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July 17, 2009

Economist's View - 5 new articles

"Let The Good Times Roll Again?"

The question of how to interpret Goldman Sachs' unexpectedly large earnings has been addressed here and here (with an addendum at the bottom of the second post). One lesson appears to be that the bad incentives underlying executive compensation are still be present. However, exactly why that is the case - other than the sheer size of the profits - has not been fully addressed. This argument from Lucian Bebchuk takes a step in that direction by noting that the Goldman Sachs' bonuses are a reward for short-term gains, when we ought to be tying compensation to long-run performance. Thus, the problematic incentive to take on large amounts of risk in pursuit of immediate profits is still present. (Though it's not included below, he also argues that compensation should be based upon the long-run value of a broad basket of securities, not just common shares as has been typical in the past, to avoid distorting incentives in a way that gives executives another reason to take on too much risk):

Let the good times roll again?, by Lucian Bebchuk, Commentary, Project Syndicate: Goldman Sachs announced this month plans to provide bonuses at record levels, and there are widespread expectations that bonuses and pay in many other firms will rise substantially this year. Should the good times start rolling again so soon?

Not without reform. Indeed, one key lesson of the financial crisis is that an overhaul of executive compensation must be high on the policy agenda.

Indeed, pay arrangements were a major contributing factor to the excessive risk-taking by financial institutions that helped bring about the financial crisis. By rewarding executives for risky behaviour, and by insulating them from some of the adverse consequences of that behaviour, pay arrangements for financial-sector bosses produced perverse incentives, encouraging them to gamble.

One major factor that induced excessive risk-taking is that firms' standard pay arrangements reward executives for short-term gains, even when those gains are subsequently reversed. Although the financial sector lost more than half of its stock-market value during the last five years, executives were still able to cash out, prior to the stock market implosion, large amounts of equity compensation and bonus compensation.

Such pay structures gave executives excessive incentives to seek short-term gains ... even when doing so would increase the risks of an implosion later on. ...

Following the crisis, this problem has become widely recognised... But it still needs to be effectively addressed: Goldman's recent decision to provide record bonuses as a reward for performance in the last two quarters, for example, is a step in the wrong direction.

To avoid rewards for short-term performance and focus on long-term results, pay structures need to be re-designed. As far as equity-based compensation is concerned, executives should not be allowed to cash out options and shares given to them for a period of, say, five years after the time of "vesting"...

Similarly, bonus compensation should be redesigned to reward long-term performance. For starters, the use of bonuses based on one-year results should be discouraged. Furthermore, bonuses should not be paid immediately, but rather placed in a company account for several years and adjusted downward if the company subsequently learns that the reason for awarding a bonus no longer holds up. ...

A thorough overhaul of compensation structures must be an important element of the new financial order.

The latest I'm aware of on this topic is draft legislation Barney Frank circulated today:

All publicly traded U.S. companies, and particularly financial firms, would face new executive-compensation requirements under draft legislation circulated Friday by a top lawmaker in the U.S. House of Representatives.

The measure proposed by Rep. Barney Frank, D-Mass., would give shareholders a greater ability to weigh in on compensation packages, require compensation consultants to satisfy independence criteria established by the government and would ensure that compensation committees are made up of independent directors. ...

Banks, broker-dealers, investment advisers and all other financial firms would be required to disclose any incentive-based compensation structures, while federal regulators would be able to limit "inappropriate or imprudently risky" pay practices.

The panel is expected to take up some form of the legislation next week.

This legislation would give regulators the power to limit executive pay structures that they believe are excessively risky, but exactly what types of compensation structures would be allowed or required under this legislation is a bit vague. It doesn't sound like it will be as restrictive as Lucian Bebchuk would like, but we shall see.

There are two related issues here. First, was the compensation fair in terms of being a reward for productive activities such as directing capital where it was most needed, or distributing and reducing risk? Before the crash, some people tried to make that argument, but for financial executives, it seems clear that the compensation was based upon bubble rather than fundamental values, and that this lead to inflated rewards relative to the value that was actually created. But even for non-financial executives, it's hard to believe that the generous compensation high-level managers and executives received in recent years is due entirely to their superior productivity. The "say on pay" part of the proposed legislation tries to give shareholders a greater voice in setting compensation levels, and is directed at this problem.

