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September 10, 2009

Economist's View - 7 new articles

"Trade Activity Up, But Rebalancing Stalled"

Tim Duy takes a look at recent data on international trade:

Trade Activity Up, But Rebalancing Stalled, by Tim Duy: I was somewhat distressed this morning when I realized that, with the absence of Brad Setser, I would have to do my own analysis of the trade data - data Brad taught me how to analyze over a decade ago. I may be a little rusty.
The good news in the data was the widely touted revival of global trade, an indication of economic healing. The bad news in the data was the return of an old enemy, a pattern of unbalanced trade. To be sure, I would not focus too intently on a single data point, but the July numbers raise the possibility that the external sector will weigh on US GDP growth in the third quarter. That, of course, is the price to be paid for attempting to revive growth via household spending as a portion of that spending flows overseas in the form of increased imports.
The trade deficit rose to $32 billion in July on the back of rising import growth that easily swamped export growth. Note to that higher oil prices were not the primary culprit; goods imports drove the trend:
The firming of the US economy is thus having the expected impact, as efforts to sustain consumer spending combined with stabilizing business investment plans have combined to drive import growth in the expected sectors - capital, consumer, and automotive goods. Similarly, with oil prices having little impact, real goods imports gained sharply, rising 5.3%:
Exports got a boost from reviving global growth, but, in contrast imports, real goods exports gained a smaller (although still respectable) 3.7%:
On net, the real goods deficit increased 8.5% compared to June to $38,811. Moreover, the July figure compares to a second quarter average of $38,500. If this trend continues, trade will likely be a net drag on growth, something of a disappointment for those looking for continued rebalancing to help support the US economy.
Again, a single data point does not make a trend. Indeed, it is a trend that should not return. Perhaps the US economy stumbles while the rest of the world remains strong, the long-awaiting decoupling. Moreover, the falling Dollar should help support rebalancing, driving export growth in excess of import growth. But perhaps with each new recession the structural nature of global imbalances becomes more entrenched as manufacturing capacity that is lost in the US during recessions is revived overseas, particularly China, thus explaining why durable goods manufacturing employment failed to recover from the 2001 recession and is not likely to recover after this recession. And clearly nondurable goods manufacturing is simply dying in the US, as employment is in virtual freefall with the advent of the strong Dollar policy. It may simply be that as the US emerges from the recession, sustained rebalancing cannot continue without a very significant depreciation of the Dollar that justifies the more rapid expansion of export and import-competing industries in the US, a depreciation that appears in excess of what Chinese policymakers are willing to tolerate (or other nations are willing to tolerate on their behalf). Or a more significant relative compression of US consumer spending than US policymakers are willing to endure.
And, of course, if rebalancing does not resume while labor markets remain anemic, expect trade tensions with China to continue to rise. Never a dull moment on the international policy front.

Solving the Free Rider Problem using fMRI Measurements

If we hook up a randomly chosen set of people to magnetic neural imaging machines to see if they are truthfully revealing their valuation of public goods, we can improve our ability to provide these services, but the intrusiveness of the solution seems problematic, at least to me. Does this bother you, or does it seem like a good idea to move in this direction? [Update: Cheap Talk has good comments on the research]:

