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October 31, 2009

Economist's View - 4 new articles

Long-Term Unemployment

[Calculated as the this divided by the this.]

Jeremy Piger's US Recession Probabilities

Using data released Friday morning, Jeremy Piger updated his estimates of U.S. recession probabilities through August of 2009. The results now suggest that the probability of recession was below 50% for both July and August. He notes that:

According to the model, the trough is June of 2009, with the peak being December 2007 (which matches the NBER peak). This makes the recession 18 months in duration, which would be the longest post-war recession (by two months over the 1973-1975 recession and the 1981-1982 recession).

Note that if I were to estimate a model that used only employment data, rather than the four variables highlighted by the NBER, the probability of an "employment recession" would still be quite high.


links for 2009-10-30

"The Berlin Wall Had to Fall, But Today's World is No Fairer"

Mikhail Gorbachev says the crisis "was needed to reveal the organic defects of the present model of western development that was imposed on the rest of the world":

The Berlin wall had to fall, but today's world is no fairer, by Mikhail Gorbachev, Comment is Free: Twenty years have passed since the fall of the Berlin wall...
Alas, over the last few decades, the world has not become a fairer place: disparities between the rich and the poor either remained or increased, not only between the north and the developing south but also within developed countries themselves. The social problems in Russia, as in other post-communist countries, are proof that simply abandoning the flawed model of a centralized economy and bureaucratic planning is not enough, and guarantees neither a country's global competitiveness nor respect for the principles of social justice or a dignified standard of living for the population. ...
The real achievement we can celebrate is the fact that the 20th century marked the end of totalitarian ideologies, in particular those that were based on utopian beliefs.
Yet new ideologies are quickly replacing the old ones, both in the east and the west. Many now forget that the fall of the Berlin wall was not the cause of global changes but to a great extent the consequence of deep, popular reform movements that started in the east, and the Soviet Union in particular. After decades of the Bolshevik experiment and the realization that this had led Soviet society down a historical blind alley, a strong impulse for democratic reform evolved in the form of Soviet perestroika, which was also available to the countries of eastern Europe.
But it was soon very clear that western capitalism, too, deprived of its old adversary and imagining itself the undisputed victor and incarnation of global progress, is at risk of leading western society and the rest of the world down another historical blind alley.
Today's global economic crisis was needed to reveal the organic defects of the present model of western development that was imposed on the rest of the world as the only one possible; it also revealed that not only bureaucratic socialism but also ultra-liberal capitalism are in need of profound democratic reform – their own kind of perestroika.

Today, as we sit among the ruins of the old order, we can think of ourselves as active participants in the process of creating a new world. Many truths and postulates once considered indisputable, in both the east and the west, have ceased to be so, including the blind faith in the all-powerful market and, above all, its democratic nature. There was an ingrained belief that the western model of democracy could be spread mechanically to other societies with different historical experience and cultural traditions. In the present situation, even a concept like social progress, which seems to be shared by everyone, needs to be defined, and examined, more precisely.

I don't agree with everything he says (the full essay is much longer), but I think it is true that the market-based development models based upon strict ideological versions of the Washington consensus that were implemented in various places did not work out very well, and this undermined faith in these models. In addition, the economic crisis, along with the success China and other countries have had with different development models, has further undermined the faith that once existed in traditional market-based development strategies.

October 30, 2009

Economist's View - 6 new articles

Where Did the Bush Tax Cuts Go?

[click on figure to enlarge, via, story]

Paul Krugman: The Defining Moment

Centrists have a choice to make:

The Defining Moment, by Paul Krugman, Commentary, NY Times: O.K., folks, this is it. It's the defining moment for health care reform. ...[L]egislation ... will almost surely pass. It's not a perfect bill, by a long shot, but it's a much stronger bill than almost anyone expected... And it would lead to near-universal coverage.
As a result,... politicians, people in the news media,... whoever is in a position to influence the final stage of this legislative marathon — now has to make a choice. The seemingly impossible dream of fundamental health reform is just a few steps away..., and each player has to decide whether ... to help it across the finish line or stand in its way.
For conservatives, of course, it's an easy decision: They don't want Americans to have universal coverage, and they don't want President Obama to succeed.
For progressives, it's a slightly more difficult decision: They want universal care, and they want the president to succeed — but the proposed legislation falls far short of their ideal. There are still some reform advocates who won't accept anything short of ... Medicare for all... And even those who have reconciled themselves to the political realities are disappointed that the bill doesn't include a "strong" public option, with payment rates linked to those set by Medicare.
But the bill does include a "medium-strength" public option, in which the public plan would negotiate payment rates... It also includes more generous subsidies than expected, making it easier for lower-income families to afford coverage. And according to Congressional Budget Office estimates,... 96 percent of legal residents too young to receive Medicare ... would get health insurance.
So should progressives get behind this plan? Yes. And they probably will. The people who really have to make up their minds, then, are ... the self-proclaimed centrists.
The odd thing about this group is that while its members are clearly uncomfortable with the idea of passing health care reform, they're having a hard time explaining exactly what their problem is. Or to be more precise and less polite, they have been attacking proposed legislation for doing things it doesn't and for not doing things it does.
Thus, Senator Joseph Lieberman ... says, "I want to be able to vote for a health bill, but my top concern is the deficit." That would be a serious objection to the proposals ... if they would, in fact, increase the deficit. But they wouldn't, at least according to the Congressional Budget Office...
Or consider the remarkable exchange that took place this week between Peter Orszag, the White House budget director, and Fred Hiatt, The Washington Post's opinion editor. Mr. Hiatt had criticized Congress for not taking what he considers the necessary steps to control health-care costs — namely, taxing high-cost insurance plans and establishing an independent Medicare commission. ... Mr. Orszag pointed out, not too gently, that the Senate Finance Committee's bill actually includes both of the allegedly missing measures.
I won't try to psychoanalyze the "naysayers"... I'd just urge them to take a good hard look in the mirror. If they really want to align themselves with the hard-line conservatives, if they just want to kill health reform, so be it. But they shouldn't hide behind claims that they really, truly would support health care reform if only it were better designed.
For this is the moment of truth. The political environment is as favorable for reform as it's likely to get. The legislation on the table isn't perfect, but it's as good as anyone could reasonably have expected. History is about to be made — and everyone has to decide which side they're on.

Fed Watch: Sustainable Growth?

