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September 21, 2009

Economist's View - 6 new articles

"Economists Need to Study Bubbles"

Robert Shiller says economists and their models need to take bubbles seriously (compare Dani Rodrik's "Blame Economists, not Economics"):

Economists need to study bubbles, reinvent models, by Robert Shiller, Commentary, Project Syndicate: The widespread failure of economists to forecast the financial crisis ... has much to do with faulty models. This lack of sound models meant that economic policymakers and central bankers received no warning of what was to come. ...
[T]he current financial crisis was driven by speculative bubbles in the housing market, the stock market, energy and other commodities markets. ... You won't find the word "bubble," however, in most economics treatises or textbooks. Likewise, a search of working papers produced by central banks and economics departments in recent years yields few instances of "bubbles" even being mentioned. Indeed, the idea that bubbles exist has become so disreputable ... that bringing them up in an economics seminar is like bringing up astrology to a group of astronomers.
The fundamental problem is that a generation of mainstream macroeconomic theorists has come to accept a theory that has an error at its very core — the axiom that people are fully rational. ...
[E]conomists assume that people ... use all publicly available information and know, or behave as if they know, the probabilities of all conceivable future events. ... They update these probabilities as soon as new information becomes available and so any change in their behavior must be attributable to their rational response to genuinely new information. If economic actors are always rational, then no bubbles — irrational market responses — are allowed. ...
In fact, people almost never know the probabilities of future economic events. They live in a world where economic decisions are fundamentally ambiguous, because the future doesn't seem to be a mere repetition of a quantifiable past. ...
To be sure, the purely rational theory remains useful for many things. ... Economists have also been right to apply his theory to a range of microeconomic issues... The theory, however, has been overextended. For example, the "Dynamic Stochastic General Equilibrium Model of the Euro Area," developed by Frank Smets ... and Raf Wouters..., is very good at giving a precise list of external shocks that are presumed to drive the economy, but nowhere are bubbles modeled. The economy is assumed to do nothing more than respond in a completely rational way to these external shocks.
Milton Friedman and Anna Schwartz, in their 1963 book A Monetary History of the United States, showed that monetary-policy anomalies — a prime example of an external shock — were a significant factor in the Great Depression of the 1930s. ... To some, this revelation represented a culminating event for economic theory. The worst economic crisis of the 20th century was explained — and a way to correct it suggested — with a theory that does not rely on bubbles.
Yet events like the Great Depression, as well as the recent crisis, will never be fully understood without understanding bubbles. The fact that monetary policy mistakes were an important cause of the Great Depression does not mean that we completely understand that crisis, or that other crises fit that mold.
In fact, the failure of economists' models to forecast the current crisis will mark the beginning of their overhaul. This will happen as economists' redirect their research efforts by listening to scientists with different expertise. Only then will monetary authorities gain a better understanding of when and how bubbles can derail an economy and what can be done to prevent that outcome.

Financial Reform: The Consolidation of Regulatory Authority

Here's something I wrote for CBS Money Watch:

Who Should Oversee the Financial System?, by Mark Thoma

I expect many of you will disagree.

"The Costs of Economic Growth"

Lee Arnold says via email "this is interesting." It's an analysis of when and if economic growth should be maximized when technological progress involves risks as well as benefits:

