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June 3, 2009

Economist's View - 6 new articles

"One-Party State Watch"

Arnold Kling on the future of the Republican Party:

One-Party State Watch, Econlog: I went to an event on the future of conservatism, described here.

No one was raising bright prospects for the Republican Party. At one point, Governor Daniels, the cover boy for National Review this week and the featured speaker, referred to the Republican Party as an "old jalopy." I believe it was also Governor Daniels who said that "we're in the penalty box." Rich Lowry said that a party's success depends on leaders, tone, policies, and circumstances, and that the Republicans have none of these going for them at the moment. At various points, it was noted out that the Republicans are hurting with young voters, Hispanics, and with intellectuals (a Republican committee staffer made the latter point during the question period). Lowry compared his coming of age under Reagan to today's young voters coming of age under Obama. I estimated the audience as 2 percent Black, 0 percent Hispanic, 2 percent Asian (including South Asians), and 96 percent white.

My question was whether, given all of the baggage of the Republican Party, conservatism ought to look elsewhere. The answers the panelists gave were that the Republicans are pretty much the only game in town for conservatives, and that sooner or later the Democrats will mess up and/or the public will get tired of the Democrats winning all the time.

I would not bet a whole lot on the theory that the American people will vote Republican because they love good competition. ... As the Republicans lose competitiveness... [w]e will ... be under ... the one-party state. ...

Today we heard an attempt to walk back on previous statements as Limbaugh now says maybe he could vote for Sotomayor - though he attached a poison pill to the proposition that tries to incite pro choice Democrats against her - and Gingrich now says it was a mistake to call her a racist. They are clearly worried.

Will the Debt be Monetized?

David Altig doesn't think the recent concern that the debt will be monetized is fully justified:

Debt and money, macroblog: If you are hunkered down on inflation watch, yesterday's news offered some soothing words. From Reuters:

Chinese officials have expressed concern that heavy deficit spending and an ultra-loose monetary policy could spark inflation, eroding the value of China's U.S. bond holdings.

But [U.S. Treasury Secretary Timothy] Geithner said: "We have a strong, independent Fed and I am completely confident they have the ability to do their job under the law, which is to keep inflation stable and low over time..."

And from Bloomberg:

He said that there was 'no risk' of the U.S. monetizing its debt...

Concerns about such monetization arose in the wake of the FOMC's decision at its March meeting to purchase up to $300 billion of longer-term Treasury securities and that decision's coincidence with the very large fiscal deficits contemplated in President Obama's budget proposals. Those concerns have accelerated as longer-term Treasury yields have moved higher since. ...

I will offer just a little perspective in the form of the chart below, which shows the recent and (near-term) prospective shares of federal debt held by the Federal Reserve. The red line represents the share of debt that will be held by the Fed at the end of fiscal year 2009 if the $300 billion Treasury purchase program is completed and the federal deficit emerges as currently predicted by the Congressional Budget Office.


The financial crisis has, of course, borne witness to the shift in the Fed's balance sheet from Treasuries (which have been much in demand by the private sector) to a variety of loans and mortgage-backed securities. The consequence has been a sharp fall in the fraction of government debt held by the central bank, a fact that will be little changed under the current trajectory of Fed purchases and projected deficit spending.

A large decline in Fed holdings of Treasury bills—securities that mature in one year or less—drives much of the pattern seen in the chart above. The drop-off in share is not as large for Treasury notes—securities in the two- to ten-year maturity range, and some assumptions have to be made to get a picture of how the Fed's share might evolve over the near term. Without knowing how this evolution will occur, I developed two general assumptions for argument sake. ... Though these numbers are not as unusually low in historical context as is the case for total outstanding debt, neither would they jump off the page as an extreme aberration in the other direction.


Some might argue that "monetization" these days involves a whole lot more than government debt, but Chairman Bernanke has been pretty clear about his intentions regarding the overall size of the Fed's balance sheet. And, as I see it, so far allegations that extraordinary steps are being taken specifically to accommodate fiscal deficits are properly characterized as risk rather than fact.

Bernanke: Current Economic and Financial Conditions and the Federal Budget

[A simulated interview based upon the speech Current economic and financial conditions and the federal budget, by Ben Bernanke, Chair, FRB (lightly edited - deletions only).]