Caltech scientists develop novel use of neurotechnology to solve classic social problem, EurekAlert: Economists and neuroscientists from the California Institute of Technology (Caltech) have shown that they can use information obtained through functional magnetic resonance imaging (fMRI) measurements of whole-brain activity to create feasible, efficient, and fair solutions to one of the stickiest dilemmas in economics, the public goods free-rider problem—long thought to be unsolvable.
This is one of the first-ever applications of neurotechnology to real-life economic problems, the researchers note. "We have shown that by applying tools from neuroscience to the public-goods problem, we can get solutions that are significantly better than those that can be obtained without brain data," says Antonio Rangel, associate professor of economics at Caltech and the paper's principal investigator.
The paper describing their work was published today in the online edition of the journal Science, called Science Express.
Examples of public goods range from healthcare, education, and national defense to the weight room or heated pool that your condominium board decides to purchase. But how does the government or your condo board decide which public goods to spend its limited resources on? And how do these powers decide the best way to share the costs?
"In order to make the decision optimally and fairly," says Rangel, "a group needs to know how much everybody is willing to pay for the public good. This information is needed to know if the public good should be purchased and, in an ideal arrangement, how to split the costs in a fair way."
In such an ideal arrangement, someone who swims every day should be willing to pay more for a pool than someone who hardly ever swims. Likewise, someone who has kids in public school should have more of her taxes put toward education.
But providing public goods optimally and fairly is difficult, Rangel notes, because the group leadership doesn't have the necessary information. And when people are asked how much they value a particular public good—with that value measured in terms of how many of their own tax dollars, for instance, they'd be willing to put into it—their tendency is to lowball.
Why? "People can enjoy the good even if they don't pay for it," explains Rangel. "Underreporting its value to you will have a small effect on the final decision by the group on whether to buy the good, but it can have a large effect on how much you pay for it."
In other words, he says, "There's an incentive for you to lie about how much the good is worth to you."
That incentive to lie is at the heart of the free-rider problem, a fundamental quandary in economics, political science, law, and sociology. It's a problem that professionals in these fields have long assumed has no solution that is both efficient and fair.
In fact, for decades it's been assumed that there is no way to give people an incentive to be honest about the value they place on public goods while maintaining the fairness of the arrangement.
"But this result assumed that the group's leadership does not have direct information about people's valuations," says Rangel. "That's something that neurotechnology has now made feasible."
And so Rangel, along with Caltech graduate student Ian Krajbich and their colleagues, set out to apply neurotechnology to the public-goods problem.
In their series of experiments, the scientists tried to determine whether functional magnetic resonance imaging (fMRI) could allow them to construct informative measures of the value a person assigns to one or another public good. Once they'd determined that fMRI images—analyzed using pattern-classification techniques—can confer at least some information (albeit "noisy" and imprecise) about what a person values, they went on to test whether that information could help them solve the free-rider problem.
They did this by setting up a classic economic experiment, in which subjects would be rewarded (paid) based on the values they were assigned for an abstract public good.
As part of this experiment, volunteers were divided up into groups. "The entire group had to decide whether or not to spend their money purchasing a good from us," Rangel explains. "The good would cost a fixed amount of money to the group, but everybody would have a different benefit from it."
The subjects were asked to reveal how much they valued the good. The twist? Their brains were being imaged via fMRI as they made their decision. If there was a match between their decision and the value detected by the fMRI, they paid a lower tax than if there was a mismatch. It was, therefore, in all subjects' best interest to reveal how they truly valued a good; by doing so, they would on average pay a lower tax than if they lied.
"The rules of the experiment are such that if you tell the truth," notes Krajbich, who is the first author on the Science paper, "your expected tax will never exceed your benefit from the good."
In fact, the more cooperative subjects are when undergoing this entirely voluntary scanning procedure, "the more accurate the signal is," Krajbich says. "And that means the less likely they are to pay an inappropriate tax."
This changes the whole free-rider scenario, notes Rangel. "Now, given what we can do with the fMRI," he says, "everybody's best strategy in assigning value to a public good is to tell the truth, regardless of what you think everyone else in the group is doing."
And tell the truth they did—98 percent of the time, once the rules of the game had been established and participants realized what would happen if they lied. In this experiment, there is no free ride, and thus no free-rider problem.
"If I know something about your values, I can give you an incentive to be truthful by penalizing you when I think you are lying," says Rangel.
While the readings do give the researchers insight into the value subjects might assign to a particular public good, thus allowing them to know when those subjects are being dishonest about the amount they'd be willing to pay toward that good, Krajbich emphasizes that this is not actually a lie-detector test.
"It's not about detecting lies," he says. "It's about detecting values—and then comparing them to what the subjects say their values are."
"It's a socially desirable arrangement," adds Rangel. "No one is hurt by it, and we give people an incentive to cooperate with it and reveal the truth."
"There is mind reading going on here that can be put to good use," he says. "In the end, you get a good produced that has a high value for you."
From a scientific point of view, says Rangel, these experiments break new ground. "This is a powerful proof of concept of this technology; it shows that this is feasible and that it could have significant social gains."
And this is only the beginning. "The application of neural technologies to these sorts of problems can generate a quantum leap improvement in the solutions we can bring to them," he says.
Indeed, Rangel says, it is possible to imagine a future in which, instead of a vote on a proposition to fund a new highway, this technology is used to scan a random sample of the people who would benefit from the highway to see whether it's really worth the investment. "It would be an interesting alternative way to decide where to spend the government's money," he notes.

