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June 10, 2009

Economist's View - 5 new articles

Fed Watch: Rate Hike?

Tim Duy responds to talk of a rate hike:

Rate Hike?, by Tim Duy: Seriously, a rate hike in this environment? Or anytime before the end of 2009? At the moment, I just can't see it happening. That said, long rate are higher, and inflation expectations in some corners of the market are rising. What is going on? My explanation for recent market action revolves around three themes:

1.)Financial Armageddon appears to have been avoided - at least for the moment. The "all but explicit" implicit guarantee that no significant US financial institution will be allowed to fail established a return to financial stability. And with that stability comes an end to the flight to safety that buoyed Treasury prices. Something off a conundrum for Treasury Secretary Timothy Geithner - cheap financing of the staggering US deficit appears to be dependent on financial instability.

2.)Recent inflation numbers are not exactly what I would call benign. The trend in core PCE is not deflationary:


I think deflation fears were always overblown - the current batch of monetary policymakers are simply dead set against such an outcome. The deflation trade, like the flight to safety, needed to be priced out of Treasury's and TIPS. The outcome: Breakeven spreads are up sharply.

3.) The US, in aggregate, is borrowing less from the world than a year ago. But make no mistake, we still rely on capital inflows to maintain a substantial US current account deficit. Lacking a flight to safety, it is not clear that private investors are willing to support that deficit at 2.75%. Or even 4%, for that matter. That fact that foreign central banks are accumulating Dollars is proof positive that private investors don't want to do the job - and the transition in central bank purchases from the long end to the short end suggest that even they grow weary of this game. Remember, the argument that "Japan ran a massive budget deficit so we can too" falls apart when you recognize that for decades Japan has been able to rely entirely on internal savings to finance the deficit. My interpretation: The invisible hand (apologies to Gavin Kennedy) is still pushing for lower US consumption to bring the external accounts into better balance - and that means higher rates to maintain inflows while suppressing the pace of economic growth. I understand this is in direct conflict with the output gap story; reconciling the two, I believe, requires an admission that the US economy is terribly structurally imbalanced internally. We may have excess capacity, but not excess capacity to make anything anybody real wants.

Where do Federal Reserve policymakers stand on recent dynamics? Turning to Federal Reserve Chairman Ben Bernanke:

In markets for longer-term credit, bond issuance by nonfinancial firms has been relatively strong recently, and spreads between Treasury yields and rates paid by corporate borrowers have narrowed some, though they remain wide. Mortgage rates and spreads have also been reduced by the Federal Reserve's program of purchasing agency debt and agency mortgage-backed securities. However, in recent weeks, yields on longer-term Treasury securities and fixed-rate mortgages have risen. These increases appear to reflect concerns about large federal deficits but also other causes, including greater optimism about the economic outlook, a reversal of flight-to-quality flows, and technical factors related to the hedging of mortgage holdings.

Not terribly different from my interpretation. The greater optimism and safety reversal is effectively the same as the end of the Armageddon trade, and the federal deficit concern ties into aggregate US borrowing. The technical factors - referring to hedging against the increased expected duration of mortgage assets as mortgage rates rise - appears to me to be related to a general increase in rate pressures as a whole, but I will defer to fixed income specialists on that topic. He does not identify the change in central bank purchasing patterns, but neither does he mention the Fed's decision at the last FOMC meeting not to expand their Treasury purchase program.

Note that he also does not mention inflation concerns, which some believe is the true reason for recent market action. On inflation, Bernanke covers familiar territory:

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, and the unemployment rate is likely to rise for a time, even after economic growth resumes.

In this environment, we anticipate that inflation will remain low. The slack in resource utilization remains sizable, and, notwithstanding recent increases in the prices of oil and other commodities, cost pressures generally remain subdued. As a consequence, inflation is likely to move down some over the next year relative to its pace in 2008. That said, improving economic conditions and stable inflation expectations should limit further declines in inflation.

He is sticking to the output gap argument to dismiss inflationary concerns. Those expecting hyperinflation dismiss this Bernanke's position, arguing that emerging markets often experience weak growth combined with high inflation. I believe this line of reasoning ignores the institutional differences that prevent price inflation from being propagated via wage inflation in the US. We simply lack the populist/union dynamic that makes such a dynamic possible. Can such a dynamic develop? Sure, over time, with sufficient policy errors. But in time to prompt a rate hike in 2009? Doubtful. Very, very doubtful.