Tim Duy:

Sustainable Growth?, by Tim Duy: October is becoming my lost month. Between the beginning of Fall term and my annual conference in Portland, the month is a blur, and time to blog becomes a luxury. Now, however, I can see the light at the end of the tunnel. And we can also see the light at the end of the tunnel after this long recession, with a GDP report that confirms what everyone thought - the economy turned the corner in the third quarter of this year. Policymakers undoubtedly breathed a sigh of relief, and rightly so. That said, it is far too early for complacency; I found the underlying details less than comforting, especially in comparison to Wall Street's ebullient reaction to the data.
That the recession would end was never in doubt. Indeed, the timing is almost exactly what one would expected given the steep declines in spending in the first half of 2008 that triggered the flood of job losses later in the year. Spending, consumer spending most importantly, would not fall indefinitely, especially with the benefit of significantly lower energy costs beginning in the second half of last year. Moreover, as the Wall Street Journal notes, rebuilding household balance sheets is not accomplished by just increased savings; a default can do the job much more quickly, quickly adding to household cash flow. Indeed, I admit to being surprised that strategic defaults are not much higher.
The more important question is what will be the durability and sustainability of the recovery in the years ahead? The GDP report raises some significant red flags when considering this question. The consumer spending number was clearly goosed by the Cash for Clunker program and a much slower pace of inventory depletion than expected, which combined to add almost 2 percentage points to the headline figure. But auto sales have slipped back under the 10 million mark in September when the Clunkers program ended, with only a slight gain expected in October. And the slower inventory depletion suggests that firms are further along than expected in realigning stockpiles with demand, and that future improvement will need to stem from more significant improvements in underlying demand (see James Hamilton for a more positive interpretation).
Growth was further boosted by a jump in residential construction, but, as Calculated Risk points out, this sector's future contributions are likely to remain under pressure from high home and rental vacancy rate. Moreover, the impact of fiscal stimulus will fade as we move through next year, and there appears to be little political will to offer up additional stimulus.
Finally, note that net exports subtracted 0.53 percentage points of growth as import growth exceeded import growth. A balanced, sustainable recovery requires, in my opinion, that net exports contribute to growth. This showing reminds us of the ongoing dependence of US consumption on overseas production - stimulating consumption spending flows in part right out of the economy via imports. Recall also Federal Reserve Chairman Ben Bernanke's recent warning:
Another set of lessons that Asian economies took from the crisis of the 1990s may be more problematic. Because strong export markets helped Asia recover from that crisis, and because many countries in the region were badly hurt by sharp reversals in capital flows, the crisis strengthened Asia's commitment to export-led growth, backed up with large current account surpluses and mounting foreign exchange reserves….To achieve more balanced and durable economic growth and to reduce the risks of financial instability, we must avoid ever-increasing and unsustainable imbalances in trade and capital flows. External imbalances have already narrowed substantially as a consequence of the crisis...As the global economy recovers and trade volumes rebound, however, global imbalances may reassert themselves. As national leaders have emphasized in recent meetings of the G-20, policymakers around the world must guard against such an outcome.
Couple this with a Wall Street Journal story earlier this week:
For more than a year, China has kept the yuan largely unchanged against the dollar. So, like the dollar, the yuan has been falling steadily against the currencies of China's neighbors, including the Malaysian ringgit, the Indonesian rupiah and the South Korean won. That makes goods produced in those countries more expensive compared with China's.
"If you have one large economy in Asia lock itself against the U.S. dollar, everyone feels pressure," says Frederic Neumann, Asia economist for HSBC in Hong Kong. "Even 5% in this context feels painful."
The countries that compete with China are at a critical juncture. To stem the rise of their currencies against the yuan (and the dollar), central banks around Asia have in recent months been purchasing gobs of greenbacks and building their foreign reserves. And now those reserves are back up to precrisis levels.
At the same time, Asian economies are under pressure eventually to allow their currencies to rise and reduce their emphasis on exports to fuel growth. Some economists and international policy makers fear continued intervention in currency markets would reflect an unwillingness to break old habits of export growth driven by policies that kept currencies undervalued. Intervention can also raise the risks of domestic inflation.
Note also that the Europeans are growing frustrated with recent currency movements. From Market News International (no link):
European central bankers, worried that the soaring euro could squelch a nascent economic recovery, are increasingly pressuring U.S. authorities to put some bite into their bark(ing) about a strong dollar, well-placed monetary sources told Market News International.
European monetary officials need the active support of U.S. and Chinese authorities to help restrain the euro and stem the greenback's slide, these sources said. Some noted that with the financial system awash in cash, it would be hard to mount an effective intervention in global currency markets.
The international political dynamics on this issue bear careful attention; it is not clear that the US and Europe will be able to tolerate Chinese currency policy indefinitely. But do they have a choice?
Add in another concern - the jobless (or perhaps job-loss) recovery. The underlying rate of economic growth (firms look through the Clunkers boost) remains well below rates sufficient to generate job growth. Indeed, as David Altig notes, the jobless recovery is almost certainly upon us once again, and if anything will prod the Administration to initiate a second stimulus package, it will be the prospect of sustained double-digit unemployment - an outcome that will only be aggravated if Chinese policy is to take advantage of the recession to consolidate more productive capacity behind its borders. Perhaps then we develop a new dependency, with Chinese saving redirected to US consumers via the US government rather than the housing market.
All of which boils down to a simply question: Can the US and global economies rebalance to a sustained, healthy pattern of growth without the cooperation of Chinese policymakers? In other words, can a Dollar depreciation against the Euro alone sustain a rebalancing? I think not, which implies that global economic stability is being supported on a very vulnerable base at the moment.
How will the Fed view these numbers? They will be relieved, but have much of the same skepticism regarding the sustainability of these numbers. Policymakers know the economy is being push along by a wave of federal stimulus, and are uncertain of how much momentum would be left in that absence of that stimulus. At the same time, however, the solid GDP showing will support already heightened worries that while interest rates need to be sustained at very low levels, officials may be late to the game when it comes to reversing the expansion of the balance sheet. Note St. Louis Federal Reserve President James Bullard:
"It is a little disappointing that private-sector economists are thinking so much about when we are going to move our fed funds rate up," he said. "We are at zero. We are going to be there awhile. The focus should be more on" the Fed's asset purchase program.
Given high unemployment and ongoing disinflation, there will be no rush to raise rates. What will comes first is the contraction in the balance sheet - and positive GDP numbers will push the discussion further in that direction.
Bottom Line: The GDP report is confirmation that the recession has come to an end. But I am not ready to breath easy - too many potentially unsustainable factors drove the boost, and too much remains dependent on federal stimulus. Until the economy can stand on its own, it remains vulnerable to unsustainable, unbalanced patterns of growth. And the negative contribution of trade to growth, especially coupled with growing tension over currency movements, is a warning sign that trade and capital flows are at risk of falling back into old and unehlpful patterns.

"Are Those $250 Social Security Checks Just Pandering to Seniors?"

