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June 30, 2009

Economist's View - 7 new articles

Bankslaughter?

Paul Collier says we should hold financial institutions responsible for reckless behavior if we want to temper their inclination to take excessive risk:

A law to tame wild bankers, by Paul Collier, Commentary, CIF: Deregulation of the banks was built on two intellectual pillars. One was that regulation was not necessary because banks would self-regulate in order to protect their reputation. Please stop laughing. The other was that regulation would not work because regulators would always be one step behind the bankers. And unfortunately we cannot laugh this one off. Indeed, the technical problems facing regulation are now compounded by political impediments. Green shoots, lobbying by the banks, and turf wars among the regulators have eroded the momentum for action. So if banks cannot effectively be regulated by the authorities, what can be done?

The Turner review came up with two solutions. One is radically to raise the capital requirements of banks so that shareholders have something to lose if management goes wrong. The other is to change incentive payments for managers so bonuses depend on the past three years of performance. The increase in capital requirements makes sense. But the three-year rule is weak. The inherent problem facing shareholders is that incentive payments cannot go negative. However much damage a manager inflicts, wiping out both shareholders and depositors, the consequences cannot be remotely commensurate. As a result, even bonuses with a three-year lag bias the system towards risk-taking. If you thought big bonuses were history you have missed BAB, the new banking mnemonic: yes, Bonuses Are Back.

So how can we avoid another Northern Rock? While shareholders cannot impose genuine penalties, governments can. Fear of jail would discourage excessive risk. Before bankers huff about blunting incentives, yes, I realise that without carrots, bankers will just sit and gaze at the office ceiling. Bankers, set your minds at rest: the introduction of penalties would permit BABEL: that is, the carrots for genuinely smart behaviour could be Even Larger.

The key problem with using the law against bankers has been the difficulty of getting a conviction: surely, the managers of Northern Rock did not intend to profit at our expense. We do not need to set the burden of proof that high. Intention misses the point. Faced with a corpse and a killer, police do not need to prove ill intent: manslaughter sets the hurdle lower than murder. It is enough to show the killer was irresponsible. That is the standard we need; we need a crime of managing a bank irresponsibly: in other words, bankslaughter.

On Turner's proposal a manager can still benefit from recklessness – as long as the bank does not blow up within three years. After that, if the bank crashes he can be off playing golf. With bankslaughter, when the bank blows up – even if it is a decade later – a criminal investigation traces back to determine whether crucial decisions were reckless. If a reasonable banker faced with the information available at the time would not have taken those risks, the person responsible is dragged off the golf course and jailed.

Once bankslaughter was on the books, bonuses would be less dangerous. Managers would have to weigh the balance between risk and return and take defensible decisions. I doubt hyper-caution would be a problem: the overly cautious would not get bonuses. Surely we can rely on our bankers to exhibit the necessary degree of greed.

Bankslaughter would target the wild fringe rather than the average banker. The wild fringe matters: sometimes it generates a crisis that becomes systemic. We now know that as early as 2004, the Bank of England anticipated that Northern Rock would implode. Its business model was so risky that other banks had not adopted it. But in the short term, reckless behaviour looks smart, and so wiser management teams were coming under pressure to emulate it. By the time of its demise, the Rock was doing a fifth of British mortgages.

By curtailing the wild fringe, bankslaughter would complement Turner's approach, which is to make the average bank behave better. Both are needed. Turner's concern about performance is manifestly necessary. But the crisis has revealed that some banks are more rotten than others. In Britain, the two Scottish banks and Northern Rock were pioneers of imprudence. In Ireland two banks run by an alliance of construction firms and politicians swept the country to ruin. Even if shareholder capital is at risk, some banks are likely to suffer because of poor corporate governance.

Had bankslaughter been on the books, the management of Northern Rock would now perhaps be in the dock. But, vengeful as we feel, the point of criminal sanction would not be to punish reckless behaviour but to discourage it. If this law had existed, would our financial knights have been so errant?


Do Tipping Points Exist?

Are tipping points "mythological"?:

The Tipping Point: Fascinating but Mythological?, by William Easterly: The "tipping point" is a popular concept covering a whole range of phenomena (and a best-selling book by Malcolm Gladwell) where individual behavior depends on the behavior of the herd.