"The Economic Impact of the American Recovery and Reinvestment Act of 2009"

The Council of Economic Advisers has released a report on the economic impact of the stimulus package. The estimates, which have a lot of uncertainty attached to them, are that the recovery package "added roughly 2.3 percentage points to real GDP growth in the second quarter and is likely to add even more to growth in the third quarter" and that "the ARRA and other policy actions caused employment in August to be slightly more than 1 million jobs higher than it otherwise would have been":

The Economic Impact of the American Recovery and Reinvestment Act of 2009, First Quarterly Report: Executive Summary As part of the unprecedented accountability and transparency provisions included in the American Recovery and Reinvestment Act of 2009 (ARRA), the Council of Economic Advisers was charged with providing to Congress quarterly reports on the effects of the Recovery Act on overall economic activity, and on employment in particular. In this first report, we provide an assessment of the effects of the Act in its first six months.

Evaluating the impact of countercyclical macroeconomic policy is inherently difficult because we do not observe what would have happened to the economy in the absence of policy. And the sooner the evaluation is done after passage, the less data one has about key economic indicators. Any estimates of the impact of the ARRA at this early stage must therefore be regarded as preliminary and understood to be subject to considerable uncertainty. In this regard, it is important to note that there has not yet been any direct reporting by recipients of ARRA funds on job retention and creation. Such direct reporting data will be evaluated and incorporated in future reports.

Because of the inherent difficulties in the analysis, we approach the task of estimating the impact of the Recovery Act from a number of different directions. Our multi-faceted analysis suggests that the ARRA has had a substantial positive impact on the growth of real gross domestic product (GDP) and on employment in the second and third quarters of 2009. That various approaches yield similar estimates increases the confidence one can have in the results.

Among the key finding of the study are:

  • As of the end of August, $151.4 billion of the original $787 billion has been outlaid or has gone to American taxpayers and businesses in the form of tax reductions. An additional $128.2 billion has been obligated, which means that the money is available to recipients once they make expenditures. The areas where stimulus has been largest in the first six months are individual tax cuts, state fiscal relief, and aid to those most directly hurt by the recession. That recovery funds have gone out rapidly certainly increases the probability that the Act has been effective in its first six months.
  • Following implementation of the ARRA, the trajectory of the economy changed materially toward moderating output decline and job loss. The decomposition of the GDP and employment change by components or sector suggests that the ARRA has played a key role in this change of trajectory.
  • Estimates of the impact of the ARRA made by comparing actual economic performance to the predictions of a plausible, statistical baseline suggest that the Recovery Act added roughly 2.3 percentage points to real GDP growth in the second quarter and is likely to add even more to growth in the third quarter.
  • This analysis indicates that the ARRA and other policy actions caused employment in August to be slightly more than 1 million jobs higher than it otherwise would have been. We estimate that the Act has had particularly strong effects in manufacturing, construction, retail trade, and temporary employment services. The employment effects are distributed across states, with larger effects in states more severely impacted by the recession.
  • In addition to the estimates based on statistical projection, we provide estimates of the effects of the ARRA from standard economic models. Both our multiplier analysis and estimates from a wide range of private and public sector forecasters confirm the estimates from the statistical projection analysis. There is broad agreement that the ARRA has added between 2 and 3 percentage points to baseline real GDP growth in the second quarter of 2009 and around 3 percentage points in the third quarter. There is also broad agreement that it has likely added between 600,000 and 1.1 million to employment (again, relative to what would have happened without stimulus) as of the third quarter.
  • Fiscal stimulus appears to be effective in mitigating the worldwide recession. Nearly every industrialized country and many emerging economies responded to the severe financial crisis and recession by enacting fiscal stimulus. However, countries differed greatly in the size of their fiscal actions. We find that countries that adopted larger fiscal stimulus packages have outperformed expectations relative to those adopting smaller packages.
  • State fiscal relief was one of the ways in which the Recovery Act was able to provide support for the economy most quickly, and it played a critical role in helping states facing large budget shortfalls because of the recession. Our analysis indicates that state fiscal relief increased employment at the state level relative to what would have happened without stimulus. Thus, this analysis both provides evidence of how one particular type of fiscal stimulus impacts the economy and corroborates the more fundamental finding that fiscal stimulus in general is an effective countercyclical tool.

