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July 1, 2009

Economist's View - 7 new articles

"A Bubble Mystery"

Barkley Rosser has a post that elaborates on comments he made here to Should We Pop Bubbles?, but first some background. This is from last July:

Gradual Decline before the Crash?: Barkley Rosser says the period after the peak of a speculative bubble can often be broken into two periods, the first characterized by a gradual decline, i.e. a period of "financial distress," and a second where there is a massive panic and crash. He also says he has a model that can explain how this happens...:

Falling from the Period of Financial Distress into the Panic and Crash, by Barkley Rosser: In 1972, Hyman Minsky described the "period of financial distress," in a paper in a journal that no longer exists..., "Financial Instability: The Economics of Disaster." Charles P. Kindleberger picked up on this and followed Minsky's analysis in his famous book, Manias, Panics, and Crashes: A History of Financial Crises, the 4th edn of which appeared in 2000... The period of financial distress is a gradual decline after the peak of a speculative bubble that precedes the final and massive panic and crash, driven by the insiders having exited but the sucker outsiders hanging on hoping for a revival, but finally giving up in the final collapse. According to Appendix B of Kindleberger's 2000 edition, 37 of the 47 great historical speculative bubbles exhibited such a period before the final crash, even though all the theoretical models predict a crash immediately following the peak with no such period. In 1991 I published the first mathematical model of such a phenomenon in my book From Catastrophe to Chaos: A General Theory of Economic Discontinuities_(Kluwer, Chap. 5)..., although nobody seems to have noticed... In 1997, I published a paper describing this model (and related matters)... This paper has never been cited. More recently I have coauthored a paper that ...[is] now under a long revise and resubmit, still waiting for an answer ... with Mauro Gallegati and Antonio Palestrini, "The Period of Financial Distress in Speculative Markets: Interacting Heterogeneous Agents and Financial Constraints" (available at my website), that lays all this out in much more up-to-date mathematical modeling. So, why am I boring all of you with this self-citation? Well, Dean Baker is constantly claiming credit for his forecasts of doom and gloom. It looks like we might be finally reaching the big crash in the US mortgage market after a period of distress that started last August (if not earlier). I and my coauthors are the only people to have provided actually formal models of this phenomenon, beyond the verbal and historical discussions provided by the brilliant Minsky and Kindleberger (both of whom I knew...). I have been forecasting this in unpublished lectures all over the globe for years, but never have put it up into the blogosphere. So, I am claiming credit, to the extent it is due, although the basic ideas were clearly laid out earlier by Minsky and Kindleberger. ...

Here's the follow-up:

Update on the Period of Financial Distress and a Bubble Mystery, by Barkley Rosser: Nearly a year ago (7/12/08) I posted here on "Falling from the Period of Financial Distress into Panic and Crash" In that I noted my own work on this concept, which Charles Kindleberger claimed in his Manias, Panics, and Crashes has been the most common pattern of speculative bubbles and crashes (37 out of 47 bubbles listed in Appendix B of his 2000 4th edition). What is involved is for there to be a gradual decline in prices initially after the peak of a bubble, with the crash coming sometime later. The paper I cited then on this by Mauro Gallegati, Antonio Palestrini, and me ... has now been accepted for publication and is forthcoming in Macroeconomic Dynamics.

The three patterns that Kindleberger, drawing on the work of Hyman Minsky, argued we have generally seen are ones with such a period of distress as described above, ones that go up to a peak and then crash hard (which are what most theoretical models of crashes predict), and ones that go up to a peak and then decline gradually without a crash, but usually a bit faster than they went up. In the last few years I would argue we have seen all three patterns. The peak-followed-by-crash pattern looks like the oil market last year, which hit $147 per barrel last July only to fall hard to $32 per barrel by November. The more or less symmetric up-then-down-without a crash pattern looks like the US housing market, which, according to the Case-Shiller index, began rising in 1998, peaked in mid-2006, and has been going down since about the way it went up, with quite a ways to go.

Last year I had it in my mind that the global financial derivatives market smelled like a period of financial distress pattern, and now I think that it was indeed. The peak was in August 2007, when the problems in those markets first began to appear. The crash was the dramatic "Minsky moment" in mid-September 2008.

Which brings me to a fourth pattern that is somewhat mysterious, a variation on the pattern that does not have a crash. Whereas most such bubbles go down more rapidly than they went up, and some go down at about the same rate, there is one that has gone down at a much slower rate, indeed may still be in its decline. I am referring to housing in Japan. A graph of the pattern up to 2005 can be seen here. Around 2006 there was a brief cessation of the decline, but it has since resumed. In any case, that figure shows that the index rose in three years from 150 to its peak around 200, but took ten years thereafter to get back to 150, and it took 15 years from the peak in 1991 to get back down to the level it was in 1986, a clear asymmetry in the direction of going up much faster than it has gone down.