Its original application was to racial segregation. Nobel Laureate Thomas Schelling developed a beautifully simple model for this. Suppose that whites have different degrees of racism – some would "tolerate" higher shares of nonwhites than others. Schelling showed that the less racist whites would still wind up exiting during tipping because of a chain reaction. At first only the most extreme racist whites exit. But their departure causes the white share to go down, making the second most extreme racist whites uncomfortable, so they also exit. The white share goes down some more, and so now even less racist whites will be uncomfortable being a white minority, and they will wind up exiting too. So the remarkable prediction of the tipping point model is that just a little bit of integration that directly bothered only the most racist whites wound up causing ALL of the whites to exit. So even if the typical white was perfectly happy with integrated neighborhoods, these neighborhoods would be so unstable that the final outcome would be extreme racial segregation. ...

It's easy to imagine development applications for the tipping point idea. Suppose that people decide to get highly educated based on what is the share of highly educated people in the population. After all, it's only worthwhile being educated if you can talk to and work with a lot of other highly educated people. If the share of educated people falls below a tipping point, a lot of people will stop getting highly educated, which decreases even further the incentive to get highly educated, and we get the same kind of chain reaction... Assuming that low education causes poverty, this is a "poverty trap" story of low education and underdevelopment.

The tipping point stories are fascinating, but do we observe them in the real world? I got intrigued with this question a while ago, and eventually published a paper testing the predictions of the tipping point story (ungated version here) for its original application: racial segregation of US neighborhoods (reminder to self: my job is not only to blog, also to be a full time academic researcher that must "publish or perish"). The basic prediction is that mixed neighborhoods are unstable but segregated neighborhoods are stable. Data on American neighborhoods from 1970 to 2000 rejected these predictions – it was the segregated neighborhoods that were unstable. There was as much "white flight" out of all-white neighborhoods as there was out of mixed neighborhoods, and there was a white influx into segregated nonwhite neighborhoods. Neighborhoods are still very segregated in the year 2000, but not because of tipping. ...

Of course, this is only one test of the tipping point for racial segregation over one time period. Maybe the tipping point is real in other contexts. But think twice and check for evidence before you accept popular stories like the Tipping Point.


Did Greenspan Make a Mistake in 2001-2004 by Keeping Too Rates Low?

David Beckworth says Brad DeLong can quit wondering, Greenspan's "low interest rate policy in the early-to-mid 2000s was truly a mistake" [Update: see Brad Delong for more]:

Yes Brad, the Fed's Low Interest Rate Policy Was a Mistake, by David Beckworth: Brad Delong is wondering whether the Federal Reserves' low interest rate policy in the early-to-mid 2000s was truly a mistake:

There is, however, active debate over whether there was a fourth mistake: whether Alan Greenspan's decision in 2001-2004 to push and keep nominal interest rates on Treasury securities very very low in order to try to keep the economy near full employment was a fourth mistake...I am genuinely not sure which side I come down on in this debate.

Brad's uncertainty is understandable given he invokes the entire 2001-2004 time frame. For during this period there was a time when the U.S. economic recovery was sputtering along (2001-2002) and a time when the recovery began to take hold (2003-2004). It was during this latter period that Fed's low interest rates were a big mistake. But even for that period I think Brad is misreading the data:

People claim that the Greenspan Federal Reserve "aggressively pushed the interest rate below its natural level."... [T]he market interest rate[, however,] was if anything above the natural interest rate in the early 2000s... You ... cannot argue that he aggressively pushed the interest rate below its natural level. The low interest rate was at its natural level.

I think the evidence shows the opposite. The natural interest rate is a function of individual's time preferences, productivity, and the population growth rate. Of these three components, the one that changed the most in 2003-2004 was productivity as can be seen in the figure...

Here we see productivity growth soaring just as the real federal funds rate is being pushed into negative territory. Normally, a rise in productivity growth should lead to a rise in the natural interest rate and ultimately, a rise in the federal funds rate for monetary policy to stay neutral. However, this latter development did not happen. It seems, then, the Fed did push its policy rate below the natural rate and in the process created a huge Wicksellian-type disequilibria. This interpretation of events has been borne out more rigorously in this ECB paper. One a more practical level, this disequilbria comes through in the Taylor rule which similarly shows the federal funds rate was below the neutral rate during this time.