"On Krugman"

Robert Levine of Rand emails this reaction to Paul Krugman's essay on the state of macroeconomics:

On Krugman, by Robert A. Levine, Rand: Being a saltwater economist, by ideology and a bicoastal education and career, I of course think that Paul Krugman's "How Did Economists Get it So Wrong?" made some major points that needed making, and as usual made them very well.
But he also left two major omissions, inclusion of which may change the states of both theory and the economic outlook. Neither has either appeared in the commentaries I have seen.
The first omission is of Joseph Alois Schumpeter.1 Krugman did mention the name in two sour asides; it apparently does not appear in any of the commentaries. Schumpeter is remembered by many of his colleagues as an unpleasant man as well as a political reactionary. I was not in a position, as an undergraduate in one of his courses shortly before he died, to judge the former. The latter was certainly true: he was a royalist.
He was also one of the seminal economists of the 20th century. He was a rabid anti-Keynesian, but in fact his central concepts of innovation and entrepreneurship integrate well with Keynes and fill in a major gap. Keynes's discussion of investment provides a complex analysis of the relationship of profits and interest rates; it says little about where the profits come from. That is what Schumpeter is about: not the routine buying and replacing of capital goods, strongly influenced by the close profit/interest relationship, but the "autonomous" investment stemming from doing new things in new ways. Such investment then invokes the Keynesian multiplier, the Keynesian (but post-Keynes) accelerator, and business cycles endogenous to the narrow profit/interest relationship but exogenously induced.
In particular, Schumpeter's emphasis on innovation-induced "long waves" (which he named after their discoverer, Nicolai Kondratieff), starting with the industrial revolution and continuing through railroads, the telegraph, the telephone, automobiles, aircraft, radio, and—after Schumpeter—television and computers and the "information revolution" fills a crucial gap in the saltwater/freshwater debate. Much of the causation for the really major macroeconomic movements since World War II simply lies outside of that debate as now waged..
Schumpeter's emphasis on the regular periodicity of Kondratieff and other shorter cycles has been generally and properly criticized; in the last century such regularity if it existed at all was interrupted at least by the two World Wars. But the concept of innovation, with creative destruction and all that goes with it, stands; it is widely accepted by economists—and then ignored as a macroeconomic factor, e.g., in the current debate.
This leads to the second omission, the failure to treat with the fundamental causes of the dreadful decade of the 1970s. Krugman covers it as a cause of the major parting of the waters between salt and fresh, which it is, but in fact the major cause of the dismal economy and the consequent dismal economics lay outside of both; rather, it was in the fundamental global redistribution led by consolidation of OPEC and the oil boycotts stemming from the Yom Kippur war and then the Iranian revolution. The oil sheiks took control of a crucial portion of world product. Oil consumers had to adjust, cutting back on their own portion either by slowing growth and increasing unemployment, or bidding for what was left, thus engendering inflation. Economists adjusted by inventing, and then arguing about, rational expectations. Stagflation brought about no good responses either in the real world or the economics stratosphere.
The 70s can be looked at as a Schumpeterian wave in reverse: instead of growth-engendering structural change, the assertion of power by the oil-producers was a growth-inhibiting (at least for the major developed economies) structural change—with consequences yet to be analyzed.
The developed economies, and the rest of the world, recuperated from the 70s via a true Schumpeterian wave created by computers and information technology, and ending, as Schumpeterian waves do, in the bursting of the IT bubble in the late 1990s.
Whether the housing/financial bubble has anything to do with Schumpeter is arguable: the attempt to spread home ownership through financial innovation might be treated as an example of useful entrepreneurship gone bad, or the pervasive financial devices themselves might be classed in the same genre.
Underlying much of the current malaise, however, is another real-economy factor not mentioned in the current debate, the rise of the developing economies, led by China and India. Like the oil producers of the 70s, they are claiming increasing portions of world product. Unlike the sheiks, however, they are producing more rather than rather than grabbing existing product. The needed adjustments for the developed world may nonetheless be traumatic, including stagflation as the world economy (apparently already led by China and India) returns to growth.
Whether this is "negative Schumpeterianism" is probably not worth worrying about. What we should worry about instead is coping with the consequences—to Us—of major economic restructuring. Financial reform and short-run monetary or Keynesian stimulus, necessary for short-run melioration have little to do with the long run. We may have to await the onset of another truly Schumpeterian technological wave, whenever that occurs.
A term of the 1930s, long-since forgotten, was "secular stagnation"; when the Great Depression was ended not by technology but by deficit spending to finance World War II, the fears that growth had ended until an unforeseeable future were forgotten. One hopes that this time the turnaround will be based on technology, not war or even indefinite peacetime deficits, with positive change beginning soon.
In my grandmother's version of Keynes's most famous statement, "We should live so long."
1 Another; name, completely omitted, is that of John Kenneth Galbraith, but his semi-institutional economics remains, of course, beyond the pale.
(Much of this commentary is based on Robert A. Levine, "Adjusting to Global Economic Change: the Dangerous Road Ahead", RAND OP-243-RC)