Some pushback against a recent article that questions the value of giving people on Social Security a $250 check to stimulate the economy and denounces President Obama for pandering to the elderly:

Are Those $250 Social Security Checks Just Pandering to Seniors?, by pgl: David Leonhardt tries to make this case... But why did Mr. Leonhardt start his discussion by talking about the depressed economy and who would be most likely to consume any checks that the government may wish to extend?
If you wanted to help the economy and you had $14 billion to bestow on any group of people, which group would you choose: a) Teenagers and young adults, who have an 18 percent unemployment rate. b) All the middle-age long-term jobless who, for various reasons, are not eligible for unemployment benefits. c) The taxpayers of the future (by using the $14 billion to pay down the deficit). d) The group that has survived the Great Recession probably better than any other, with stronger income growth, fewer job cuts and little loss of health insurance. The Obama administration has chosen option d — people in their 60s and beyond.
Let's think about the macroeconomic impact of a $14 billion one-time transfer payment in terms of a life-cycle model of consumption. This would be equivalent to a one-time increase in household wealth with the impact effect on consumption being equal to the increase in wealth divided by the number of remaining years of life for the individual receiving the check. If a young person were given $250, he would likely save most of it. If the $250 were given to the elderly instead, then more of the transfer payment would be consumed. Mr. Leonhardt seems to be unhappy with the President's proposal but his reasoning here seems to be very confused.
Dean Baker:
David Leonhardt's Age-Based Politics, by Dean Baker: David Leonhardt is upset that people on Social Security will get a $250 check from the government next year and denounces President Obama for pandering to the elderly. There is a lot of serious confusion in this piece.
First, he argues that the elderly have suffered less from the downturn from other groups be comparing declines in income and employment. This is actually a much tougher question that Leonhardt implies. The elderly have accumulated assets over their working lifetime. These assets plunged in value with the collapse of the housing bubble and the plunge in stock prices. This plunge has hit the elderly far more than other groups... So, if we took a wealth-based measure of impact, we would find that the wealthy were hit hardest by the downturn. ...
Second, in terms of government assistance, the making work pay tax credit is giving money to the vast majority of the under 65 population. The $250 boost to Social Security beneficiaries can be seen as an effort to provide comparable help to those who are no longer working. It's not obvious how this creates an injustice.
The third point is that Leonhardt seems to misunderstand the point of stimulus. We need people to spend money. Given the enormous idle capacity in the economy, we would benefit from handing checks to anyone who will agree to spend it. (Contrary to Leonhadt's assertion, this does not create a burden on children and grandchildren -- if anything the growth created by the stimulus is likely to mean we hand them a wealthier country.) The elderly will spend a high share of their checks, which makes this a good form of stimulus.
In fact, we really need larger deficits at this point to boost the economy, but politically this is not acceptable. We should thank the elderly for making some additional stimulus politically acceptable. ...
Lastly, we get a line about protecting Medicare benefiting the elderly at the expense of our grandchildren. Actually, we could substantially reduce costs for Medicare and fully protect the quality of care. However, this would require attacking the interests of the health care industry. This is an interest group that the politicians (and the media) really pander to.

The "Silver Spoon" in Ancient Societies

The intergenerational transfer of wealth and advantage is nothing new, but what causes it?:

Inequality, 'silver spoon' effect found in ancient societies, EurekAlert: The so-called "silver spoon" effect -- in which wealth is passed down from one generation to another -- is well established in some of the world's most ancient economies, according to an international study coordinated by a UC Davis anthropologist.
The study, to be reported in the Oct. 30 issue of Science, expands economists' conventional focus on material riches, and looks at various kinds of wealth, such as hunting success, food sharing partners, and kinship networks.
The team found that some kinds of wealth, like material possessions, are much more easily passed on than social networks or foraging abilities. Societies where material wealth is most valued are therefore the most unequal, said Monique Borgerhoff Mulder, the UC Davis anthropology professor who coordinated the study with economist Samuel Bowles of the Santa Fe Institute.
The researchers also showed that levels of inequality are influenced both by the types of wealth important to a society and the governing rules and regulations.
The study may offer some insight into the not-too-distant future.
"An interesting implication of this is that the Internet Age will not necessarily assure equality, despite the fact that its knowledge-based capital is quite difficult to restrict and less readily transmitted only from parents to offspring," Borgerhoff Mulder said.
"Whether the greater importance of networks and knowledge, together with the lesser importance of material wealth, will weaken the link between parental and next-generation wealth, and thus provide opportunities for a more egalitarian society, will depend on the institutions and norms prevailing in a society," she said.
For years, studies of economic inequality have been limited by a lack of data on all but contemporary, market-based societies. To broaden the scope of that knowledge, Borgerhoff Mulder, Bowles and 24 other anthropologists, economists and statisticians from more than a dozen institutions analyzed patterns of inherited wealth and economic inequality around the world.
The team included three others from UC Davis - economics professor Gregory Clark, anthropology professor Richard McElreath and Adrian Bell, a doctoral candidate in the Graduate Group in Ecology.
They focused not on nations, but on types of societies - hunter gatherers such as those found in Africa and South America; horticulturalists, or small, low-tech slash-and-burn farming communities typical of South America, Africa and Asia; pastoralists, the herders of East Africa and Central Asia; and land-owning farmers and peasants who use ploughs and were studied in India, pre-modern Europe and parts of Africa.

links for 2009-10-29

October 29, 2009

Economist's View - 5 new articles

GDP Growth 3.5% in 3rd Quarter

The stimulus package in action:

GDP Expanded 3.5% in 3rd Quarter, WSJ: The economy expanded in the third quarter after shrinking for four consecutive quarters, likely marking an end to the worst recession since World War II. But the recovery is expected to be slow, as the economy continues to fight rising unemployment and a persistent credit crunch.
Gross domestic product rose by a higher-than-expected seasonally adjusted 3.5% annual rate July through September, the Commerce Department said Thursday in its first estimate of third-quarter GDP. ... The rise in GDP was the first since the second quarter of 2008. It served as an unofficial confirmation that the longest and deepest recession since the Great Depression has ended. ...
The GDP gain was driven by consumer spending, which rose by 3.4% in the third quarter, compared with a 0.9% drop in the April-to-June period. Consumer spending contributed 2.36 percentage points to GDP growth.
Economists said the massive stimulus injected by the U.S. government, such as the cash for clunkers program that lifted car sales, helped boost consumer spending. Since the federal stimulus reached its maximum effect in the third quarter and the unemployment rate remains high, there's uncertainty over the sustainability of the recovery.
Price gauges showed the core inflation rate -- which strips out volatile food and energy prices and is closely watched by the Federal Reserve -- slid to 1.4% from 2.0% in the second quarter, in a sign that price pressures remain subdued. ...
While the economy has resumed rising, joblessness is still high. ... The number of U.S. workers filing new claims for jobless benefits fell slightly last week... Initial claims for jobless benefits declined by 1,000 to 530,000 in the week ended Oct. 24. The previous week's level was unrevised at 531,000. ... Claims still remain at a fairly high level, suggesting the job market has a long recovery ahead. ...

I hope we don't become overly optimistic and pull back on help for the economy too soon, we don't know for sure if the increase in growth is sustainable without help from the stimulus package, and I also hope that we don't forget about labor markets which are likely to lag far behind the recovery for output.

The "Moral Economy of the Crowd"

As I've noted here several times in the past, most recently with respect to health care, we do not always believe that the market system allocates goods and services equitably, and in those cases we often ration the good or service by means other than the price system.