The second issue is whether the compensation structures that have been used in the past lead to incentives to accumulate more risk than is optimal. It appears that they did, and the second part of the proposal is an attempt to overcome this problem by giving regulators the ability to limit systemically risky practices.

There are two types of excessive risk to be worried about, but only one is a systemic risk, i.e. a risk to the overall economy. First, a particular executive compensation structure may give an executive the incentive to take on too much risk - more than shareholders desire - but there is no danger to the overall financial system. This type of excessive risk taking needs to be prevented, but it is not a danger to the overall economy, and regulators are generally concerned with microeconomics questions concerning optimal incentive structures. Second, there is excessive risk that endangers the entire financial system and the broader economy. This is systemic risk that is the target of the proposed legislation, the kind of risk regulators such as the Fed are concerned with, and the kind we must do our best to eliminate if we want to avoid a repeat of the present crisis.

To me, both elements of the proposed legislation - the part that gives shareholders the power to limit compensation levels and the part that gives regulators the power to limit risky compensation schemes - seem vague and rather weak. I hope that changes as the legislation develops.

FRBSF: The Current Economy and the Economic Outlook

Mary Daly of the Federal Reserve Bank of San Francisco gives her views on the current economy and the outlook. There are two issues revealed in the graphs below that I wish I had time to discuss further. First, the graph labeled "Gaps are typical in downturns" shows what happens to state finances in recessions, and how severe the current recession is in that regard. The budget problems of the states in downturns is a key factor working against recovery -- many states have little choice but to reduce spending or increase taxes when the economy goes into recession -- and we need to find a way to fix that problem so that this recovery impeding mechanism doesn't get in the way the next time we face the problem of reviving a stalled economy. Second, the last graph shows the relationship, or rather the lack of a relationship, between budget deficits and inflation. This is a counterpoint to the objection to using fiscal policy based upon the claim that it will have undesirable inflationary consequences. It is also noteworthy, as shown in the second to last graph, that inflationary expectations remain well anchored:

FedViews, by Mary Daly, FRBSF [Charts]: Financial markets are improving, and the crisis mode that has characterized the past year is subsiding. The adverse feedback loop, in which losses by banks and other lenders lead to tighter credit availability, which then leads to lower spending by households and businesses, has begun to slow. As such, investors' appetite for risk is returning, and some of the barriers to credit that have been constraining businesses and households are diminishing.


The housing sector, which has been at the center of the economic and financial crisis, also looks to be stabilizing—albeit, at a very depressed level. The pace of house price declines is slowing, housing starts and new home sales have leveled off, and existing home sales have edged up in recent months. These positive developments suggest that the housing market may be reaching a bottom.


Income from the federal fiscal stimulus, as well as some improvement in confidence, has helped stabilize consumer spending. Since consumer spending accounts for two-thirds of all economic activity, this is a key factor affecting our forecast of growth in the third quarter.


Whether the adverse feedback loop will continue to slow and ultimately reverse depends in part on the labor markets, which continue to deteriorate. The economy lost 467,000 nonfarm jobs in June and the unemployment rate rose to 9.5 percent. Although recent monthly job losses remain sizable, the pace of declines, however, is lower than earlier this year.


That said, ongoing weakness in the labor markets continues to push up foreclosures and pose risks to the fledgling recovery of housing.


Although the economy continues to face many downside risks, we expect the easing of the financial crisis and the bottoming out of the housing market to allow a modest recovery to ensue in the third quarter. In our view, the recovery will be painfully gradual, with the economy expanding below potential for several quarters.


The gradual nature of the recovery will put additional pressure on state and local budgets. Following a difficult 2009, especially in the West, most states began the 2010 fiscal year on July 1 with even larger budget gaps to solve.


While such gaps are typical in recessions, state governments face far larger problems than usual since all of their major sources of revenue (income, sales, and property taxes) have been disrupted. The federal fiscal stimulus payments to states should help stave off even worse difficulties, but the states likely will face constrained budgets for years to come.