( As an aside, the rise in unit labor costs reported by the BLS will not be interpreted by Fed policymakers as evidence that wage inflation is accelerating . Note how unit labor costs are constructed - a drop in output, as one typically sees during a recession, if not matched by an equal drop in hours worked, is almost certain to generate a jump in labor costs. But this is not a signal that labor costs are rising rapidly; it signals that firms are not bringing capacity in line with demand - they need to fire more workers, or cut their wages.)

Combine Bernanke with the Beige Book:

Reports from the twelve Federal Reserve District Banks indicate that economic conditions remained weak or deteriorated further during the period from mid-April through May. However, five of the Districts noted that the downward trend is showing signs of moderating. Further, contacts from several Districts said that their expectations have improved, though they do not see a substantial increase in economic activity through the end of the year.

No significant growth implies a widening output gap and higher unemployment rates, which means no rate hike on the horizon. Even more important, with no mechanism to link price inflation to wage inflation, the Fed will not respond to high core inflation (above) and certainly not rising headline inflation, instead viewing the higher prices as a deflationary force via the erosion of real incomes. Which, interestingly, fits with my hypothesis that the invisible hand is attempting to suppress US demand growth. This suggests that neither of the deflation/inflation extremes will be correct; most likely correct is a slightly elevated inflation rate combined with low wage growth. Not pretty, but not a disaster. That is, of course, assuming policymakers will accept such an outcome. The most significant risk, in my opinion, is that the Fed has lost monetary independence. Not there yet.

To be sure, market participants will react to the occasional loose cannon from the hinterlands of US central banking, district bank presidents. The most direct has been Kansas City Fed President Thomas Hoenig, but Richmond Fed President Jeffrey Lacker often gets the more prominent headlines:

In his speech to North Carolina's lawmakers, Lacker stressed the importance of not waiting too long before raising interest rates in case this allowed inflation to take root.

How long is too long? Even Lacker does not sound itching to raise rates this year:

But he emphasized during his discussion with reporters that he still expected the very weak state of the economy to warrant low Fed rates for a while.

"I think growth is likely to warrant rates as low as they are for some time, but just how long is uncertain and hard to predict in advance. We'll just have to wait to see how the growth process unfolds this year and into next year," he said.

Note his timeline, "into next year." Even the hawkish are not really hawkish.

Bottom Line: Looking for a rate hike this year is premature. Too much slack in the US economy will keep the Fed on the sidelines. If you are arguing for an incipient inflation outbreak that requires a policy response, you need a story explaining how price pressures are translating into wage pressures. Right now, I don't see that story. Maybe after another decade like this, but not right now.

Anna Schwartz: The Fed's Performance "Has been Disappointing"

I disagree with Anna Schwartz with respect to the Lehman Brothers bailout - she contends that the trouble started when the (ill-advised) rescue of Bear Stearns set up expectations that Lehman would be treated similarly - but if Bear Stearns or another large bank had been allowed to fail instead, I think we would have seen the same panic in financial markets. But as noted below, I don't disagree with all of her criticisms of the Fed:

Taking Stock: Lessons from History, MarketPlace [audio]: Kai Ryssdal: ...Anna Schwartz [is] 93 years old, an economist for more than 60 of them. Still working, every day, at the National Bureau of Economic Research in New York City. Her area of expertise is monetary policy... Specifically, she's an expert in how the Fed blew it during the Great Depression... When I sat down with her in her office..., she made it clear she's none too happy about all of Washington's bailouts, or how the Fed and the Treasury chose who got one and who didn't.

Schwartz: I think both Bush and the Obama administration have not been as hard headed with banks, it has been too lax. And instead if they had said if you cannot raise capital in the market, there is no reason for the government, the people of this country, to provide capital.

Ryssdal: OK, but wait a minute. Didn't we try that with Lehman Brothers last September? And there are people who will say that only made everything worse. ...

Schwartz: No, the trouble with the way the Fed operated when it rescued Bear Stearns, the market then believed this was a signal of the way the Federal Reserve would perform. If the Fed and the Treasury made a candid statement to the market: We will help a bank, which basically is solvent. We will not do that for a bank, which is on the verge of bankruptcy. And then the market understands there are principles. That's why when Lehman Brothers was permitted to fail, the market was simply bewildered. Because here you had treated Bear Stearns in this kindly fashion, and what reason was there not to do the same when Lehman Brothers arose?

Ryssdal: Now do you think the market has figured out what the policy of the federal government is toward these rescues by now? It's been six, seven months since Lehman Brothers.

Schwartz: The market is just bewildered. Bernanke came into office insisting that the Fed would be much more transparent... But I don't believe that it's lived up to that. If the market understood what the Fed was planning in each case, and could see a design, then I think the market would have reacted much more positively.