Fed Watch: Riding The Fed Train

Tim Duy looks at how the Fed is likely to respond to recent data that "continues to point to a turning point in economic activity":

Riding The Fed Train, by Tim Duy: It is difficult if not impossible to deny the firming of economic data in recent months. But that firming has been inexorably tied to a host of fiscal and monetary stimulus measures. Fiscal stimulus is dependent upon political will and Treasury's ability to sell debt cheap. And anything less than 4% on the 10-year bond looks pretty cheap historically, especially given the mountain of paper issued by the US Treasury. On the monetary side, the Fed looks poised to sustain that stimulus until a potentially inflationary situation emerges. From policymaker's perspective, that remains a distant threat. What - and how many - global distortions will emerge as a result of the Fed's extended zero-interest rate policy? And what will bring the new house of cards crashing down?
The flow of data continues to point to a turning point in economic activity. The ISM manufacturing report pushed above the 50 mark, rising to its highest level since the summer of 2007 on the back of a surge in new orders. Likewise, the nonmaufacturing counterpart moved higher as well, although the gain was not as dramatic, and overall activity failed to cross the boundary into expansion. Firmer activity in manufacturing suggests that the July gain in industrial production will be repeated this month. Adding to the manufacturing upswing are leaner inventories, with the inventory to sales ratio falling to 1.38 from its cycle high of 1.46 in January of this year. Even that much beleaguered housing sector is showing signs of life, with housing starts apparently bottoming in the spring; the cessation of the freefall is certain to support third quarter GDP. Finally, households are feeling a bit more confident, and that translated into consumption growth in July. Anecdotally, the word on the street is more positive, as summarized in the opening paragraph of the most recent Beige Book:
Reports from the 12 Federal Reserve Districts indicate that economic activity continued to stabilize in July and August. Relative to the last report, Dallas indicated that economic activity had firmed, while Boston, Cleveland, Philadelphia, Richmond, and San Francisco mentioned signs of improvement. Atlanta, Chicago, Kansas City, Minneapolis, and New York generally described economic activity as stable or showing signs of stabilization; St. Louis remarked that the pace of decline appeared to be moderating. Most Districts noted that the outlook for economic activity among their business contacts remained cautiously positive.
All in all, it seems a fair bet that the NBER recession cycle dating team will pin the end of the recession sometime during the summer of 2009.
That said, even the most optimistic bull will note that I just cherry-picked the data. While time and inventory control have come into play, firming activity has been inexorably linked to a host of fiscal and monetary stimulus measures. Consumption and manufacturing have both been boosted by the now concluded "Cash for Clunkers" program; we are now anxiously waiting for the likely painful hangover from that spectacular demolition derby where all contestants won a prize. And, interestingly, despite the car buying binge, consumer credit contracted by a whopping 10% annualized in July, a testament to the mix of restriction to and aversion of credit that continues to weigh on household spending plans. Likewise, housing sales have been supported by the $8,000 tax credit for "first-time" buyers, which has been estimated to fatten real estate agent wallets with the addition of almost 400,000 home sales. Like the Clunkers program, the homebuyer's tax credit is set to expire, threatening to pull the rug out of the housing market just as foreclosure activity looks to be heading higher. Should it be extended? Not just real estate agents and home builders think extension - and enhancement - is a no brainer:
"There will be some payback, particularly late this year and early next and that's one of the reason house prices are going to begin weakening," Mr. Zandi says.
