stimulus in place and no likelihood of more, financial policy by the Fed and the Treasury is the only active possibility for further action to offset the recession.

The current state of the economy The stock market thinks that the economy is turning around, and the financial press greeted last Friday's payroll report with a positive spin, for once. But the news is not good. ...

Apart from the successful effort to prevent the collapse of the financial system, the primary financial action to offset the recession has been the Fed's adoption of an interest-rate target for interbank lending of essentially zero. Rates on short-term safe assets–Treasury obligations and private instruments enjoying explicit or implicit government guarantees–are close to zero. But, sadly, rates actually paid by most private decision makers are almost as high, or in some cases higher, than before the recession began. ...

The notion that monetary policy has been highly expansionary–promoted by those looking only at safe government (Treasury) interest rates and at the volume of bank reserves–is plainly incorrect. Rather, higher interest rates are discouraging spending and production.

Monetary expansion The Fed is attacking high interest rates by purchasing private debt. Higher demand for any class of debt will drive down the interest rate for that class. One of the important lessons of the past year has been that various interest rates do not all move together in times of severe financial stress (or at other times either). Thus, the Fed has not run out of options after it drives the Fed funds rate to zero. Unfortunately, the Fed is not able to expand its holdings of private securities efficiently. The efficient borrower is the Treasury, which floats short-term debt at very low rates in the world credit market. ... By contrast, the Fed borrows only from American banks. The Fed currently pays twice as high an interest rate on its borrowings as does the Treasury for its shortest-term borrowings... Earlier in the crisis, the Treasury did borrow and place the funds at the Fed's disposal, providing the efficient approach to Fed expansion, but the Treasury has withdrawn most of those funds. It's time for the Treasury to resume its past practice on a much larger scale and for the Fed to cut reserves back to more normal levels. The political obstacle to this move is the ceiling on the national debt, which fails to count reserves as part of the debt, so the government can circumvent the ceiling by creating reserves instead of issuing Treasury securities, at a somewhat higher cost.

Current policy for weak financial institutions Economists are increasingly puzzled by the government's treatment of banks and other financial institutions that are teetering near insolvency. The doctrine is widely accepted that institutions in this state are a danger to the economy (because their incentive is to take some big risks to try to get out of the hole, as the S&Ls did in the 1980s) and that regulators should take prompt, aggressive action to return them to sound financial condition. This doctrine calls for institutions to be reorganized or recapitalized so that they are unambiguously solvent and the consequences of risk-taking are mainly their own. The government's actions for Chrysler and General Motors follow the doctrine. ...

By contrast, the government's current policy for all large financial institutions is to dribble taxpayers' funds into the institutions so that they can meet their stated obligations to all parties, including debtholders, but just barely. ... The government has forgotten the doctrine of immediate full recapitalization in the case of financial institutions, despite the clear lessons of international experience. The Scandinavian countries aggressively reorganized and recapitalized banks after the crisis of the early 1990s and quickly restored full employment and growth; the Japanese followed the policy of supporting marginal banks for what became the "lost decade."

The celebrated stress tests, just completed, illustrate the current policy perfectly. The test asks if it is likely that a bank can sustain its current status through the end of 2010. "Sustain" means earn enough ... to cover losses that would occur under a pessimistic macro forecast. ... If the bank can just squeak through the next 20 months..., then it passes the test. ... The stress test is the right way to figure out the minimum amount needed to inject in weak banks to keep them barely afloat, but that is the wrong policy. ...

Unfavorable developments since the design of the stress test raise questions about its interpretation as the most pessimistic reasonable forecast. ...

The bottom line is that Congress and the taxpayers are intolerant of continued expenditures for bailouts that generate large capital gains for debtholders, that the bailout policy maintains shaky financial institutions while a better policy would deliver fully capitalized, reliable ones, and that Congress should enact legislation promptly that would make these reorganizations possible.

Reform for the longer run

...The idea that banks should have large amounts of fully subordinated debt is hardly new. The only novelty in this line of thought is methods for protecting banks and similar institutions from breakdowns in high-speed financial transactions. And this novelty arises because our financial institutions have new moving parts they did not have even 25 years ago, and because it has been such a long time since our largest banks were so close to insolvent. The regulatory structure has not kept up....

[There's quite a bit more, including graphs, in the full version.]

Antitrust Enforcement

This is a welcome change. I've long been an advocate of stepped up enforcement of antitrust law, mostly because of the economic consequences of monopoly power. But the financial crisis has caused me to realize how much political power comes with dominance in the marketplace, and that is another reason to take a more aggressive approach to antitrust enforcement:

Administration Plans to Strengthen Antitrust Rules, by Stephen Labaton, NY Times: President Obama's top antitrust official this week plans to restore an aggressive enforcement policy against corporations that use their market dominance to elbow out competitors or to keep them from gaining market share. The new enforcement policy would reverse the Bush administration's approach, which strongly favored defendants against antitrust claims. ...

The head of the Justice Department's antitrust division, Christine A. Varney, is to announce the policy reversal in a speech she will give on Monday... The administration is hoping to encourage smaller companies in an array of industries to bring their complaints to the Justice Department about potentially improper business practices by their larger rivals. Some of the biggest antitrust cases were initiated by complaints taken to the Justice Department.

Ms. Varney is expected to say that the administration rejects the impulse to go easy on antitrust enforcement during weak economic times. She will assert instead that severe recessions can provide dangerous incentives for large and dominating companies to engage in predatory behavior that harms consumers and weakens competition.

The announcement is aimed at making sure that no court or party to a lawsuit can cite the Bush administration policy as the government's official view in any pending cases. ... Ms. Varney is expected to explicitly warn judges and litigants in antitrust lawsuits not involving the government to ignore the Bush administration's policies...

During the Bush administration, the Justice Department did not file a single case against a dominant firm for violating the antimonopoly law. Many smaller companies complaining of abusive practices by their larger rivals were so frustrated by the Bush administration's antitrust policy that they went to the European Commission and to Asian authorities. ...

Ms. Varney is expected to say that the Obama administration will be guided by the view that it was a major mistake during the outset of the Great Depression to relax antitrust enforcement, only to try to catch up and become more vigorous later. She will say the mistake enabled many large companies to engage in pricing, wage and collusive practices that harmed consumers and took years to reverse.

While Ms. Varney is not expected to mention any specific companies or industries..., she is aiming at agriculture, energy, health care, technology and telecommunications companies. She may also be reviewing the conduct of some in the financial services industry...

Signaling her intent to revive a moribund antitrust program, she has recruited a collection of senior aides, many of whom are seasoned antitrust litigators or worked in the Clinton administration and the Federal Trade Commission and were involved in many prominent cases, including the one against Microsoft. ...

links for 2009-05-11

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