It is also worth noting that these same rapid productivity gains were the source of the deflationary pressures in 2003 that Brad mentions. Thus, these deflationary pressures did not indicate a weakening economy. In fact, aggregated demand (AD) was growing at at rapid rate in 2003-2004 which, if anything, indicated an overheating economy. The figure below shows a measure of AD, final sales to domestic purchasers, relative to the federal funds rate and has the period 2003-2004 marked off by the dotted lines...

The productivity gains, apparently, were offsetting the upward pressure on prices being created by the robust growth in AD at this time. There simply was no real deflationary threat in 2003. By way of contrast, this figure shows for 2008-2009 what a real AD-induced deflationary threat looks like. ...

The final data issue is the weak employment growth coming out of the 2001 recession. Given the above discussion, the best interpretation of this development is there was less demand for labor in the recovery given the productivity gains. In fact, this was common explanation given at the time. One could also argue that the Fed's low interest rate policy may have pushed some firms to inordinately substitute out of labor to capital.

Here is the bottom line: there is enough evidence for Brad DeLong to conclude that Federal Reserve's low interest rate policy was a mistake.


Should We Pop Bubbles?

This may help Brad DeLong settle his inner conflict over whether Greenspan made an error by not moving interest rates to limit the housing boom. Guillermo Calvo and Rudy Loo-Kung argue that the benefits of bubbles almost always outweigh their costs (and thus there's no need for regulation to prevent them).

I think the authors are correct to point out that distributional issues are omitted from the analysis. Also, the assumption that social welfare depends only upon consumption is important as it rules out any utility costs associated with losing a home, a job, changing schools, etc. over and above the loss of consumption. In addition, using the aggregate consumption level of a composite commodity to index social welfare doesn't capture the costs associated with producing the subotimal mix of goods (e.g. too much housing, not enough of other goods), all that matters is the total quantity that is produced and consumed. Finally, I was surprised that the downturn and upturn phases of the cycle were assumed to be of equal length as I thought a slower return to normal growth (as compared to the downturn) - something that would increase the costs of the collapse - was the normal scenario:

Should we rush to further regulate financial institutions?, by Guillermo Calvo and Rudy Loo-Kung, Vox EU:

'Tis better to have loved and lost, Than never to have loved at all. Tennyson, 1850.

In times of systemic financial distress, hunting for culprits becomes a popular sport. The Madoffs of this world are easy targets because crisis makes crookery harder to conceal. While there is no question that crooks should be sent to jail, increasing financial regulation is a different issue and requires careful analysis. Rushing to impose tighter regulations may hamper recovery and growth. Empirical evidence strongly supports the view that growth and financial development go hand in hand (Demirgüç-Kunt and Levine 2008). Although it is much harder to establish that financial development causes growth, few would doubt that, at least temporarily, financial deregulation could promote higher growth. A genuine concern, however, is that the financial sector is prone to crises, which are typically associated with serious effects on output and employment.

We cannot reach definite conclusions about the desirability of risky financial arrangements in a short column. Our objective is much more modest. We examine the welfare implications of financial deregulations that result in higher growth but end in tears and perform the exercise in the context of a benchmark case in which consumption is the ultimate source of welfare, ignoring possibly relevant behavioural finance and political economy considerations. We base our analysis on estimates of the costs of financial crises in emerging market economies (since the 1980s), a cauldron of financial crises in the last thirty years. Our results support deregulation even under those dire circumstances.1

A model of growth, collapse, and welfare

More specifically, suppose that financial deregulation is implemented at time 0 and that, as a result, consumption grows at rate gH (where H stands for "high"); after T periods, there is a crisis that produces a (symmetric) collapse-recovery recession phase in consumption, resembling those observed in the 1990s' Emerging Economies crises (see Figure 1) . That is, we assume that, starting at time T consumption decreases for a while and then begins to recover. The recession phase takes DT periods. During the first half of this phase, i.e., for DT/2 periods after time T, consumption declines at the rate g*; and then, for the next DT/2 periods, consumption resumes growth at the same rate g*. By construction, at time T + DT (end of the recession phase) consumption reaches its pre-crisis level (i.e., the level prevailing at time T). Afterwards, we assume that consumption grows at a lower rate gL (where L stands for "low"). We assume that gL is also the growth rate that would prevail if no financial deregulation had been implemented. Thus, this corresponds to a financial deregulation experiment in which when crisis hits authorities get cold feet and meekly go back to the old, low-growth, financial system forever. This extremely pessimistic scenario will allow us to make a stronger case for deregulation.