Mr. Zandi's reasoning could provide fuel to those in Congress and the administration who want to extend the tax credit. While some in the administration think it should be extended, concerns about the mounting deficit may make such an argument politically tricky.
For his part, Mr. Zandi says the tax credit should be extended and possibly expanded to all home buyers — not just those purchasing for the first time. He says the credit could have a bigger impact once the job market recovers and fewer people are out of work and able to buy homes
Leaving aside the issue of whether or not it is wise to create a fresh entitlement for housing purchases (not), the likely all-out push for an extension points to the current vulnerability of the recovery. It looks neither durable nor sustainable at this juncture; moreover, once again the recovery falls short of providing a significant boost to the labor market. Yes, the pace of deterioration in nonfarm payrolls is clearly improving, and a turning point has been reached. But payrolls data continues to deteriorate nonetheless, with only the health care and social assistance sector proving a significant supporting role during the month of August. Moreover, unemployment is staring at the 10% mark while underemployment is just shy of 16%. The pace of improvement in initial claims has become anemic, and soon claimants will begin dropping off the roles, another headwind for consumption spending (let alone the human cost) if hiring intentions don't soon head significantly higher.
The weak labor market is clearly weighing on inflationary pressures. From the Beige Book:
Wage pressures remained low across all Districts. Several Districts noted businesses and local governments imposing wage freezes or even reducing employee compensation in some instances. Boston noted that several manufacturers who have cut wage rates do not expect to restore pay levels until next year. Kansas City, Philadelphia, Chicago, Minneapolis, San Francisco, Dallas, and Richmond noted an increase in the cost of some raw materials, including fuel, metals, and steel. Chicago and Dallas mentioned that excess supply was putting substantial downward pressure on natural gas prices. Retail prices were described as generally steady in most Districts, although Kansas City and San Francisco noted continued discounting and downward pressure on consumer prices.
From the Fed's perspective, the flow of data and anecdotal evidence points to an economy that is definitely improving but not so much as to generate inflationary pressures. Moreover, the profound and persistent weakness in the job market leaves open the question the sustainability of an external inflation pressures (from commodity prices, for example). If high prices do not trigger higher wages, the much feared inflationary spiral cannot take hold. And thus is why Fed officials keep warning that a rate rise is not in the cards in the near term; Chicago Federal Reserve President Charles Evans reiterated this position Wednesday:
Evans also said that when it comes to rate hikes and major unwinding of other emergency support programs now, a shift lies "some time down the road." In reaching a determination of whether rate hikes are needed, Evans said that "we are going to be looking very carefully at how the economic recovery is preceding," and will be watching inflation and unemployment measures.
"As the economy continues to improve, and when we see rising inflation pressures, Fed policy will respond aggressively," Evans said. When the time does come to raise rates, "we could have a pretty reasonable withdrawal of accommodation."
Remember, in the last jobless recovery the Fed was still cutting rates well after the official end of the recession. Of course, the Fed could very well move faster when the signs of sustainable recovery emerge - but if sustainability and inflation potential are based on the labor market, that recovery is easily a long way off. Moreover, the Fed will not be keen on risking a premature reversal of policy; such reversals never did the Japanese economy any favors. Speaking of Japan, another prime example of start-stop "recovery":
Japanese machinery orders fell more than economists forecast in July, signaling companies are wary that a rebound in sales abroad will last.
Orders, an indicator of capital spending in the next three to six months, declined 9.3 percent from June, when they jumped 9.7 percent, the Cabinet Office said today in Tokyo. Economists surveyed by Bloomberg News predicted a 3.5 percent decline...