Here's Daniel Little on the "moral economy of the crowd":

Fair prices?, by Daniel Little: We live in a society that embraces the market in a pretty broad way. We accept that virtually all goods and services are priced through the market at prices set competitively. We accept that sellers are looking to maximize profits through the prices, quantities, and quality of the goods and services that they sell us. We accept, though a bit less fully, the idea that wages are determined by the market -- a person's income is determined by what competing employers are willing to pay. And we have some level of trust that competition protects us against price-gouging, adulteration, exploitation, and other predatory practices. A prior posting questioned this logic when it comes to healthcare. Here I'd like to see whether there are other areas of dissent within American society over prices. Because of course it wasn't always so. E. P. Thompson's work on early modern Britain reminds us that there was a "moral economy of the crowd" that profoundly challenged the legitimacy of the market; that these popular moral ideas specifically and deeply challenged the idea of market-defined prices for life's necessities; and that the crowd demanded "fair prices" for food and housing (Customs in Common: Studies in Traditional Popular Culture). The moral economy of the crowd focused on the poor -- it assumed a minimum standard of living and demanded that the millers, merchants, and officials respect this standard by charging prices the poor could afford. And the rioting that took place in Poland in 1988 over meat prices or rice riots in Indonesia in 2008 are reminders that this kind of moral reasoning isn't merely part of a pre-modern sensibility. (For some quotes collected by E. P. Thompson from "moral economy" participants on the subject of fair prices see an earlier posting on anonymity.) So where do contemporary Americans show a degree of moral discomfort with prices and the market? Where does the moral appeal of the principles of market justice begin to break down -- principles such as "things are worth exactly what people are willing to pay for them" and "to each what his/her market-determined purchasing power permit him to buy"? There are a couple of obvious exceptions in contemporary acceptance of the market. One is the public outrage about executive compensation in banking and other corporations that we've seen in the past year. People seem to be morally offended at the idea that CEOs are taking tens or hundreds of millions of dollars in compensation -- even in companies approaching bankruptcy. Part of the outrage stems from the perception that the CEO can't have brought a commensurate gain to the company or its stockholders, witness the failing condition of many of these banks and companies. Part is a suspicion that there must be some kind of corrupt collusion going on in the background between corporate boards and CEOs. But the bottom line moral intuition seems to be something like this: nothing could justify a salary of $100 million, and executive compensation in that range is inherently unfair. And no argument proceeding simply along the lines of fair market competition -- "these are competitive rational firms that are offering these salaries, and therefore whatever they arrive at is fair" -- cuts much ice with the public. Here is another example of public divergence from acceptance of pure market outcomes: recent public outcries about college tuition. There is the common complaint that tuition is too high and students can't afford to attend. (This overlooks the important fact that public and private tuitions are almost an order of magnitude apart -- $6,000-12,000 versus $35,00-42,000!) But notice that this is a "fair price" argument that would be nonsensical when applied to the price of an iPod or a Lexus. People don't generally feel aggrieved because a luxury car or a consumer device is too expensive; they just don't buy it. It makes sense to express this complaint in application to college tuition because many of us think of college as a necessity of life that cannot fairly be allocated on the basis of ability to pay. (This explains why colleges offer need-based financial aid.) And this is a moral-economy argument. And what about that other necessity of life -- gasoline? Public complaints about $4/gallon gas were certainly loud a year ago. But they seem to have been grounded in something different -- the suspicion that the oil companies were manipulating prices and taking predatory profits -- rather than an assumption of a fair price determined by the needs of the poor. Finally, what about salaries and wages? How do we feel about the inequalities of compensation that exist within the American economy and our own places of work? Americans seem to accept a fairly wide range of salaries and wages when they believe that the differences correspond ultimately to the need for firms to recruit the most effective personnel possible -- a market justification for high salaries. But they seem to begin to feel morally aggrieved when the inequalities that emerge seem to exceed any possible correspondence to contribution, impact, or productivity. So -- we as Americans seem to have a guarded level of acceptance of the emergence of market-driven inequalities when it comes to compensation. One wonders whether deeper resentment about the workings of market forces will begin to surface in our society, as unemployment and economic recession settle upon us.

"China to Investigate US Car Subsidies"

China sends a message:

China to investigate US car subsidies, by Sarah O'Connor: China is preparing to launch a trade investigation into whether US carmakers are being unfairly subsidised by the US government...
The move comes at a time of heightened trade tensions between the two countries after the US imposed duties on Chinese tires last month. Many warned this would prompt Beijing to retaliate.
Few vehicles are actually exported from the US to China, but the move would have symbolic power by turning the tables on Washington. ... The investigation could lead to import duties. ...
China has already told the US that it has received a petition for an investigation, which ... would formally launch on Wednesday. Before that, the two countries will negotiate. Top US government officials are already in China for trade talks this week, and Barack Obama, US president, is due to visit the country next month.
China had notified the US it had received anti-dumping and countervailing duty petitions on cars, a spokeswoman for the United States Trade Representative said.
World Trade Organization rules require China to invite the US to consult on the countervailing duty petition before initiating any investigation... The countries expect to consult over coming days. ...
China has received an anti-dumping petition as well, which asks for investigation into whether US car exports are being sold at unfairly low pries. ...

Feldstein: America's Healthcare Debate

Martin Feldstein says bond markets disagree with him, so they must be wrong:

The global impact of America's healthcare debate, Commentary, Project Syndicate: Since assuming the presidency earlier this year, Barack Obama's ... proposals are meeting strong opposition from fiscally-conservative Democrats as well as from Republicans, owing to their potential impact on future fiscal deficits. ...
[A]n overwhelming majority of Americans are insured, with government a major financier of healthcare. But there remain about 54 million individuals who are not formally insured, and some insured individuals still face the risk of financially ruinous medical costs if they have very expensive medical treatment.
Obama campaigned on the goals that everyone should have health insurance, that high medical costs should not bankrupt anyone... But, rather than producing a specific proposal, he left it to Congress to design the legislation. ...
In fact, there is a strong risk that this legislation would ultimately add to the fiscal deficit. Increasing the number of insured by 35 million and broadening protection for some who are now insured implies increased demand for healthcare, which could raise the cost of care paid for by the government as well as by private healthcare buyers. In addition, both sources of financing are also uncertain. ...
In considering the fiscal implications of Obama's health proposals, it is important that the current legislation would still leave 25 million individuals without insurance.
How much would it cost to insure them if the gross cost is now projected at US$800bil for the easier-to-insure 35 million? And how could that cost be financed...? Closing that gap could add more than $1 trillion to the government's cost over the next 10 years.
It is clear that there is a significant danger that the current legislation would add substantially to future US deficits – and establish a precedent for even more expensive expansions of healthcare in the future.
This would come on top of the currently projected fiscal deficits in both the near term and over the coming decade – and before America's demographic shift substantially raises the cost of Social Security and Medicare.

Surprisingly, the bond market still seems almost oblivious to this risk. But holders of US debt worldwide have every reason to be concerned.