The Costs of Economic Growth, by Charles I. Jones, Stanford GSB and NBER, August 18, 2009: 1. Introduction In October 1962, the Cuban missile crisis brought the world to the brink of a nuclear holocaust. President John F. Kennedy put the chance of nuclear war at "somewhere between one out of three and even." The historian Arthur Schlesinger, Jr., at the time an adviser of the President, later called this "the most dangerous moment in human history."1 What if a substantial fraction of the world's population had been killed in a nuclear holocaust in the 1960s? In some sense, the overall cost of the technological innovations of the preceding 30 years would then seem to have outweighed the benefits.
While nuclear devastation represents a vivid example of the potential costs of technological change, it is by no means unique. The benefits from the internal combustion engine must be weighed against the costs associated with pollution and global warming. Biomedical advances have improved health substantially but made possible weaponized anthrax and lab-enhanced viruses. The potential benefits of nanotechnology stand beside the threat that a self-replicating machine could someday spin out of control. Experimental physics has brought us x-ray lithography techniques and superconductor technologies but also the remote possibility of devastating accidents as we smash particles together at ever higher energies. These and other technological dangers are detailed in a small but growing literature on so-called "existential risks"; Posner (2004) is likely the most familiar of these references, but see also Bostrom (2002), Joy (2000), Overbye (2008), and Rees (2003).
Technologies need not pose risks to the existence of humanity in order to have costs worth considering. New technologies come with risks as well as benefits. A new pesticide may turn out to be harmful to children. New drugs may have unforeseen side effects. Marie Curie's discovery of the new element radium led to many uses of the glow-in-the-dark material, including a medicinal additive to drinks and baths for supposed health benefits, wristwatches with luminous dials, and as makeup — at least until the dire health consequences of radioactivity were better understood. Other examples of new products that were initially thought to be safe or even healthy include thalidomide, lead paint, asbestos, and cigarettes.
The benefits of economic growth are truly amazing and have made enormous contributions to welfare. However, this does not mean there are not also costs. How does this recognition affect the theory of economic growth?
This paper explores what might be called a "Russian roulette" theory of economic growth. Suppose the overwhelming majority of new ideas are beneficial and lead to growth in consumption. However, there is a tiny chance that a new idea will be particularly dangerous and cause massive loss of life. Do discovery and economic growth continue forever in such a framework, or should society eventually decide that consumption is high enough and stop playing the game of Russian roulette? The answer turns out to depend on preferences. For a large class of conventional specifications, including log utility, safety eventually trumps economic growth. The optimal rate of growth may be substantially lower than what is feasible, in some cases falling all the way to zero.
This paper is most closely related to the literature on sustainable growth and the environment; for example, see Gradus and Smulders (1993), Stokey (1998), and Brock and Taylor (2005). Those papers show that when pollution and the environment directly enter utility or the production function, a "growth drag" may result. Here, the key concern —the loss of life associated with potentially dangerous technologies —is quite different. Nevertheless, there are interesting links with this literature that will be discussed later. ...
...8. Conclusion Technological progress involves risks as well as benefits. Considering the risks posed to life itself leads potentially to first-order changes in the theory of economic growth. This paper explores these possibilities, first in a simple "Russian roulette" style model and then in a richer model in which growth explicitly depends on the discovery of new ideas. The results depend somewhat on the details of the model and, crucially, on how rapidly the marginal utility of consumption declines. It may be optimal for growth to continue exponentially despite the presence of existential risks, or it may be optimal for growth to slow to zero, even potentially leading to a steady-state level of consumption.
The intuition for the possible end to exponential growth turns out to be straightforward. For a large class of standard preferences, safety is a luxury good. The marginal utility associated with more consumption on a given day runs into sharp diminishing returns, and ensuring additional days of life on which to consume is a natural, welfare enhancing response. When the value of life rises faster than consumption, economic growth leads to a disproportionate concern for safety. This concern can be so strong that it is desirable that growth slow down.
The framework studied here clearly omits other factors that may be important. Health technologies can help to extend life, possibly offsetting some of the concerns here. Even dangerous technologies like nuclear weapons could have a life-saving use—for example if they helped to divert an asteroid thatmight otherwise hit the earth.
This paper suggests a number of different directions for future research on the economics of safety. It would clearly be desirable to have precise estimates of the value of life and how this has changed over time; in particular, does it indeed rise faster than income and consumption? More empirical work on how safety standards have changed over time—and estimates of their impacts on economic growth—would also be valuable. Finally, the basic mechanism at work in this paper over time also applies across countries. Countries at different levels of income may have very different values of life and therefore different safety standards. This may have interesting implications for international trade, standards for pollution and global warming, and international relations more generally.
1For these quotations, see (Rees, 2003, p. 26).

Paul Krugman: Reform or Bust

The administration needs to take a more forceful approach to financial sector reform, especially reform that places limits on how executives can be paid:

Reform or Bust, by Paul Krugman, Commentary, NY Times: In the grim period that followed Lehman's failure, it seemed inconceivable that bankers would, just a few months later, be going right back to the practices that brought the world's financial system to the edge of collapse. ...
But now that we've stepped back a few paces from the brink — thanks, let's not forget, to immense, taxpayer-financed rescue packages — the financial sector is rapidly returning to business as usual. Even as the rest of the nation continues to suffer from rising unemployment and severe hardship, Wall Street paychecks are heading back to pre-crisis levels. And the industry is deploying its political clout to block even the most minimal reforms.
The good news is that senior officials in the Obama administration and at the Federal Reserve seem to be losing patience with the industry's selfishness. The bad news is that it's not clear whether President Obama himself is ready, even now, to take on the bankers.
Credit where credit is due: I was delighted when Lawrence Summers ... lashed out at the campaign the U.S. Chamber of Commerce, in cooperation with financial-industry lobbyists, is running against the proposed ... agency to protect consumers against financial abuses... The chamber's ads, declared Mr. Summers, are "the financial-regulatory equivalent of the death-panel ads..."
Yet protecting consumers from financial abuse should be only the beginning of reform. If we really want to stop Wall Street from creating another bubble,... we need to change the industry's incentives — which means ... changing the way bankers are paid. ... In a nutshell, bank executives are lavishly rewarded if they deliver big short-term profits — but aren't correspondingly punished if they later suffer even bigger losses. This encourages excessive risk-taking...
The Federal Reserve, now awakened from its Greenspan-era slumber,... is considering ... requiring that banks "claw back" bonuses in the face of losses and link pay to long-term rather than short-term performance. ... But the industry — supported by nearly all Republicans and some Democrats — will fight bitterly against these changes. And while the administration will support some kind of compensation reform, it's not clear whether it will fully support the Fed's efforts.
I was startled last week when Mr. Obama ... questioned the case for limiting financial-sector pay: "Why is it," he asked, "that we're going to cap executive compensation for Wall Street bankers but not Silicon Valley entrepreneurs or N.F.L. football players?"
That's an astonishing remark — and not just because the National Football League does, in fact, have pay caps. Tech firms don't crash the whole world's operating system when they go bankrupt; quarterbacks who make too many risky passes don't have to be rescued with hundred-billion-dollar bailouts. Banking is a special case — and the president is surely smart enough to know that.
All I can think is that this was another example of ... Mr. Obama's visceral reluctance to engage in anything that resembles populist rhetoric. And that's something he needs to get over.
It's not just that taking a populist stance on bankers' pay is good politics — although it is: the administration has suffered more than it seems to realize from the perception that it's giving taxpayers' hard-earned money away to Wall Street, and it should welcome the chance to portray the G.O.P. as the party of obscene bonuses.
Equally important, in this case populism is good economics. Indeed, you can make the case that reforming bankers' compensation is the single best thing we can do to prevent another financial crisis... It's time for the president to realize that sometimes populism, especially populism that makes bankers angry, is exactly what the economy needs.

Fed Watch: Even With Growth, A Long, Hard Road

Tim Duy looks forward to the Federal Open Market Committee rate setting meeting later this week:

Even With Growth, A Long, Hard Road, by Tim Duy: The economic backdrop behind this week's FOMC meeting is almost startlingly refreshing. The recession likely ended at some point during the summer, an occasion effectively confirmed this week by the highest authority in the land, Federal Reserve Chairman Ben Bernanke. For those still in denial, industrial production posted its second consecutive gain, and there is little doubt that GDP will post a significant positive reading for the third quarter. Finally, in a seemingly impossible development, the retail sales report suggested that consumers eagerly converged onto the nation's shopping establishments in August. The economic summary paragraph in the upcoming FOMC statement will certainly identify the positive economic developments since their last gathering. But will improving conditions be sufficient to prod the FOMC to adopt language that points in the direction of tighter policy? Almost certainly not. The exit from the recession is clearly much too tenuous - and much too dependent on fiscal and monetary life support - to allow the risk of premature policy withdrawal. Moreover, even if economy activity were on a self-sustaining upward trend, the hole we are climbing out of is so deep that it could literally be years before resources are sufficiently utilized as to allow for significant policy reversal.
Let's start off with the good news. The stabilization of consumer spending that we saw begin earlier this year is supporting an inventory correction story. Firms are no longer chasing spending plans down, which alone gives some boost to final output. Moreover, some restocking is likely occurring; anecdotally, I hear from firms that are surprised to learn that their suppliers are running low on inventories despite weak final sales. Restocking is also a consequence of the "Cash for Clunkers" program, as auto firms look to rebuild depleted inventories. And, the August retail sales report points to sales gains across a wide range of retail stores. All in all, the inventory cycle looks to be making a pretty clear turn, offering support to activity:
In addition, the strength of fiscal stimulus is coming to bear on the economy. And one cannot discount the additional boost delivered by the first time homebuyers credit, which helped support a bottom into the new housing market this summer. Adding everything together, it is not difficult to see why forecasters are looking for growth in the range of 3 to 4% this quarter. Not surprisingly, industrial production numbers are turning:
All of that is well and good. The FOMC, however, will look at this data flow and ask "what's next?" An inventory correction in the wake of the 2001 recession provided little lasting support, leaving the economy struggling until the housing bubble gained force in 2003-04. The clunkers program and the homebuyers credit likely borrowed some spending from the future. And even if the homebuyers credit is extended, the marginal impact is likely to decline as it increasingly benefits those looking to buy anyway. Moreover, there is growing concern that this summer's buying binge - such that it is was - can be partly attributed to a slowing in foreclosure activity earlier this week. Now that the pace of foreclosures looks to be picking up, and the threat of the option-ARM lending comes more clearly into the view, the sustainability of this summer's housing gains comes into question. On top of all that housing concern, the possibility that the FHA might need a bailout indicates that the risk of loaning into an overpriced housing market has simply been shifted from the private sector to the taxpayer. Consequently, the FHA - the current housing lender of last resort -is poised to tighten credit standards. And even the surprisingly strong retail sales numbers are somewhat suspect, as they don't appear to comport with the anecdotal reports of retailers. A reasonable midpoint analysis, via the Wall Street Journal:
The July/August average for "core" retail sales is still not much stronger than the [second-quarter] average, but after a string of contractions, these data suggest that consumer demand is, at a minimum, stabilizing. Core retail sales may even be starting to firm slightly (up in 2 of the past 3 months), but we will need to see another month or two of positive data to have confidence in that view. –Stephen Stanley, RBS
In addition, financial markets remain glued up by many metrics. Importantly, consumer credit growth is still significantly restrained, as is bank lending for commercial and industrial loans:
Given the steady anecdotal buzz surrounding the deterioration of the commercial real estate market, it is difficult to expect a rapid reversal of these trends. In short, if you think credit markets are still under stress, as the Fed certainly does, and are worried about the availability of credit to support future spending, also among Fed concerns, then shifting rhetorically to signal a tighter policy stance irrational. Moreover, it would seem inconsistent with plans to continue expanding the balance sheet via purchases of mortgage backed securities and TALF assets.
Now, the above are among the reasons many expect a relatively tepid recovery to emerge in the years ahead. Suppose instead that you, logically, believe that the economy is set to come roaring back on the straightforward hypothesis that deep recessions are always followed by strong recoveries. James Grant makes just such an argument in this past weekend's Wall Street Journal:
"At the business trough in 1933," Mr. Darda points out, "the unemployment rate stood at 25% (if there had been a 'U6' version of labor underutilization then, it likely would have been about 44% vs. 16.8% today. . . ). At the same time, the consumption share of GDP was above 80% in 1933 and the household savings rate was negative. Yet, in the four years that followed, the economy expanded at a 9.5% annual average rate while the unemployment rate dropped 10.6 percentage points." Not even this mighty leap restored the 27% of 1929 GNP that the Depression had devoured. But the economy's lurch to the upside in the politically inhospitable mid-1930s should serve to blunt the force of the line of argument that the 2009-10 recovery is doomed because private enterprise is no longer practiced in the 50 states.
One would have to wonder if Grant has ever seriously considered a different analysis of the path of the business cycle. After all, I have never heard it argued by the more pessimistic forecasters that the fundamentally reason for their concerns is that private enterprise is no longer practiced in the US. That this should be his line of argument seems silly. That aside, the post-1933 rebound is illustrated by the industrial production series:
What one could add to this story, however, is that despite the rapid growth of 1933-1937, unemployment remained unacceptably high and inflation remained sufficiently contained such that the price level never came close to regaining the ground lost during the depression:
And - critically for divining the path of policy - the growth in the 1933-1937 period was not sufficient to allow for policy tightening, as evidenced from the 1937 recession. One does not have to deny that the recession is over - and can even expect nontrivial growth - while still expecting a sufficiently weak outcome that prevents a significant reversal of the Fed's monetary stance. Or further fiscal stimulus, for that matter. Which is to say that those who see rapid growth as a reason for an imminent Fed reversal are looking in the wrong direction. Even rapid growth could leave the Fed on the sidelines for much, much longer than many anticipate - and they know it. Bernanke has schooled policymakers well on the lasting damage that typically follows the collapse of a debt-driven bubble.
Bottom Line: Economic activity is clearly on the upswing - but the durability and sustainability of the recovery remains in doubt. The FOMC statement will certainly take notice of strengthening economic data. But a resumption of growth is not the only issue that factors into policymaking. At this juncture, the focus to resource utilization - how long will persistently weak labor marks sustain downward pressure on wages and thus make a wage-price inflation spiral simply unattainable? For now, a seemingly long period of time. Indeed, I find it virtually impossible that Fed officials will dare shift from "sure, we can withdraw stimulus when needed" to "it is not necessary to aggressively withdraw stimulus" until the unemployment rate begins a sustained march downward. And for now, we are still waiting for the upward march to end.

links for 2009-09-20

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