Now, according to private communication from Kindlebeger to me, this is the only major bubble in world history to exhibit such a pattern, and why it has done so remains a mystery. I saw a paper (still unpublished) some years ago that argued that it was Japanese banks manipulating the real estate market to keep the value of their most important collateral from declining too rapidly in the face of broader financial pressure that have been behind this pattern, but I have not seen that confirmed. That would suggest that the pattern has had deep implications for the broader Japanese economy. In any case, this curious decline in Japan remains a mystery (and some say that US housing prices could go down for a much longer time than many think, pointing to this strange case), but it may ultimately have to do with the Japanese wishing to preserve their broader economic system in the face of pressures to more deeply transform it.


Video: Krugman and Taylor

I thought the list of questions asked by the moderator, Fareed Zakaria, and particularly the way some of the questions were framed said a lot about how the debate over economic policy is playing in public (e.g. calling Robert Samuelson a "sober guy" in the premise to a question on health care reform):


"Deficits are Worrisome, but Not as Worrisome as an Economy that is Not Growing and is Rapidly Shedding Jobs"

What do you think of this administration's arguments for deficit spending to spur the economy?:

Remarks of the Chair of the Council of Economic Advisers: ...I very much appreciate the opportunity to speak with you today. I will take this time to discuss recent developments in the economy, and some of the challenges the nation faces going forward. I ... also ... want to discuss some larger issues about how fiscal policy should be evaluated...

I view the economy as experiencing something similar to a tug of war. ... On the contraction end of the rope are the shocks that the U.S. economy has experienced... Pulling hard on the other end of the rope are the expansionary forces of monetary and fiscal policy—the Federal Reserve's series of interest rate cuts and the Administration's ... stimulus package...

Monetary and fiscal policy – the two main levers of macroeconomic stabilization policy – are both actively engaged..., both leaning hard against the headwinds...I will not say much today about monetary policy. This is not to diminish in any way the crucial role of the Federal Reserve in helping to counter the adverse forces in this recession. But fiscal policy is my beat as CEA chair, so that will be the focus of my comments. ...

[A]nalysis done within the Administration has shown ... that ... the ... job market is not what we would like it to be right now, but it would have been worse without the Administration's actions.

One can view the short-run effects [of our policies]... from a classic Keynesian perspective. ... This ... helps maintain the aggregate demand for goods and services. There is nothing novel about this. It is very conventional short-run stabilization policy: You can find it in all of the leading textbooks. ...

The qualitative effects ... on the short-run output gap ... are not controversial. There is less agreement on quantifying these effects—how many jobs are created, how much growth is increased, and so on. To answer these questions, one would normally turn to a macroeconomic model such as those maintained by private forecasting firms, the Federal Reserve, and other institutions. I view such models as being very useful at relatively short time horizons such as one or two years. ...

Of course, the expansionary effects ... will be offset to some degree by the effects of the budget deficits that arise... Deficits can raise interest rates and crowd out of investment, although I should note that the magnitude of this effect is much debated in the economics literature. The main problem now facing the U.S. economy is not high interest rates...

The Administration would prefer not to have deficits, but deficit reduction is only one of many goals. ... Deficits are worrisome, but not as worrisome as an economy that is not growing and is rapidly shedding jobs. ...

The most important fiscal challenge facing the United States is not the current short-term deficits,... but instead the looming long-term deficits associated with the rise in entitlement spending ...

We do not yet have all the answers to the problems posed by entitlement costs, but we are hard at work. ... These longer-term issues, however, should not blind us to the immediate needs of the economy. The President came into office inheriting an economy ...[in] a recession. He has responded vigorously to the challenges and, as a result, the current outlook for the U.S. economy is bright...

That was Greg Mankiw, on September 15, 2003 in a speech to the NABE. [Note: verb tense changed from past to present in a few places, 'chairman' was changed to 'chair,' and he is, of course, mainly promoting tax cuts, not government spending.]


"The Revival of the Big Markets vs. State Planning Debate"

The possibility of an outbreak of protectionism has been raised frequently as a potential byproduct of the recession, but that may not be the biggest concern with regard to developing countries. When Stiglitz and Easterly agree, that's noteworthy:

Joe Stiglitz preaches markets to poor countries!, by William Easterly: Stiglitz in the current issue of Vanity Fair is afraid how poor countries will respond to the global crisis and the record of American hypocrisy on economic policy (like what America prescribed for itself in 2008-2009 vs. what it prescribed for Asia during 1997 crisis). All of this will tarnish market economics so much, fears Stiglitz, that poor countries will turn away from markets altogether in favor of some heavy-handed state planning and socialism. Stiglitz, who is not usually considered market economics' best friend, is right to be scared. ...

One of the reasons to be worried is the precedent from the 1930s Depression – not the usual worry about a huge wave of global protectionism. No, the worry is about the intellectual precedent that the Depression so discredited markets that government planning and intervention became the default model of development economics for the next 30 years – the 1950s through the 1970s.