The bond markets are right.

links for 2009-10-28

October 28, 2009

Economist's View - 5 new articles

Woodford on Financial Markets

Part of an interview of Michael Woodford:

Q&A: Economist Woodford on Fed and Rate Expectations, RTE: ...Given the importance of financial stability for the wider economy, do you think financial stability should play a greater or explicit role in the Federal Reserve's policy strategy?
Woodford: No doubt, the Fed should give greater attention to financial stability than it did in the past. One should try and set up a framework to safeguard financial stability, and it may very well be that ... central banks should play a key role. But, ideally, one would be scrutinizing the risks developing and adjust capital requirements accordingly, rather than using monetary policy to respond to these risks. You've got to realize that pretending you can do everything with one tool means you won't do any of them too well.
Should the Fed be more reactive — leaning against the wind -toward sharp moves in asset prices, such as house prices and equities? Should the Fed include a broader range of asset prices in its policy strategy?
Woodford: I'm not too sympathetic of that way of putting things. Using monetary policy to prevent certain moves in asset prices wouldn't be a terribly effective tool. And to the extent that it would be effective, it'd involve important costs for the rest of the economy. It'd be particularly bad for the Fed to be saying "we have a view on where asset prices should be, and we're going to get them there by using monetary policy." Instead, the focus of the Fed's investigation should be on what kind of risks financial institutions get themselves into — not on asset prices as such.
The Fed has downgraded the role of money and credit aggregates in its policy strategy. Given the more recent developments, do you think it's now time to reconsider, or reverse the move?
Woodford: The issue that deserves more attention is monitoring risks to financial stability and identifying possible systemic risks. Unfortunately, traditional monetary and credit statistics aren't that closely related to the things you really ought to be measuring. For example, lending by non-bank entities has played an important role in the recent real-estate euphoria. Given the emergence of new kinds of institutions and financing arrangements, you cannot simply revert to the old statistics people used to look at decades ago. There should be more research on understanding which measures are in fact the valuable indicators.

The last section is important. Many people have said that we cannot tell when a bubble is inflating (and thus when risks are increasing), but how hard have we actually tried? Have we seriously looked at data on, to name just one element of what I have in mind, leverage cycles? Do we know how leverage cycles relate to crises, that kind of knowledge that years of hard work by a variety of researchers brings about? Some people likely know the answer to this, or at least have some idea about this, but it's not data you'll find in standard sources such as FRED. As another example, what about measures and data on the degree of financial market connectedness? This can be measured in principle, but little effort has been devoted to doing so. Even traditional measures such as P/E ratios and Q-ratios haven't received the attention they deserve.

Until we dig in and try seriously to develop new empirical measurements that can monitor and identify risks, measures intended to inform us when risks are increasing to dangerous levels, we won't know if we can identify bubbles or not. I understand that financial theory says such predictions are impossible, and this has led people to shy away from such work, but that result relies upon assumptions that may not be true. The crisis has revealed the shaky foundation those models rest upon, so it's no longer an excuse for not trying, or, as in the past, for dismissing work along these lines as unimportant and a waste of time.

"Labor's Share"

Spencer at Angry Bear on the "secular decline in labor's share of the pie":

Labor's Share, by Spencer: The issue of a jobless recovery is getting a lot of attention recently. I've found the best way to look at the issue is to compare the change in real growth and productivity over the long run. There have been three periods of different productivity trends in modern US economic history. Prior to about 1973 productivity growth averaged 2.8%. In the second or low productivity era, running from 1974 to 1995, productivity growth slowed to 1.5% before rebounding to 2.4% since 1995. But real GDP growth also slowed over this period. ... Basically, real GDP growth equals productivity growth plus hours worked or employment growth. A consequence of stronger productivity in an era of weaker GDP growth this suggests that each percentage point increase in real GDP growth generates a much weaker increase in hours worked or employment. ...
But to a certain extent comparing productivity and real GDP is comparing apples to oranges. To be accurate one should look at productivity versus output in the nonfarm sector. GDP includes the farm sector of course, but also the nonprofit and government sectors where productivity is assumed to be zero. If you look at what happened in the 1990s and early 2000s recoveries in the nonfarm business sector, you see that productivity growth significantly outpaced output growth in the early recovery phase of the cycle. As a consequence hours worked or employment fell, generating the jobless recoveries. It looks like the problem in these two cycles was much weaker growth rather than strong productivity. ... This shift to an environment of stronger productivity and weaker real growth generated an interesting development that has received little attention among economists or in the business press.
This development was a secular decline in labor's share of the pie. Prior to the 1982 recession there was a strong cyclical pattern of labor's but it was around a long term or secular flat trend. But since the early 1980s labor's share of the pie has fallen sharply by about ten percentage points. Note that the chart is of labor compensation divided by nominal output indexed to 1992 = 100. That is because the data for each series is reported as an index number at 1992=100 rather than in dollar terms. So the scale is set to 1992 =100 rather than in percentage points. But it still shows that labor payments as a share of nonfarm business total output has declined sharply over the last 20 years and prior to the latest cycle we did not even see the normal late cycle uptick in labor's share.

If this chart gets a lot of attention it will be interesting to see how the libertarian and/or conservative analysts who keep coming up with all types of excuses to explain away the weakness in real labor compensation in recent years explain this away. If you really want to raise a stink you could look at this as a great example of the Marxist immiseration of labor that Marx believed was one of the internal contradictions of capitalism that would eventually lead to its self destruction.

I'll just add that the point at which the decline begins (in the early 1980s) is generally associated with the onset of the Great Moderation.

"A Clunker of a Climate Policy"

Jeff Sachs says we need to be sure that climate control legislation is not captured by powerful special interest groups:

A Clunker of a Climate Policy, by Jeffrey D. Sachs, Commentary, Scientific American: The Cash for Clunkers program offers a cautionary tale for the future of climate change control. ... The broad principle of climate change mitigation is to reduce greenhouse gas emissions ... to target levels at the minimum net cost to society. There are many ways to reduce emissions: drive more efficient or electrically powered vehicles; produce electricity with renewable energy sources; capture CO2 from power plants and store it geologically; restart the nuclear power sector; weatherproof homes... The list is long, with different time horizons, costs and uncertainties.
Clearly, not every method of reducing emissions makes equal sense. ...McKinsey & Company has recently published estimates of the abatement costs of various technologies. Highly efficient lighting, appliances and vehicles, along with better insulation and other technologies, can save more in energy costs during their lifetime than the upfront capital for installing them: they are better than free to society. Other options—notably, renewable energy sources, forest conservation programs and carbon capture and storage—tend to come in below $60 per ton of avoided CO2 emissions.
Some carbon-reduction ideas are so expensive they should play no part in the policy mix. Yet because lobbyists overrun our legislative processes,... lots of terrible ideas will no doubt be advocated.
Let's make a rough calculation of how much mitigation per dollar the Cash for Clunkers program really achieved. ...[calculations]... The net annual cost of the CO2 reduction is therefore ... $141 per ton of CO2. ... This crude calculation is subject to many refinements but shows that Cash for Clunkers represented a very high cost per ton of CO2 avoided. Countless ways to reduce CO2 emissions are less expensive than smashing up autos five years before their natural demise.
We will blunder badly and repeatedly in climate change control unless we put some transparent control systems in place. We should rely heavily on price signals rather than one-by-one subsidized programs, except for the subsidies needed to bring new technologies such as electric vehicles to the commercial phase. An economy-wide tax on each ton of CO2 emissions, programmed to rise gradually over time at an appropriate social discount rate, would induce the marketplace to take actions that are less expensive per ton than the tax and to leave behind measures such as Cash for Clunkers or corn to ethanol. A carbon tax would be far more effective in this regard than the cumbersome cap-and-trade system proposed by the House of Representatives.
We'll need to spend trillions of dollars over time to save the planet from climate change. All the more reason not to let lobbyists make a financial game out of this deadly serious effort.