Figure 1. Consumption paths under alternative regimes for the average emerging economy

Bubble

Note: The consumption path associated with financial innovation shows the calibrated collapse-recovery phase for the average emerging economy and the calculated break-even T using a degree of risk aversion (σ) equal to 4.

To calibrate DT and g*, we focus on average output collapse and recovery patterns (the recession phase) observed in emerging markets during times of systemic financial turmoil throughout the period 1980-2004, discussed in Calvo, Izquierdo and Talvi (2006).2 More specifically, we set DT equal to the time that it took for average output to recover its pre-crisis level. The growth rate g* is calibrated to match accumulated output loss, which is defined as the sum of the differences between the pre-crisis peak GDP and observed GDP within the recession phase. This procedure suggests setting g* = 3.11% per year and DT = 3.43 years.

Moreover, we set gH equal to the average GDP growth rate observed in emerging markets during 1992-97, a period in which many countries opened up to capital inflows. The low growth rate gL is set equal to the average growth rate observed in the previous ten years (1982-91). This leads us to set gH = 4.7% and gL = 2.7% per year.3

We focus on the following question: How long should the bonanza or high-growth period T last for financial deregulation to be socially desirable? To answer that question, we examine the benchmark case in which welfare can be expressed as the present discounted value of a utility index which depends on aggregate consumption.4

We define the break-even T as the number of bonanza years that would make deregulation welfare equivalent to not deregulating at all and generating low growth, gL, at all times. If the bonanza period exceeds break-even T, then financial deregulation is preferable to doing nothing, even though it results in a painful crisis. Table 1 and Figure 1 summarise the results (parameter σ is the coefficient of relative risk aversion).5

Table 1

Bubble1

Emerging market episodes lasted 5 to 6 years on average, implying that the experiments were socially beneficial despite ending in large recessions. Admittedly, the boom-bust episodes are not identical across economies. To test for robustness, we perform the same exercise for two polar episodes in Latin American, namely, Argentina's and Chile's, for which the bonanza period was 4 and 13 years, respectively.6 In both cases, results point in favour of financial liberalisation for σ = 4. However, in the case of Argentina (and σ=1), the methodology yields borderline results (Chile passes the test with flying colours).7

Two points are worth making: (1) support for deregulation is stronger if the coefficient of relative risk aversion is more realistically set at 4, and (2) break-even T is the same if one assumes that the cycle is repeated as many times as desired (high growth-bust-high growth), and only after the last cycle the economy resumes low growth.8 This is more realistic because emerging markets returned to exhibiting high growth during 2003-2007.

The analysis abstracts from the important issues of poverty and income distribution, which might alter our assessment of past deregulation episodes, but that does not make our analysis less relevant looking forward. For example, for the type of social welfare function considered here, if income distribution remains fairly constant, one would reach the same pro-deregulation conclusions even if one entirely focused on the welfare of the poor, à la Rawls. This shows that financial deregulation would be desirable under the Rawlsian criterion if one can find suitable social protection mechanisms, and that the effectiveness of those mechanisms should be explored as part of the grand design of new financial regulations – especially before enacting new regulations that would stifle the dynamism of the financial sector.

Conclusion

Our analysis in this column may help explain why policymakers are hesitant to prick the bubble when it starts – they may simply be trying to maximise social welfare and realise that a potential crisis is not strong enough reason to prevent the bubble from developing (Tennyson's verses ringing in their ears?). Of course, no policymaker likes crises. When crises strike, much of the discussion focuses on how to avoid them or lessen their impact in the future. This is quite understandable. However, this does not insure that "they are not going to fall in love again." Therefore, the policy debate should give equal time to discussing what to do when crises happen and to developing institutions that help to assuage their blow.

In closing, we would like to point out that even though this note gives some support to financial deregulation, it does not rule out the existence of financial arrangements that are far superior to the ones currently available. A case in point would be the creation of a global lender of last resort. Central banks have successfully filled that role at the local level and likely prevented many serious self-fulfilling banking crises in the last seventy years. However, there is no equivalent to a lender of last resort at the global level. Its absence was clearly felt in emerging markets in the aftermath of the Russian August 1998 crisis. Even the subprime crisis suffered from the absence of a fully effective lender of last resort. To be sure, central banks stepped up to the plate early on in the current episode, but their coverage was and still is quite limited. Many central financial institutions were left without a safety net, or the net was stretched out after they hit the ground. We feel that the issue of a global lender of last resort should be given more weight in the current debate (see Calvo 2009).