As the financial crisis has subsided and the economy has begun to stabilize, some worries about inflation have emerged. In the near-term, we expect the slow recovery and the persistent and considerable slack in product and labor markets to keep inflation below its preferred longer-run rate as reflected in the minutes of the Federal Open Market Committee meeting held in April.


In manufacturing, capacity utilization is at an all time low. This excess capacity should continue to exert downward pressure on both input and final goods prices.

There also is unprecedented slack in the labor markets. Considering the official unemployment rate plus the number of workers who are employed part-time involuntarily for economic reasons, the overall measured slack is in excess of the 1982 recession. Moreover, we foresee this measure rising even higher by the end of the year.

This slack in the labor markets should continue to temper growth in wages and salaries, which has dropped off sharply over the course of the recession.


Despite the considerable downward pressures on prices, concerns about deflation appear to have abated. Market participants now expect inflation over the next five years to be on average around 1%, roughly in line with our forecast.


Over the longer-run, inflation expectations are higher, hovering in a 2 to 3% range, and despite considerable media worries about future inflation risk, expectations remain well-anchored.


Still, many remain worried that large fiscal deficits will eventually be inflationary. However, a look at the empirical link between fiscal deficits and inflation in the United States shows no correlation between the two. Indeed, during the 1980s, when the United States was running large deficits, inflation was coming down.

The views expressed are those of the authors, with input from the forecasting staff of the Federal Reserve Bank of San Francisco. They are not intended to represent the views of others within the Bank or within the Federal Reserve System. FedViews generally appears around the middle of the month. The next FedViews is scheduled to be released on or before September 14, 2009.

Paul Krugman: The Joy of Sachs

What can we learn from the fact that Goldman Sachs earned record profits despite the stagnation in the broader economy?:

The Joy of Sachs, by Paul Krugman, Commentary, NY Times: The American economy remains in dire straits, with one worker in six unemployed or underemployed. Yet Goldman Sachs just reported record quarterly profits — and it's preparing to hand out huge bonuses, comparable to what it was paying before the crisis. What does this contrast tell us?

First, it tells us that Goldman is very good at what it does. Unfortunately, what it does is bad for America.

Second, it shows that Wall Street's bad habits — above all, the system of compensation that helped cause the financial crisis — have not gone away.

Third, it shows that by rescuing the financial system without reforming it, Washington has ... made another crisis more likely.

Let's start by talking about how Goldman makes money.

Over the past generation — ever since the banking deregulation of the Reagan years — the U.S. economy has been "financialized." The business of moving money around, of slicing, dicing and repackaging financial claims, has soared...

Such growth would be fine if financialization really delivered on its promises — if financial firms made money by directing capital to its most productive uses, by developing innovative ways to spread and reduce risk. But can anyone, at this point, make those claims with a straight face? ...

Goldman's role in the financialization of America was similar to that of other players, except for one thing: Goldman didn't believe its own hype. ... Goldman, famously, made a lot of money selling securities backed by subprime mortgages — then made a lot more money by selling mortgage-backed securities short, just before their value crashed. All of this was perfectly legal, but the net effect was that Goldman made profits by playing the rest of us for suckers.

And Wall Streeters have every incentive to keep playing that kind of game.

The huge bonuses Goldman will soon hand out show that financial-industry highfliers are still operating under a system of heads they win, tails other people lose. ... You have every reason, then, to steer investors into taking risks they don't understand.

And the events of the past year have skewed those incentives even more, by putting taxpayers as well as investors on the hook if things go wrong. ... Wall Street in general, Goldman very much included, benefited hugely from the government's provision of a financial backstop — an assurance that it will rescue major financial players whenever things go wrong.

You can argue that such rescues are necessary if we're to avoid a replay of the Great Depression. In fact, I agree. But the result is that the financial system's liabilities are now backed by an implicit government guarantee.

Now, the last time there was a comparable expansion of the financial safety net, the creation of federal deposit insurance in the 1930s, it was accompanied by much tighter regulation, to ensure that banks didn't abuse their privileges. This time, new regulations are still in the drawing-board stage — and the finance lobby is already fighting against even the most basic protections for consumers.