I'm thrilled to have a heavyweight like Joe Stiglitz to make this case better and more credibly than I could.... The issue now is not subtleties about the right type of financial regulation, global vs. local standards, or calibrating fiscal stimulus. The issue in development now is the revival of the big markets vs. state planning debate. Let's hope it comes out differently this time than it did for early development economics after the Depression.

Here's a small part of Stiglitz' essay:

Wall Street's Toxic Message, by Joseph Stiglitz: ...[N]o crisis, especially one of this severity, recedes without leaving a legacy. And among this one's legacies will be a worldwide battle over ... what kind of economic system is likely to deliver the greatest benefit to the most people. Nowhere is that battle raging more hotly than in the Third World... In much of the world,... the battle between capitalism and socialism—or at least something that many Americans would label as socialism—still rages. While there may be no winners in the current economic crisis, there are losers, and among the big losers is support for American-style capitalism. This has consequences we'll be living with for a long time to come. ...

I worry that, as [other countries] see more clearly the flaws in America's economic and social system, many in the developing world will draw the wrong conclusions. A few countries—and maybe America itself—will learn the right lessons. They will realize that what is required for success is a regime where the roles of market and government are in balance, and where a strong state administers effective regulations. They will realize that the power of special interests must be curbed.

But, for many other countries, the consequences will be messier, and profoundly tragic. The former Communist countries generally turned, after the dismal failure of their postwar system, to market capitalism, replacing Karl Marx with Milton Friedman as their god. The new religion has not served them well. Many countries may conclude not simply that unfettered capitalism, American-style, has failed but that the very concept of a market economy ... is ... unworkable under any circumstances. Old-style Communism won't be back, but a variety of forms of excessive market intervention will return. And these will fail. The poor suffered under market fundamentalism—we had trickle-up economics, not trickle-down economics. But ... these new regimes ... will not deliver growth. Without growth there cannot be sustainable poverty reduction. There has been no successful economy that has not relied heavily on markets. ... The ... governments brought to power on the basis of rage against American-style capitalism ... will lead to more poverty. ...

Faith in democracy is another victim. In the developing world, people look at Washington and see a system of government that allowed Wall Street to write self-serving rules which put at risk the entire global economy—and then, when the day of reckoning came, turned to Wall Street to manage the recovery. They see continued re-distributions of wealth to the top of the pyramid, transparently at the expense of ordinary citizens. They see, in short, a fundamental problem of political accountability in the American system of democracy. After they have seen all this, it is but a short step to conclude that something is fatally wrong, and inevitably so, with democracy itself. ...

Francis Fukuyama ... was wrong to think that the forces of liberal democracy and the market economy would inevitably triumph, and that there could be no turning back. But he was not wrong to believe that democracy and market forces are essential to a just and prosperous world. The economic crisis, created largely by America's behavior, has done more damage to these fundamental values than any totalitarian regime ever could have. ...


"The Treasury View"

Free Exchange:

The Treasury view, Free Exchange: ...Noam Scheiber has a nice post up examining the view of PPIP—the plan to sell subsidised toxic assets at auction—from inside the Treasury. Here's a quote from a Treasury official:

...If you had asked--I don't want to speak for the secretary--what's problem number one? I think he'd say capital. Problem two? Capital. Problem three? Capital. Everything was in the service of that view. The legacy loans program was meant to help clean balance sheets. It was not an independent good in itself. It was seen as friendly to equity raising. Now people say the legacy loans thing is not gaining as much traction, so is that a failure? But because we had a good outcome in terms of raising equity, [the banks] were able to raise equity without shedding assets ... you should be okay with that.

Mr Scheiber also reprints a quote from a Goldman Sachs employee, originally in the Wall Street Journal, noting that PPIP is "the greatest program that never occurred... [because it] created confidence in the markets so banks can raise equity capital".

I don't know that I buy the Treasury spin—that they saw that banks needed more capital than the government could provide, and so they crafted an incredibly generous asset purchase plan understanding that it would boost Wall Street spirits, allowing banks to raise private capital and thereby making actual deployment of the plan unnecessary. Remember just how dire things appeared at the time of the plan's construction, and recall how many defenders of the plan—myself included—argued that there were no other options with tolerable risk levels available. Meanwhile, it's not clear that PPIP (as opposed to other interventions or the natural resolution of the crisis) had anything to do with the market's rebound, which began well after the initial description of the administration's proposal and well before the release of key programme details.

Which isn't to say that no one in the administration foresaw this possibility or planned for it. I would argue, however, that the current state of affairs was not really the expected outcome, and that the banking plan benefitted enormously from events outside of Treasury's control.

I don't disagree with that. But if it's true that the plan inspired confidence, intended or not, and that caused private investors to put capital into these institutions based upon the assumption that the banks would be made healthier by ridding themselves of toxicity through the PPIP, and now the government says "just kidding," isn't that a double-cross? Would the private investors have still put capital into the banks had they known the double-cross was coming? And if they wouldn't have, doesn't the continued presence of these assets on the books mean there's more risk present than we ought to be comfortable with?


links for 2009-07-01


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