Ryssdal: It sounds like you're frustrated with Chairman Bernanke...

Schwartz: Well, I think that that's a fair statement. ...Bernanke's ... performance ...[s]eemed to be ... ad hoc and introduced without considering all the implications.

Ryssdal: You know, Alan Greenspan was lionized in this country for many years. And then a year ago went up to Capitol Hill and said, "You know what, I blew it." Does he get the appropriate amount of credit and/or blame for this whole thing?

Schwartz: Well, I think the verdict of history will be different with regard to his stature than it has been so far.

Ryssdal: In your mind, these toxic assets, the bad assets that these banks still have on their books, are they still a big problem or have they worked their way through the system now?

Schwartz: No, and I think the big shortcoming of the Obama administration, and Bush before that, was that it didn't make a concerted effort to get rid of these assets. I mean in a sense it's a condemnation of the Federal Reserve. They did not respond to securitization, which is the basic condition for the creation of these toxic assets. Neither Alan Greenspan or anybody else at the Fed seemed to be concerned.

Ryssdal: Securitization, that is the buying and selling of these packages of mortgages. There are those who will say it contributed a lot to the economic growth in this country. Do you buy that?

Schwartz: Well, I suppose the people who made money on it will say, Sure. But you have to be able to divine what you're letting yourself in for,... nobody took action to say, "Wait a minute. What are we doing when we are permitting these mortgage companies to issue these securities backed by a pool of mortgages of varying quality, and you don't know how to price the security?" Nobody raised that question.

Ryssdal: When an economic historian comes along in 25 or 30 years and tries to do for this episode what you and Professor Friedman did for the Great Depression, what's their verdict going to be...?

Schwartz: ...I don't know whether the verdict will be charitable. It's always possible to find reasons why other alternatives were not really available. But I think on the whole the performance has been disappointing. Because now two years and more after Bernanke came into office we don't see visible signs of change for the better.

For me, the failure to develop and quickly implement a plan for removing toxic assets from bank balance sheets has been the biggest policy failure. It's looking now like we may eventually get through this downturn without having ever put an effective toxic asset removal plan in place (though the administration claims they are still trying), and some contend that means we never needed a plan in the first place. But I disagree. We will never know the answer to this counterfactual, but I believe that if we has responded with a program quickly - a year an a half ago say and maybe even before that - I don't think the downturn would have been as severe. Yes, it's a hard problem to value these assets, but that's what made it essential to get it resolved - having assets on bank books that nobody wants anything to do with because their value is unknown is partly what has kept asset markets frozen (and banks that are allowed to overvalue these assets to appear solvent are in no hurry to get this resolved). Getting a toxic asset program in place quickly - even if it meant assuming some risk of losses by the government - would have made a difference.

2009 Reith Lectures: Markets and Morals

Have markets overstepped their societal bounds? Here's the radio broadcast from the BBC, and here is a (much shortened) transcript of Michaels Sandel's attempt to make the case that we need "a politics oriented less to the pursuit of individual self-interest and more to the pursuit of the common good" (also, I wish I had read this before writing the post below this one on financial community norms, his point that "norms matter" - see the Grand Canyon and Kyoto examples - is along the lines of what I was trying to say):

Reith Lectures 2009: A New Citizenship, Presenter: Professor Michael Sandel, Lecture 1: Markets and Morals: SUE LAWLEY: ...This year's lecturer believes we need to think afresh about what we mean by 'the common good'... He's one of today's most eminent philosophers and political thinkers. His course on justice at Harvard University is one of the most oversubscribed in the history of the place. And his books have received worldwide acclaim. So I ask you, please, ladies and gentlemen, to welcome the BBC Reith Lecturer for 2009: Michael Sandel. ...

[Y]ou've told me that you ... were thinking about, as you were becoming an academic, of studying Economics further; and then you decided, you decided it was "a spurious science". Your words. Why? ...

MICHAEL SANDEL: It's a spurious science in so far as it is used to tell us what we ought to do because questions of what we ought to do in politics or as a society are unavoidably moral and political, not merely economic questions, and so they require democratic debate about fundamental values. Economists can inform us about possible implications of policy choices, but they can't tell us - and they don't really claim to tell us - what's right and wrong, what's just and unjust. So I decided to veer into that line of work.

SUE LAWLEY: But we're hoping that's what you're going to tell us during the course of these lectures. Hence, your first salvo: markets and morality. Michael, can I invite you to deliver Lecture number one? Thank you.

MICHAEL SANDEL: Well thank you, thank you very much. ...