If these lobbying efforts succeed, we'll have set the stage for an even bigger financial disaster a few years down the road. The next crisis could look something like the savings-and-loan mess of the 1980s, in which deregulated banks gambled with, or in some cases stole, taxpayers' money — except that it would involve the financial industry as a whole.

The bottom line is that Goldman's blowout quarter is good news for Goldman and the people who work there. It's good news for financial superstars in general, whose paychecks are rapidly climbing back to precrisis levels. But it's bad news for almost everyone else.

The other reason we are more vulnerable is, as this story points out, is that "two giants" are emerging from the financial crisis, and they are "starting to tower over the handful of financial titans that used to dominate the industry." Thus, if other competitors cannot recover similarly, and if the government does not use regulation and other means to level the playing field, the banking industry could end up even more concentrated and vulnerable than it was before (a point I wish I'd made here).

Fed Watch: FOMC Forecasts - Reality or Fantasy?

Tim Duy analyzes the economic projections in the minutes from the June FOMC meeting:

FOMC Forecasts - Reality or Fantasy?, by Tim Duy: It takes some time to work through the minutes from the June FOMC meeting. They are, in the words of David Altig, "meaty." Altig concentrated his remarks on the implications of the Fed's balance sheet explosion. I found myself pulled to the various economic projections spread throughout the minutes. Do those projections pass the laugh test? Are they realistic? Are they optimistic? Or just plain delusional? I think a little of all those descriptions are accurate.

The staff's projections comes first, and appear to be what Calculated Risk describes as an "immaculate recovery":

In the forecast prepared for the June meeting, the staff revised upward its outlook for economic activity during the remainder of 2009 and for 2010…The staff projected that real GDP would decline at a substantially slower rate in the second quarter than it had in the first quarter and then increase in the second half of 2009, though less rapidly than potential output. The staff also revised up its projection for the increase in real GDP in 2010, to a pace above the growth rate of potential GDP. As a consequence, the staff projected that the unemployment rate would rise further in 2009 but would edge down in 2010. Meanwhile, the staff forecast for inflation was marked up. Recent readings on core consumer prices had come in a bit higher than expected; in addition, the rise in energy prices, less-favorable import prices, and the absence of any downward movement in inflation expectations led the staff to raise its medium-term inflation outlook. Nonetheless, the low level of resource utilization was projected to result in an appreciable deceleration in core consumer prices through 2010.

Looking ahead to 2011 and 2012, the staff anticipated that financial markets and institutions would continue to recuperate, monetary policy would remain stimulative, fiscal stimulus would be fading, and inflation expectations would be relatively well anchored. Under such conditions, the staff projected that real GDP would expand at a rate well above that of its potential, that the unemployment rate would decline significantly, and that overall and core personal consumption expenditures inflation would stay low.

Leaving aside inflation (which will stay low over the long term if you assume that expectations remain anchored), the staff upgraded the forecast for 2009, is expecting growth to rebound to potential next year (which, is now less than six months away) and then accelerate further in subsequent years. Is such optimism justified? Yes and no.

I think it is fair to say that mounting evidence points to the formation of a rather clear bottom in the most recent stage of this economic cycle. Hear I refer to the sharp contractions beginning in late 2008, not to the "official" start of the recession in December 2007. Indeed, I think one would have to be almost blind to not see the clear signals emerging in a wide range of data, such as the ISM data:



See also consumption data:


Not to mention to mention the initial claims data (see CR and his caveats). To be sure, one could worry that industrial production continues to fall, but note the rate of decline is slowing and capacity utilization looks to be stabilizing. Moreover, the recent stability in auto sales will lend support for manufacturing in the months ahead:


Notice that the vehicle sales increased 1.3% during the quarter, pointing to a gain in this component of GDP. As always, do not underestimate the data impact of moving from significant declines to just flattening out. With such clear evidence of bottoming out emerging, not only does the near term data get a boost, but downside risks fall - and both point to upward revisions of near term forecasts.

The more interesting parts of the staff's forecast are in the 2010 and beyond range. The fact that they suggest immaculate recovery, I suspect, is largely a model driven outcome. Econometric models tend to force forecasts back to trend, and, in this case, are likely fighting with a large gap between actual and potential GDP. The only way to close that gap is through rapid growth which would in turn lead to "significant" declines in the unemployment rate.