..."There's been an enormous wave of confidence in the stock markets but that hasn't been shared by business leaders," said Martin Schulz, senior economist at Fujitsu Research Institute in Tokyo. "Producers know that lots of the improvement in exports and in the overall outlook has been on the back of government programs and they're still troubled by the outlook."
It is not easier to pull one over on Japanese business leaders; they have been living this dynamic for nearly two decades.
To be sure, there will be consequences of the Fed's extended ZIRP policy; pump enough money in the economy, and it has to show up somewhere. Pump enough of a reserve currency into the global economy, and things can get interesting fast. From Bloomberg today:
"Over the next few months, we see the yen strengthening against the dollar and European currencies," Greg Gibbs, a foreign-exchange strategist at RBS in Sydney, wrote today in a report. "We expect the yen to continue to be replaced by the dollar, and even possibly European currencies, as the preferred funding vehicle for higher-risk, higher-yielding assets and currencies."
Consider what has occurred - the principle reserve currency, that which is supposed to be an effective facilitator of exchange and a store of wealth, is threatening to overtake the yen and become the primary financing vehicle of hot money gambling. Under such circumstances, the current market dynamic should come as little surprise - commodities stronger (Gold again breached the $1,000 mark before retreating) while the Dollar is substantially weaker and US equities get a lift. Seriously, can this really end well?
The game is on. And we all know it. According to China Investment Corporation Chairman Lou Jiwei (ht Baseline Scenario):
"It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we're just taking advantage of that. So we can't lose," he said
When will it come crashing down, as all free money pyramids eventually do? As always, it will come when some aspect of policy or economic activity makes a fundamental shift. We need to be on the watch those changes. Renewed financial crisis that sparks a flight to safety, assuming the Dollar is still considered safe? But what is the likelihood of true counterparty risk when US policymakers have effectively implemented a too-big-to-fail policy that will soon evolve into a too-big-to-regulate policy - even as, according to the Wall Street Journal, the appetite for risk of the top five banks has risen to record levels. Sure, if your counterparty is Podunk Bank in Nowhere, North Dakota, you have risk. But Bank of America or Morgan Stanley? Get real - they have tighter security than President Obama. Domestic policy change? The Fed is trying to get credit flowing to consumers, but the data is saying that just is not happening. Would the situation improve by raising rates? No, and assuming the jobless recovery scenario emerges, there will be no pressing domestic reason to rush to tighten. And if markets stumble as the Fed winds down its purchases of Treasuries and mortgage securities, the best bet is that the Fed would reverse course and expand the balance sheet further. Lack of political will to maintain US stimulus? Goodness knows that when push comes to shove, the US Congress loves to spend as much as any drunken sailor. External changes? China becomes unwilling to hold its Dollar portfolio in response to rising protectionism and makes a bid for the Renminbi to supplant the Dollar as the global reserve currency? Or rising commodity prices foster foreign inflation, which in turn prompt foreign central banks to raise rates and choke off growth?
The Fed is fueling a nice little train of trading, if not economic, activity. The Fed will fuel the ride until inflation pressures truly emerge, a ride that can last for a long time given the current state of the labor market. Everyone should join in for that ride. But train rides fueled by cheap money always end the same - we pretend the ride can continue indefinitely, but eventually the train moves on to a track that policymakers cannot tolerate. We need to be watching for that track. The risk: That track could be a ways off, and we will become complacent before we get to it.