We live in a time of financial crisis and economic hardship - everybody knows that - but we also live in a time of great hope for moral and civic renewal. ... Whatever reforms may emerge, one thing is clear: the better kind of politics we need is a politics oriented less to the pursuit of individual self-interest and more to the pursuit of the common good. That at least is the case I shall try to make in these lectures. ...

Which brings me to ... this first lecture. We're living with the economic fallout of the financial crisis and we're struggling to make sense of it. One way of understanding what's happened is to see that we're at the end of an era, an era of market triumphalism. The last three decades were a heady, reckless time of market mania and deregulation. We had the free market fundamentalism of the Reagan-Thatcher years and then we had the market friendly Neo-Liberalism of the Clinton and Blair years, which moderated but also consolidated the faith that markets are the primary mechanism for achieving the public good. Today that faith is in doubt. Market triumphalism has given way to a new market scepticism. Almost everybody agrees that we need to improve regulation, but this moment is about more than devising new regulations. It's also a time, or so it seems to me, to rethink the role of markets in achieving the public good. There's now a widespread sense that markets have become detached from fundamental values, that we need to reconnect markets and values. But how?

Well it depends on what you think has gone wrong. Some say the problem is greed, which led to irresponsible risk taking. If this is right, the challenge is to rein in greed, to shore up values of responsibility and trust, integrity and fair dealing; to appeal, in short, to personal virtues as a remedy to market values run amuck.

We might call this diagnosis 'the greed critique'. But the greed critique is flawed or, at best, partial. Markets have always run on self-interest. ... Greed is a vice in personal relations, but the whole point of markets is to turn this vice into an instrument of the public good. ... This was Adam Smith. So it's tempting to say that all we need to do is rein in greed and restore integrity among bankers and business executives and politicians, but this response is ... not really much help in rethinking the role that markets play in our societies. So what's the alternative? The alternative is to re-think the reach of markets into spheres of life where they don't belong. We need a public debate about what it means to keep markets in their place. And to have this debate, we have to think through the moral limits of markets. We need to recognise that there are some things that money can't buy and other things that money can buy but shouldn't.

Looking back over three decades of market triumphalism, the most fateful change was not an increase in the incidence of greed. It was the expansion of markets and of market values into spheres of life traditionally governed by non-market norms. We've seen, for example, the proliferation of for profit schools, hospitals and prisons; the outsourcing of war to private military contractors. We've seen the eclipse of public police forces by private security firms, especially in the US and the UK... Or consider some recent proposals to use market incentives to solve social problems. Some New York City schools are trying to improve academic performance by paying children 50 dollars if they get good scores on standardised tests. ...

Or consider the vexed issue of immigration policy. Gary Becker, the Nobel Prize winning free market economist at the University of Chicago, has a solution: to resolve the contentious debate over whom to admit, the US, he says, should simply set a price and sell American citizenship for 50,000 dollars, or perhaps 100,000. Immigrants willing to pay a large entrance fee, Becker reasons, would automatically have desirable characteristics. (LAUGHTER) ...

There is something distasteful about a market in refugees, even if it's for their own good, but what exactly is objectionable about it? It has something to do with the fact that a market in refugees changes our view of who refugees are and how they should be treated. It encourages the participants - the buyers, the sellers and also those whose asylum is being haggled over - to think of refugees as burdens to be unloaded or as revenue sources rather than as human beings in peril. What this worry shows is that markets are not mere mechanisms. They embody certain norms. They presuppose, and also promote, certain ways of valuing the goods being exchanged. Economists often assume that markets are inert, that they do not touch or taint the goods they regulate. But this is a mistake. Markets leave their mark. Often market incentives erode or crowd out non-market incentives.

Let's go back to the case of cash for kids who make good test scores. Why hesitate to pay a child for getting good marks or for reading a book? The goal, after all, is to motivate the child to study or to read, and the payment is an incentive to promote that end. Economics teaches that people respond to incentives, and while some children may be motivated to read books for the love of learning, others may not. So why not use money to add a further incentive? Economic reasoning would suggest that two incentives work better than one, but it could turn out that the monetary incentive undermines the intrinsic one, leading to less reading rather than more, or to more reading in the short-run but for the wrong reason. On this scenario, the market is an instrument but not an innocent instrument. What begins as a market mechanism becomes a market norm. The obvious worry is that the payment may habituate children to think of reading books as a way of making money, and so erode or crowd out or corrupt the intrinsic good of reading. ...

When we impose a fine for littering, we're saying that littering is wrong. Tossing a beer can into the Grand Canyon not only imposes clean-up costs; it reflects a bad attitude that we want to discourage. Suppose the fine is 100 dollars and a wealthy hiker decides it's worth the convenience. He treats the fine as a fee and tosses his beer can into the Grand Canyon. Even if he pays up, we consider that he's done something wrong. By treating the Grand Canyon as an expensive dumpster, he's failed to appreciate it in an appropriate way. ...