How should we handicap this optimistic forecast? First off, I would remind readers that the bar has been lowered. The long run growth forecast from the FOMC participants are in the 2.5-2.7% range. While this is not a revision, I think commentators tend to forget how much the bar has been lowered since the late 1990s, when some foresaw potential growth as 4% or higher. Likewise, I believe evidence was building prior to the recession that the corresponding job growth rate is around 100k a month. In other words, 100k holds the unemployment rate roughly steady, rather than the 150k that is commonly suggested. In short, diminished expectations likely help the forecast clear the hurdle of reducing the unemployment rate in 2011 and beyond.

Moving toward the diminished expectation for potential output, I suspect, will not be terribly hard to accomplish. Stabilizing consumer spending itself will go a long way toward keeping GDP growth in positive territory as will just a lessening of the inventory drag. Moreover, fiscal stimulus will add positively over the next year, as will the external sector, especially if China can maintain its current dynamic and a weakened US consumer continues to weigh on import growth. And if consumer and export spending hold together, then investment spending will also cease to be a drag.

That said, positive territory for growth could easily be consistent with an economy limping along above recession but insufficient for any significant job growth, a scenario that remains my favorite. Given that 70% of the economy is driven by consumer spending, I find it hard to believe that you can supercharge growth well above potential without the active participation of households. We know, however, that households continue to struggle under heavy debt burdens which, combined with the now tighter underwriting conditions that are likely to be more permanent than temporary, suggest that spending growth is likely to be constrained sufficiently to prevent supercharged growth. I would imagine that to propel consumption growth to rates consistent with the staff's forecast, the staff must be anticipating significant real wealth gains sufficient to drive savings rates back to zero. That, I believe implies a housing rebound…which I can't see unless conditions revert back to the "let's give everyone one with a pulse a loan" era.

Could the Fed staff really believe that the stage is set for such a rebound? More importantly, could FOMC members? Perhaps some do, at least that is the impression from the growth projections:


The range of growth expectations is quite wide, as noted in this Bloomberg article. Some policymakers are expecting a solid V shaped recovery evolving in 2010, while the other side of the spectrum is looking for a more gradual acceleration to potential growth (the scenario I tend toward). The latter scenario suggests a jobless recovery, with growth insufficient to make much of a dent in unemployment. From a policy perspective, such a scenario points to additional pressure to ease further, complicated by the unknown impact of general balance sheet expansion. It certainly does not point to any rush to unwind the liquidity/credit support programs. The optimistic view implies the opposite, a concern that programs need to be unwound quickly, with a rapid move to normalize interest rates. Until the 2011 forecast comes more fully into view, sometime around the second quarter of 2010, policy will remain in a holding pattern. But note that the wide range of forecasts implies a wide range of Fedspeak, which will lend an irritating feature to the discourse: Seemingly opposite opinions nearly side by side in the press.

A final point: The range of forecasts, both high and low, can be used to argue against another stimulus package as the direction of growth is headed in the right direction. This is especially the case if unemployment stabilizes, even if at a relatively high level. Moreover, note that US Treasury Secretary Timothy Geithner is on something of a world tour, first China, now the Middle East, promising US fiscal restraint:

"Policies of the United States are designed to lay the conditions for a strong dollar," Mr. Geithner said on Tuesday, adding: "We are very committed ... to making sure that as we get through the crisis, we bring down fiscal deficits and we reverse these extraordinary interventions we've taken."

I suspect conditions would need to deteriorate markedly in order to force the Administration to push a fresh round of stimulus. That is not the Fed's projection.

Bottom Line: Clear signs of a bottom are an obvious reason to stabilize and boost near term forecasts. Still, the Fed staff's projections appear overly optimistic, seeming to imply that future dynamics will be very similar to the past. I am skeptical. Remember to interpret forecasts of potential GDP in the context of diminished expectations. The wide range of projections speaks to an interesting spectrum of Fedspeak in upcoming months. The game will be to track the data, being wary not to read to much into a short-lived bounce off the bottom. I side with the low end of the FOMC forecasts; call me a pessimist. Place your own bets, being prepared to adjust with the data.

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