Thanks for agreeing to this, I didn't think you would. Before turning to financial market conditions and the effects of the federal budget, the main topic today, let's start by getting your assessment and overview of the economy:

The U.S. economy has contracted sharply since last fall, with real gross domestic product (GDP) having dropped at an average annual rate of about 6 percent during the fourth quarter of 2008 and the first quarter of this year. Among the enormous costs of the downturn is the loss of nearly 6 million jobs since the beginning of 2008. The most recent information on the labor market--the number of new and continuing claims for unemployment insurance through late May--suggests that sizable job losses and further increases in unemployment are likely over the next few months.

What about the "green shoots" you talked about not too long ago? Are they withering or growing?

Recent data suggest that the pace of economic contraction may be slowing. Notably, consumer spending, which dropped sharply in the second half of last year, has been roughly flat since the turn of the year, and consumer sentiment has improved. In coming months, households' spending power will be boosted by the fiscal stimulus program.

So does that mean household consumption is likely to improve soon?

A number of factors are likely to continue to weigh on consumer spending, among them the weak labor market, the declines in equity and housing wealth that households have experienced over the past two years, and still-tight credit conditions.

What about housing, how do you see things there?

Activity in the housing market, after a long period of decline, has also shown some signs of bottoming. Sales of existing homes have been fairly stable since late last year, and sales of new homes seem to have flattened out in the past couple of monthly readings, though both remain at depressed levels. Meanwhile, construction of new homes has been sufficiently restrained to allow the backlog of unsold new homes to decline--a precondition for any recovery in homebuilding.

And business investment?

Businesses remain very cautious and continue to reduce their workforces and capital investments. On a more positive note, firms are making progress in shedding the unwanted inventories that they accumulated following last fall's sharp downturn in sales. The Commerce Department estimates that the pace of inventory liquidation quickened in the first quarter, accounting for a sizable portion of the reported decline in real GDP in that period. As inventory stocks move into better alignment with sales, firms should become more willing to increase production.

So what do you make of all of this? Do the signs of recovery later this year outweigh those indicating that the troubles will persist?

We continue to expect overall economic activity to bottom out, and then to turn up later this year. Our assessments that consumer spending and housing demand will stabilize and that the pace of inventory liquidation will slow are key building blocks of that forecast. Final demand should also be supported by fiscal and monetary stimulus, and U.S. exports may benefit if recent signs of stabilization in foreign economic activity prove accurate.

Any qualifications you'd like to make?

An important caveat is that our forecast also assumes continuing gradual repair of the financial system and an associated improvement in credit conditions; a relapse in the financial sector would be a significant drag on economic activity and could cause the incipient recovery to stall.

Let's come back to financial markets momentarily. But first, when you say recovery, what do you mean? What will the economy look like as it comes out of the slump?

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.

And inflation, the thing many people are so worried about, what do you see there?

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.

I ask about inflation, you talk about the risk of deflation. I suppose that answers the question. so let's move on to financial markets. In general, how are financial markets faring right now?

Conditions in a number of financial markets have improved since earlier this year, likely reflecting both policy actions taken by the Federal Reserve and other agencies as well as the somewhat better economic outlook. Nevertheless, financial markets and financial institutions remain under stress, and low asset prices and tight credit conditions continue to restrain economic activity.

Where are the improvements?

Among the markets where functioning has improved recently are those for short-term funding, including the interbank lending markets and the commercial paper market. Risk spreads in those markets appear to have moderated, and more lending is taking place at longer maturities. The better performance of short-term funding markets in part reflects the support afforded by Federal Reserve lending programs.

Is most of the improvement in short-term rather than long-term markets?

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.

What about the health of the large financial institutions? What do you learn from the SCAP program, better known as stress tests?

As you know, last month, the federal bank regulatory agencies released the results of the Supervisory Capital Assessment Program (SCAP). According to the findings of the SCAP exercise, under the more adverse economic outlook, losses at the 19 bank holding companies would total an estimated $600 billion during 2009 and 2010. After taking account of potential resources to absorb those losses, including expected revenues, reserves, and existing capital cushions, we determined that 10 of the 19 institutions should raise, collectively, additional common equity of $75 billion.

The substantial progress these firms have made in meeting their required capital buffers, and their success in raising private capital, suggests that investors are gaining greater confidence in the banking system.