At the Kyoto conference on global warming in 1997, the United States insisted that any mandatory emission standards would have to include a trading scheme, allowing countries to buy and sell the right to pollute. ...

At the time, I wrote an opinion piece in the New York Times arguing against the trading scheme. I worried that letting countries buy the right to pollute would be like letting people pay to litter. We should try to strengthen, not weaken the moral stigma attached to despoiling the environment, I thought. I also worried that if rich countries could buy their way out of the duty to reduce their own emissions, we would undermine the sense of shared sacrifice necessary to future global cooperation on the environment.

After my piece ran, The Times was flooded with scathing letters - mostly from economists (LAUGHTER), some from my own university. I utterly failed to understand the virtue of markets, they said, or the efficiencies of trade, or even the most elementary principles of economic rationality. Amidst the torrent of criticism, I did receive a sympathetic email from my old college Economics Professor. He understood the point I was trying to make, he wrote, but could he ask a small favour: would I mind not publicly revealing the identity of the person who had taught me Economics? (LAUGHTER)

I've since reconsidered my views about emissions trading to some extent, but I continue to think that in addressing this question most economists miss the crucial point: norms matter. In deciding how best to get global action on climate change, we have to cultivate a new environmental ethic, a new set of attitudes toward the planet we share. We're unlikely to foster the global cooperation we need if some countries are able to buy their way out of meaningful reductions in their own energy use. ...

My general point is this. Some of the good things in life are corrupted or degraded if turned into commodities, so to decide when to use markets, it's not enough to think about efficiency; we have also to decide how to value the goods in question. Health, education, national defence, criminal justice, environmental protection and so on - these are moral and political questions, not merely economic ones. To decide them democratically, we have to debate case by case the moral meaning of these goods in the proper way of valuing. This is the debate we didn't have during the age of market triumphalism. As a result, without quite realising it, without ever deciding to do so, we drifted from having a market economy to being a market society. The hope for moral and civic renewal depends on having that debate now. It is not a debate that is likely to produce quick or easy agreement. To argue about the right way of valuing goods is to bring moral and even spiritual questions into public discourse. Is it possible to bring moral and religious disagreements into public life without descending into intolerance and coercion? That is the question I'll turn to in the next lecture. Thank you very much. ... [...followed by long Q&A session...]

Financial Community Norms

Bill Easterly:

Rulers, communities, and revolution, by Bill Easterly: ...Some have had a simplistic view of institutions in development as deriving only from top-down formal rules and laws. ...[M]uch research indicates otherwise.

First, formal rules that are incompatible with community norms often have no effect (this extends to things like trying to have registered land titles when the local community already has customary allocation of land rights, research on paper land titles in Africa confirms they have little effect on anything).

Second, if the rulers are especially oppressive they could enforce the incompatible formal rules by force, which would make communities worse off. But in a free society, the community can resist the rulers, which is part of the benefit of a free society.

Third, most rules we live by in a free society are more the product of community norms than they are of formal laws. (Fancy version: Rules emerge out of complex social interactions in a spontaneous order.) This is a good thing, as it makes the rules more responsive to local circumstances and needs. Down with arbitrary rules, up with community norms.

There's a lesson here for regulation. It's not enough to change the rules. If the culture doesn't change to support those rules, the rules won't be effective. The current crisis wasn't just because we had ineffective regulation and all we have to do now to fix things is to change the rules of the game. Attitudes must change as well.

So having just said "I don't really buy the explanation that an erosion of culture played a big role in the crisis," something I stand by with respect to the "post-modernism" argument at dispute in that post, I think there is a sense in which culture must change. If you believe that an invisible hand guides self-interest to maximize societies interests, always and everywhere except for a set with measure zero, then you can also convince yourself that whatever greedy, self-interested action that you take is meritorious in some larger sense. But without the proper social guidance as a check on those actions, that is not the case at all. Some of those checks are formal rules and regulations, but the institutions and community norms that exist are every bit as important.

So yes, we need new regulation, but the financial community also needs to establish new norms, and people who step outside of those norms must be socially ostracized in whatever sense is required in those markets. Rules and regulations are not enough by themselves, community attitudes must change as well.

Will attitudes change enough? It seems like there's been some change, for now at least, though not everyone would agree with that, and we won't really know until the financial sector gets back on its feet -- there's no guarantee that whatever change in attitudes that has occurred will persist. I have my doubts that it will.

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