"Pro-Market Populism"

Luigi Zingales is worried that populist anger might fall into the hands of evil Democrats rather than Republicans who would, of course, use this strong populist force for good:

Pro-Market Populism Is GOP's Out, by Luigi Zingales, Commentary, ...[T]he financial crisis has created significant discontent. In a survey taken last December, 60% of Americans declared themselves "angry" or "very angry" about the economic situation.
If Republicans ignore this popular anger, as the party establishment did last autumn, they leave a powerful and potentially disruptive force in the hands of Democrats. The Democrats could channel popular anger into protectionism, 90% tax rates and onerous new market constraints.
In Republican hands, populism could become a strong force for positive change.

And Republicans would do this by adopting Democratic ideas:

The Republican Party has to move from a pro-business strategy that defends the interests of existing companies to a pro- market strategy that fosters open competition and freedom of entry.
While the two agendas sometimes coincide, they are often at odds. Established firms are threatened by competition and frequently use their political muscle to restrict new entries into their industry, strengthening their positions but putting their customers at a disadvantage.

Reducing market power through regulation and is something Democrats have long advocated, but Republicans have argued that the market takes care of this itself, there's no need for government to intervene. So how would Republicans solve the problem in, say, the financial industry?

A pro-market strategy aims to encourage the best conditions for doing business, for everyone. Large banks benefit from trading derivatives (such as credit default swaps) over the counter, rather than in an organized exchange. ... For this reason, they oppose moving such trades to organized exchanges, where transactions would be conducted with greater transparency, liquidity and collateralization — and so with greater financial stability. This is where a pro-market party needs the courage to take on the financial industry on behalf of everyone else.

Again, that sounds like what Democrats have been saying, that these markets need to be regulated.

What else is involved in this pro-market strategy that will save the Republican party?

A pro-market strategy rejects subsidies because they're a waste of taxpayers' money and because they prop up inefficient firms, delaying the entry of new and more efficient competitors.
And a pro-market approach holds companies financially accountable for their mistakes — an essential policy if free markets are to produce sound decisions.
A pro-market party will fight tirelessly against letting firms become so big that they cannot be allowed to fail, since such firms may take risks that ordinary companies would never dream of.

I can imagine a few people on the left supporting some types of subsidies, but generally I don't think you'll get much disagreement here either (e.g. see Sachs on subsidies in the post above this one). The accountability thing sounds like a jab at government intervention to save the bank (as does the first point), but take a look at the latest proposal from Democrats that attempts to put the cost of bailouts on the companies themselves while still protecting the economy (as opposed to just letting it melt down). But go on...

A pro-market party should favor a robust safety net — for people, not companies. Of course, this safety net should be run on market principles as much as possible. Unemployment insurance should retain incentives for people to look for work, and the health-insurance industry should be opened up to competition. But defenders of markets cannot ignore the importance of providing such security for citizens.

The details would differ a bit, e.g. the health insurance competition part certainly differs from a Medicare for all structure many Democrats endorse (but not all), but the general idea of a "robust safety net" for people seems consistent with Democratic ideas, less so with Republican principles.

Besides robust safety nests, what else is on the long-time concern of Republican's list?

They also cannot ignore the nation's growing income inequality and the widespread loss of confidence that the future will be better than the past. The knee-jerk Democratic reaction is to give these poorer citizens entitlements disguised as rights.
The Republican response should focus on providing opportunities. Parents should have access to good schools for their kids, regardless of their financial means or where they live. The best way to deliver on that promise is through a voucher system.

Entitlements disguised as rights? Such as? The general idea that some kids are disadvantaged by the education they receive has been a mainstay within the Democratic party for a long time, and quite a few Democrats endorse vouchers as part of the solution (even breaking up teacher's unions in some cases). And concern over inequality? From Republicans? Generally Republicans argue that inequality isn't really increasing or as bad as you think (the attack the data when you don't like the answer approach), or that it's necessary to fuel the engine of capitalism.

What's next on the list of Democratic ideas disguised as Republican concerns?

Students should have better access to loans to finance their education because everyone gains from a better-educated work force. The unemployed should have access to retraining, which can also be designed through a voucher system.

Student loans, help with finding new employment? Yet again, strong Democratic ideas. The only thing new is to toss in a voucher system, but that's a debate about how best to reach the goal, not what the goal is (and again, vouchers aren't automatically rejected by all Democrats). I suppose you'll want to adopt health care as a Republican idea as well?

Health care should be available in the marketplace. The current system, in which only employers get a tax deduction for health insurance, reduces labor mobility and increases the cost of becoming unemployed.

What is the goal here? If it's to make health care affordable and available to everyone, simple saying it ought to be "in the marketplace" is far from enough. The incompleteness of the proposal makes this hard to evaluate (but given the proposals so far, you have to think the work "vouchers" would be involved in the solution).


The U.S. has been the inspiration for all who believe in freedom, both political and economic. Its identity, however, is predicated on maintaining a political consensus that supports market values.
Growing income inequality, the financial crisis and the perceived unfairness of the market system are undermining this consensus. If Republicans don't stand up for markets, who will?

If standing up for markets means -- running down the list above in order -- reducing market power, regulating financial markets, eliminating subsidies, breaking up too big to fail firms, providing a robust safety net, overcoming income inequality, fixing schools, increasing the availability of student loans, providing retraining, and providing health care, then the answer is Democrats.

links for 2009-10-27

October 27, 2009

Economist's View - 5 new articles

"The Weakest Recovery in Modern Memory"?

As many of us have been saying for some time now, more stimulus would speed the recovery -- the jobs outlook is particularly worrisome -- but unfortunately, it doesn't appear that more stimulus is politically feasible:

The Case for More Stimulus, Editorial, NY Times: The consensus among economists is that the recession is over, and, technically, the herd is probably right. ... Immense federal stimulus has jolted the economy.
But... The economy is going to need more government support, or it is bound to be very weak for a very long time — and vulnerable to a relapse into recession. Unemployment is expected to worsen well into next year, exceeding 10 percent. Foreclosures are expected to rise, which will push home values down further. Hundreds of small and midsize banks are likely to fail in coming years. State and local governments face budget shortfalls in 2010 that are as bad or worse than this year's.
Yet Washington is not providing a coherent plan for effective stimulus. The Senate has been hamstrung for nearly a month over the most basic relief-and-recovery boost: an extension of unemployment benefits. ... Lawmakers in both parties fret that large budget deficits preclude more stimulus, lest the burden of debt outweigh the benefit of deficit spending. ... Deficits are a serious issue, but the immediate need for stimulus trumps the longer-term need for deficit reduction. A self-reinforcing stretch of economic weakness would be far costlier than additional stimulus.
The Senate could take a step in the right direction by extending unemployment benefits without further delay. ... Next, Congress and the administration should agree on ways to ease the dire financial condition of the states. Most important is continued aid for state Medicaid programs... As long as the states are suffering, any economic recovery efforts by the federal government are undermined. ...
Without another round of effective stimulus, the worst recession in modern memory will likely become — at best — the weakest recovery in modern memory. Another boost to federal spending that is targeted and timely should not be too much for politicians to deliver.