Okay, let's turn to potential costs and benefits of recent fiscal policy. First, on the benefits, is the stimulus working?

Predicting the effects of these fiscal actions on economic activity is difficult, especially in light of the unusual economic circumstances that we face. The Congressional Budget Office (CBO) has constructed a range of estimates of the effects of the stimulus package on real GDP and employment that appropriately reflects these uncertainties. According to the CBO's estimates, by the end of 2010, the stimulus package could boost the level of real GDP between about 1 percent and a little more than 3 percent and the level of employment by between roughly 1 million and 3-1/2 million jobs.

Sounds like most of the benefits are yet to come according to your assessment, but they will come. What about the cost of the stimulus package?

The increases in spending and reductions in taxes associated with the fiscal package and the financial stabilization program, along with the losses in revenues and increases in income-support payments associated with the weak economy, will widen the federal budget deficit substantially this year. The Administration recently submitted a proposed budget that projects the ratio of federal debt held by the public to nominal GDP is likely to move up from about 40 percent before the onset of the financial crisis to about 70 percent in 2011. These developments would leave the debt-to-GDP ratio at its highest level since the early 1950s, the years following the massive debt buildup during World War II.

How worried are you about the deficit?

Certainly, our economy and financial markets face extraordinary near-term challenges, and strong and timely actions to respond to those challenges are necessary and appropriate. Nevertheless, maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and continued increases in medical costs. With the ratio of debt to GDP already elevated, we will not be able to continue borrowing indefinitely to meet these demands.

What's the answer?

Addressing the country's fiscal problems will require a willingness to make difficult choices. In the end, the fundamental decision that the Congress, the Administration, and the American people must confront is how large a share of the nation's economic resources to devote to federal government programs, including entitlement programs. Crucially, whatever size of government is chosen, tax rates must ultimately be set at a level sufficient to achieve an appropriate balance of spending and revenues in the long run. In particular, over the longer term, achieving fiscal sustainability--defined, for example, as a situation in which the ratios of government debt and interest payments to GDP are stable or declining, and tax rates are not so high as to impede economic growth--requires that spending and budget deficits be well controlled.

I have been critical of Greenspan for injecting his own political views into the debate over the budget deficit. I thought he had every right to comment on how deficits affect monetary policy through the government budget constraint, the effect on interest rates, etc., but he seemed to step beyond that limited role and inject his own political philosophy into the debate over budget deficits. So I have to express some disappointment that you would define fiscal sustainability in terms of growth rates, and implicitly warn that any decline in growth is unacceptable. I'm not saying that such a tradeoff necessarily exists, but as an example, if we could provide health care and retirement security for everyone in return for, say, 0.1% lower growth - say from an average of 3.0% to an average of 2.9% - is that a reasonable tradeoff? It seems to me that is not something the Fed should be choosing for us. It's fine to talk about the costs and benefits of fiscal policy in terms of what it means for monetary policy and the economy, but I don't see why the Fed should be advocating for or against such a tradeoff if that is what people want to do. You can tell us what each scenario means to the Fed, but leave the politics at home.

But enough of the soapbox, any response?

Clearly, the Congress and the Administration face formidable near-term challenges that must be addressed. But those near-term challenges must not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances. Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth.

And, I can tell that after my comment, this interview is over. Thank you.

"Benefit-Cost Analysis is No Help"

How much should we spend to prevent global warming?

Pindyck vs. Weitzman, Greed, Green and Grains: I spent last weekend at an excellent NBER Conference, Climate Change: Past and Present..., a highlight was a fantastic exchange between two proverbial giants on the Big Climate Change Question.

I'm paraphrasing arguments from memory here... And apologies in advance if this seems too technical.

Robert Pindyck went first. He presented a more-or-less standard representative agent macro model of the world economy and built in a lot of assumptions about various kinds of uncertainty surrounding the effect of warming on output. His model had welfare as a function of output and output growth as a function of temperature change. Importantly, it seems, he assumed temperature change could not affect utility in any manner other than output—a seemingly strong assumption in my book (we all study state-dependent utility, no?). He emphasized many assumptions that were generous toward those most worried about cataclysmic consequences of global warming. And in anticipation of Weitzman, he used probability distribution functions of uncertainties with "fat tails." Pindyck concluded that society's willingness to pay to prevent or severely limit global warming could be no more than about 2.5 percent of world income, and likely much, much less.