The Real Villains in the Credit Crunch?

Andrew Leonard notes that problematic risky behavior continued even after it was well known that a financial crisis was in progress:

How "ice-nine" caused the credit crunch, by Andrew Leonard: ...Bob Ivry, Mark Pittman and Christine Harper manage to put together an interesting tale that fills in some hitherto obscure gaps in our knowledge of what happened during the fateful week following the bankruptcy of Lehman Brothers.
Never mind the nefarious credit-default swaps or bewilderingly complex mortgage-backed securities -- the real villains in the credit crunch, argues Bloomberg, were money market funds that were snapping up as much commercial paper as they could, after the the financial crisis was already well under way, following the implosion of Bear Stearns.
Commercial paper refers to short-term debt that corporations use to fund their ongoing operations. They are unsecured, which means that if the company ... can't make good on its obligations when the debt matures, the lender has no recourse.
Bloomberg shines a harsh light on Bruce R. Bent, the creator of the first money market fund ever, the Reserve Primary Fund.
For years, Bent had shunned commercial paper as too risky and scolded managers of other funds for sacrificing safety to earn higher yields... Then, in August 2007 the commercial-paper and other credit markets froze as a result of deteriorating mortgage values. ... When ... managers put their debt up for sale for as little as half the face value, Bent went on a buying spree... From July 2007 to July 2008, the commercial-paper portion of Reserve Primary's holdings jumped to almost 60 percent from 1 percent...
When Lehman Brothers went bankrupt, Primary Reserve Fund was left with nearly $785 million worth of Lehman commercial paper that was effectively worth nothing. The chaos and confusion in the financial markets, in turn, led investors in the fund to start clamoring to get their money back. But Primary Reserve did not have enough cash in hand to return their money -- the majority of its holdings were made up of commercial paper that was either worthless or impossible to put a price on.
By 1 p.m. on Monday, Sept. 15, in New York, less than 13 hours after the 12:37 a.m. bankruptcy announcement, client demands for immediate cash-outs totaled $18 billion, more than a quarter of the fund's assets. Even more alarming, Reserve Primary's bank, Boston-based State Street Corp., had quit honoring withdrawal requests.
Several months later, while appearing on CSPAN, Rep. Paul Kanjorski, D-Pa., chairman of the House Capital Markets Subcommittee, recalled that later that week Hank Paulson and Ben Bernanke had warned congressional leaders that a run on the money markets threatened "the end of our economic system and our political system as we know it." The figures Kanjorski cited never quite added up, but there seems little question that the money market funds were indeed imploding.
But the fact that at least one of them, Primary Reserve Fund, owed its misfortune to its decision to bet heavily on commercial paper after the credit crunch had already begun is new to me. And just more example of why depending on markets for prudent risk management and self-correction seems unwise.

The concentration of risk is an important factor. There would have been losses on commercial paper in any case, and that would have caused problems, but if those losses were widely dispersed rather than concentrated, the problems might not have been as bad.

links for 2009-09-09

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