Recall this recent graph from the San Francisco Fed:


Output is not expected to return to potential until well into 2012.

Now recall the long delay between the end of the last two recessions and the peak in the unemployment rate (or just about any other labor market indicator):


And the recovery for the labor market could be even slower this time.

To be fully effective, plans for additional stimulus should have been in place long ago. However, given how long the recovery is expected to take, it's not too late to do more if we get started right away. But the political climate makes it highly unlikely that labor markets and the economy will get the help that they need.

"The Chamber's Mistakes"

Daniel Gross says it's no mystery why the Chamber of Commerce suddenly finds itself on the outside looking in:

The Chamber's Mistakes, by Daniel Gross, Commentary, Slate: This has been a rough period for the Chamber of Commerce, the Washington, D.C., organization that claims to be the voice of American business. Its doubts about climate change ... have led prominent members to quit... With Democrats controlling both Congress and the White House, it doesn't have natural allies. ... The change in political facts ... and its own poor choice of words have left the chamber feeling a bit left out. CEO Thomas Donahue gave a long interview to the Wall Street Journal (the editorial page) complaining about the chamber's poor treatment, lamenting that its wise counsel wasn't being sought in the formulation of policy, and vowing to fight. ...
But there is a fundamental reason why the chamber isn't being invited into the rooms where legislation and policy are being made these days: It doesn't have much to offer. For generations, the Chamber of Commerce has held itself out as the sensible, we-know-better voice of business: Follow the policies we—i.e. American business—approve and advocate, and the nation will grow and prosper. We'll have more jobs, higher wages, rising asset values, and widely shared prosperity. ...
From 2001 to 2008, the nation listened. It elected and then put into place exactly the policies the chamber advocated. And the chamber utterly failed to deliver.
The Chamber of Commerce may not have ruled the country during the Bush years. But it had the next best thing: a Republican administration in the White House and Republican control of Congress for most of that period. The chamber applauded as they delivered cuts in marginal tax rates and in taxes on capital gains, dividends, and estates. The government was supportive of free trade and largely hostile to labor unions, which continually lost ground. We saw aggressive moves to outsource government functions and increase the use of private-sector contractors. We opened up energy resources to development. Interest rates were low. Regulation? Virtually nonexistent in many sectors. Business lobbyists were allowed essentially to write crucial legislation. These policies, the Bush administration economic team promised us, would be superior to the ones that prevailed in the 1990s. And the proof would be in the numbers: jobs, market performance, income, wealth.
But it didn't work out for anybody. By pretty much any measure, the years from 2001 to 2008 were lost ones. Job creation was extraordinarily weak... Wealth didn't expand, either. In fact,... in this decade, income inequality rose, the percentage of people living below the poverty line rose..., the number of people getting health insurance from their employers fell, and median income failed to budge. The stock market? Forget about it. Oh, and at the end of it, the financial system, which got precisely the regulatory environment it wanted from Washington, blew itself up, inflicting hundreds of billions of dollars of costs on taxpayers. ...
These were excellent conditions for businesses to do what the Chamber of Commerce says they're supposed to do. But the policies failed in their intended results, which is the reason Democrats now control every lever of power—and why the Chamber of Commerce is standing with its face pressed against the glass.

Rise and Fall of Non-Agency Securitization

[More here.]

"Reserve Accumulation and Easy Money Helped to Cause the Subprime Crisis"

Guillermo Calvo sketches an outline of a theoretical framework to explain the crisis. In this model, the demand for international reserves, low US interest rate policy and lax financial regulation leads to the creation of fragile financial instruments and the "large-scale creation of quasi-money subject to self-fulfilling-expectations runs":

Reserve accumulation and easy money helped to cause the subprime crisis: A conjecture in search of a theory, by Guillermo Calvo, Vox EU: A view that is gaining popularity as one of the fundamental explanations for the current crisis is that emerging markets' voracious appetite for international reserves coupled with record-low US policy interest rates and lax financial regulation to produce a frantic "search for yield," the creation of fragile financial instruments, and occasionally outright fraud. For example see Henry Paulson's discussion quoted in Guta (2009).

This view – particularly, the "financial fragility" component – could help to answer a central question, namely, why minor fireworks in the subprime mortgage market ignited a fearsome powder keg and a local problem became global in a short span of time.

In this column, I will present a framework that provides some conceptual support for the view. The framework stresses fragilities associated with liquid financial instruments that have long been identified in the finance literature.1 For the sake of concreteness, I will focus on the Fed and abstract from international aspects, unless strictly necessary.

The financial framework

The argument develops through eight related points:

1. A starting point is that the 1997/8 Asian/Russian crises showed emerging economies the advantage of holding a large stock of international reserves to protect their domestic financial system without IMF cooperation. This self-insurance motive is supported by recent empirical research, though starting in 2002 emerging economies' reserve accumulation appears to be triggered by other factors.2 I suspect that a prominent factor was fear of currency appreciation due to: (a) the Fed's easy-money policy following the dot-com crisis, and (b) the sense that the self-insurance motive had run its course, which could result in a major dollar devaluation vis-à-vis emerging economies' currencies.3

2. Let me make some simplifications. I will assume that reserve money is a composite of US currency and Treasury bills. Let s be the nominal interest rate on reserve money.4 Thus, when the demand for international reserves goes up, the Fed can opt for accommodating its supply or lowering the policy interest rate (which I will equate with s).

3. Enter the private sector as producer of reserve money and, as I will conjecture, generator of a rickety financial system. Asset-backed securities and collateralised debt obligations are different from Treasury bills but are certainly much closer to reserve money than the underlying assets. Thus, the development of those instruments can be seen as helping to create what might be called (reserve) quasi-money.

Quasi-money creation is costly; part of the cost stems from the fact that quasi-money competes with official reserve money. When s declines – especially when s falls more than inflation as in the US – the marginal cost of creating quasi-money goes down, stimulating supply. Therefore, an increase in the demand for international reserves accompanied by a lower interest rate on reserve money (s) will give rise to an increase in the supply of quasi-money. The effect of low s is enhanced by lax financial regulation and the expectation of bailouts in case of systemic crisis (more on this below). Without the latter, the supply effect was unlikely to be large.

4. As a general rule, quasi-money can be created by generating some type of mismatch of maturities or currency denomination. For example, bank deposits are a class of quasi-money which has shorter maturity than the assets banks hold against them. Therefore, their moneyness requires that only a handful of depositors attempt to cash their deposits at the same time. If rumour spreads that depositors will massively try to withdraw their deposits, depositors will have strong incentives to do the same, which results in widespread bank failures, destroying the moneyness of deposits. This has been one of the central motivations for the creation of central banks.5

5. We now know that the new financial instruments were partially insured by regular banks through, for example, structured investment vehicles. Learning about that seems to have startled many observers and regulators who thought that securitisation had taken meltdown risks off of banks' balance sheets. However, a little thinking should have warned them that such risk transfer was bound to be incomplete, because banks can piggy back on central banks, especially in a systemic crisis, as actually happened.6

6. Under these circumstances, banks would be called to honour the insurance contracts if a run against quasi-money materialises, thus forcing central banks to come to their rescue.