While Pindyck did use some relatively "green" assumptions that might favor a large number, it was also clear the deck was stacked. One key assumption: it makes no difference whether or not the world ends with certainty in 400 years. I had a hard time with that one. Stephen Salant, one of the discussants, had a hard time with it too. He noted that changing this assumption alone could increase willingness to pay to 99 percent of income. ...

Weitzman's view was the polar opposite of Pindyck's. Weitzman finds uncertainty everywhere, and finds thoughtful account of this uncertainty can easily lead to infinite valuations for preventing global warming. Weitzman acknowledged that plausible models give very low willingness to pay, but argued that equally plausible models could give infinite valuations. No one questioned his math. I, at least, found his assumptions and the effort he took to justify them as reasonable. Weitzman has clearly dug in deep in terms of the scientific climate change literature and thinking seriously about the long run.

A few interesting highlights:

Weitzman suggested that it's hard to take any of the climate models and economic models very seriously. He said there is little reliable temperature data because inferences from ice and sediment core samples and tree rings were noisy. In his view, the only good data are CO2 concentrations. These data ... show that we now have higher CO2 concentrations than at any point in many hundreds of thousands of years. And concentrations are growing at rate that almost surely exceed anything in millions and perhaps hundreds of millions of years. It is also clear that, broadly speaking, CO2 and temperatures moved together in history.

We are in unchartered territory, and this is the principal source of uncertainty. Even a small probability that our activities will extinguish the planet give good cause to stop emissions, even at high cost, per Weitzman's assumptions.

In the end, Weitzman said economic benefit-cost analysis is no help in situations like this one. He argued that climate change was rather unique in this way. Decisions must be made by some other means.

Pindyck argued that giving up on economic benefit-cost analysis would cede the debate to radical environmentalists. (He didn't say why not to radical climate-change denialists.) He argued it was critical for economists to wrestle with the issue and find a reasonable and balanced valuations and targets. ... Pindyck argued climate change was not unique. Other potential problems were equally ominous, including: running out of water, infectious diseases, nuclear war and nuclear terrorist attacks. So if willingness to pay for preventing climate change was infinite, it left no room for these other problems. ... Weitzman concurred that climate change risks needed to be balanced against other concerns, but where to spend money for the other concerns seemed less clear. And it wasn't clear how economists might help to quantify, realistically, these competing ominous concerns.

The inescapable conclusion to me was that we should worry a lot about what the future might hold. Technology and growth hold great promise and potential. But we also have a remarkably dangerous ability to influence our environment and destroy ourselves. How do we work collectively to make prudent choices and while preserving individual liberties? I'm pretty sure the answer is not to pretend these problems don't exist.

There was a lot of technical debate about the separability of temperature effects from output effects on utility. I found the debate rather strange because all of it was in terms of a single, globally representative individual. From where I sit, looking at how climate change will affect food supply, I can easily imagine a situation where the richer two-thirds of the world goes on growing happily as ever toward utopia while the other third starves to death. I have a hard time reconciling that view with a non-separable utility function.

Bank Mergers

As the number of banks began declining in the mid 1980s and a few Superbanks were created, the resulting concentration of risk made us Supervulnerable:

Too Few Banks, Too Many Giants: I have repeatedly mentioned Too Big To Succeed as a cause of the most recent crisis, but have you ever wondered HOW we got that way?

One obvious suspect has been the easy M&A environment of the past 20 years. Instead of a very competitive market where mergers for sheer size sake is discouraged, the opposite occurred. The number of bank acquisitions skyrocketed, and the number actual banks got slashed. Where there were once over 18,000 banks in early 1980s, today, the number is less than half, to under 8,500.

Recall that the big acquisitions and mergers in the 1980s were so banks could be competitive with Sumitomo and Mitsubishi and other big Japanese banks. (Why was that again?)

Hence, we end up with a few Superbanks. Ask yourself why Citibank, Bank of America, Washington Mutual, and Wachovia got to be too large to manage. And once again, I am compelled to ask why it is in the country's interest that 65% of the depository assets are held by only a handful of banks.

To put this into context, consider the chart below, courtesy of banking analyst Dick Bove:


links for 2009-06-03

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