Unfortunately, given the nature of their mandates, central banks stepped in only when regular banks were on the verge of collapse because insurance arrangements had been activated and they did not have the resources to meet them. At that juncture, the quasi-money's credibility had already been lost and the financial system was stuck in a situation in which the supply of quasi-money had correspondingly collapsed.

Summary of points 1 to 6

To summarise, the increase in the demand for international reserves, accompanied by low US policy interest rates and lax financial regulation, may have led to a large-scale creation of quasi-money subject to self-fulfilling-expectations runs. The probability of runs against the new instruments was presumably low but likely much higher than for bank deposits. Central banks eventually reached the source of the financial problems but damage to the credibility of the financial sector had already occurred. Liquidity collapsed, setting in motion strong price-deflation forces.

Real sector impact

Let's turn to the non-financial or real sector.

7. Keeping banks and other institutions afloat does not guarantee that credit will be revived and that credit flows will go back to normal. There are three independent reasons for credit flows to dry up.

  • First, prior to crisis, credit flows were partially structured on instruments that are no longer available or have drastically lost their appeal.
  • Second, price deflation could give rise to Irving Fisher's debt deflation and widespread bankruptcy.7
  • Third, part of the stock of quasi-money was based on asset-backed securities; as their moneyness evaporates, the relative price of the underlying assets (e.g., real estate) falls, lowering available collateral and, consequently, further dampening credit.8

8. A sudden stop of credit flows has a direct impact on the real sector,9 forcing a sudden and large cut in private sector expenditure (a flow).10 In particular, large cuts in the flow of credit for working capital results in sizable falls in investment and employment. Moreover, since it is unlikely that expenditure contraction will be uniform across the economy, the credit sudden-stop may give rise to sharp changes in relative prices, further complicating the financial landscape. Bad debts will arise but they may be just a consequence of quasi-money destruction, not of over-borrowing.

Policy implications

There are six key policy implications:

1. Financial innovation and bubbles could stem from lax monetary policy and financial regulation.

2. Bubbles are not all the same. Bubbles that involve the banking system are likely the worst kind, because they could bring about a sudden stop of bank credit, seriously draining working capital, for example.

3. With the benefit of hindsight, to prevent price deflation in the first half of the 2000s, the Fed should have resorted to quantitative easing instead of keeping interest rates low for an extended period of time. This would have signified a radical departure from the Fed's practice and, in all probability, would have been difficult to defend or even explain in a no-deep-crisis environment.

Going forward, however, the Fed (or whichever its successor may be) should add quantitative easing to its tool kit in normal situations and employ it to accommodate a major increase in the demand for reserve money. To operationalise this, the Fed could, for example, have a rule by which quantitative easing is triggered once its policy interest rate reaches a lower bound, larger than zero. For example, the lower bound could be made equal to the long-run marginal productivity of capital plus target inflation.

4. During financial crises, expansive monetary and fiscal policy may not suffice. An aggressive credit policy may be called for. Since under those circumstances credit markets don't work properly, the central bank may have to direct credit to strategic sectors, like Brazil has done on several occasions.

5. Crisis time is no time for implementing tighter financial regulation. The latter may exacerbate contraction of credit flows and enhance its deleterious effects.

6. The above observation weakens any tough statement in normal times about policy in crisis times (e.g., a commitment to no-bailout). But, normal times are the time to deactivate financial bombs.

The main challenge is that the financial sector is in constant evolution, and regulators are required to be "ahead of the curve." Thus, it would be advisable for the regulatory authority to have a unit closely following developments in the capital market. Given globalisation, this task should be coordinated with other regulatory authorities. The BIS and the IMF could play a key role in this respect.


1. See Allen and Gale (2007). See Calvo (2009a, 2009b) for models that highlight the macroeconomic role of liquid instruments.

2. See Obstfeld, Shambaugh and Taylor (2008).

3. Sometimes this policy is called "neo-mercantilism." However, emerging markets' intervention in the foreign-exchange market could also be interpreted as a defensive move vis-à-vis the US beggar-thy-neighbor policy implied by its lax monetary stance.

4. This approach is advanced in, i.e., Calvo and Vegh (1995) and Canzoneri et al (2008).

5. See Allen and Gale (2007) for a discussion of this and other related issues.

6. This applies to the US. In emerging markets, the ability of central banks to operate as lenders of last resort in terms of reserve money depends on external credit lines and their stock of international reserves. This, by the way, is one of the reasons for the self-insurance motive.

7. See Fisher (1933). For a modern discussion of debt deflation in the context of the Great Deflation, see Bernanke (2000). For the relevance of this concept for emerging market crises, see Calvo (2005).

8. See Calvo (2009a, 2009b) for models in which the relative price of quasi-money real underlying assets falls as quasi-money liquidity evaporates

9. In line with the sudden-stop literature for emerging markets, I define a sudden stop of domestic credit as a fall in credit flows to the private sector that exceeds two standard deviations; the latter is computed on the basis of the credit-flow time series prior to each point in time. For more details, see Calvo (2009b).

10. Notice that I am referring to flows, not stocks. Stocks may not decline and still a fall in credit flows may have major real effects. This is fully in line with the literature on sudden stops of international capital inflows. See Calvo (2005).


Allen, Franklin, and Douglas Gale (2007), Understanding Financial Crises, New York, NY: Oxford University Press.

Bernanke, Ben (2000), Essays on the Great Depression, Princeton, NJ: Princeton University Press.

Calvo, Guillermo (2005), Emerging Markets in Turmoil: Bad Luck or Bad Policy? Cambridge, MA: MIT Press.

Calvo, Guillermo (2009a), "Financial Crises and Liquidity Shocks: A Bank-Run Perspective," NBER Working Paper 15425.

Calvo, Guillermo, (2009b), "Looking at Financial Crises in the Eye: A Simple Finance/Macro Framework" Columbia University mimeograph.

Calvo, Guillermo, and Carlos Vegh (1995), "Fighting Inflation with High Interest Rates: The Small-Open-Economy under Flexible Prices," Journal of Money, Credit, and Banking, 27, pp 49-66.

Canzoneri, Matthew, Robert E. Cumby, Bezhad Diba, and David Lopez-Salido (2008), "Monetary Aggregates and Liquidity in a Neo-Wicksellian Framework," Journal of Money, Credit, and Banking, 40, 8, December, pp. 1667-1698.

Fisher, Irving (1933), "The Debt-Deflation Theory of Great Depressions," Econometrica, pp. 337-357.

Guha, Krishna (2009). "Paulson Says Crisis Sown by Imbalance." Financial Times, 1 January.

Obstfeld, Maurice, Jay C. Shambaugh, and Alan M. Taylor (2008), "Financial Stability, the Trilemma, and International Reserves," NBER Working Paper 14217.

This article may be reproduced with appropriate attribution.

links for 2009-10-26