References

Baldacci, Emanuele , Luiz de Mello, and Gabriela Inchauste (2002) "Financial Crises, Poverty, and Income Distribution" IMF Working Paper 02/4. Barro, Robert (2006) "Rare disaster and Asset Markets in the Twentieth Century", Quarterly Journal of Economics, 121(3). Calvo, Guillermo (2009) "Lender of Last Resort: Put it on the agenda!", VoxEU column, 23 March Calvo, Guillermo, Alejandro Izquierdo and Ernesto Talvi (2006) "Phoenix Miracles in Emerging Markets: Recovering Without Credit from Systemic Financial Crises," National Bureau of Economic Research, Working Paper 1201, March. Demirgüç-Kunt, Asli and Ross Levine (2008), "Finance, Financial Sector Policies, and Long-Run Growth," Commission on Growth and Development, Working Paper No. 11, World Bank, Washington, DC Rancière, Romain, Aaron Tornell and Frank Westermann (2008) "Systemic Crises and Growth," Quarterly Journal of Economics, pp. 359-406.

[1] Our results, thus, give further support to the line of research advanced by Aaron Tornell and Frank Westermann since 2002, which is inspired by the conjecture that financial liberalisation may be socially desirable despite the booms and busts that it may generate. See Rancière, Tornell and Westermann (2008) and their recent VoxEU column. [2] The paper focuses on episodes in which GDP peak-to-trough contraction is greater than the median fall in the sample. Note that including only the most severe collapses in the calibration constitutes a more difficult test for the case of financial deregulation. [3] Countries included are those tracked by the J.P. Morgan's EMBI Global Index: Argentina, Belize, Brazil, Bulgaria, Chile, China, Colombia, Côte d'Ivoire, Dominican Republic, Ecuador, Egypt, El Salvador, Gabon, Ghana, Hungary, Indonesia, Iraq, Jamaica, Lebanon, Malaysia, Mexico, Morocco, Pakistan, Panama, Peru, Philippines, Poland, Romania, South Africa, Sri Lanka, Thailand, Trinidad and Tobago, Tunisia, Turkey, Uruguay, Venezuela, and Vietnam. [4] More concretely, we assume that the utility index exhibits constant relative risk aversion, σ, and the instantaneous rate of discount equals 3% per year. [5] If parameters are calibrated on the basis of GDP per capita (instead of its level) yields similar results, due to the high correlation between the two series. [6] In both cases, we set gL to average GDP growth rates during 1951-1970. The parameter gH is set to the average GDP growth rates during 1991-94 for Argentina and 1984-97 in the case of Chile; The values and DT and g* are calibrated to match the characteristics of the Argentine crisis of 2002 and the Chilean crisis of 1998. [7] In an exercise in which the collapse in growth is modeled as a stochastic event with constant probability, following Barro (2006), we also find support for financial deregulation. In both cases, the break-even expected frequency of these events is lower than the ones observed in the data [8] It follows that T will be the same if the cycle is repeated an infinite number of times. [9] The empirical work of Baldacci, de Mello, and Inchauste (2002) suggests that the financial crises that struck developing countries between 1960 and 1998 had severe effects on poverty and, in some cases, income inequality.


Rapid Resolution Plans

No disagreement with this. The failure to have dissolution plans for systemically important institutions on the shelf and ready to go turned out to be costly, so credible dissolution plans are certainly needed. However, the argument seems to assume that too big and too interconnected firms cannot be avoided, something I'm not ready to concede:

A sound funeral plan can prolong a bank's life, by Anil Kashyap, Commentary, Financial Times: Buried within the 88-page Obama administration proposal to overhaul financial regulation is an overlooked option called a "rapid resolution plan". It mandates that systemically important financial companies be required regularly to file a "funeral plan": a set of instructions for how the institution could be quickly dismantled should the need to do so arise. ... It could be implemented now, without the need for legislative action. Regulators should do so immediately.

The first benefit is that regulators would gain a stronger negotiating position with a dying institution. Throughout this crisis the authorities have had to intervene without knowing exactly what hidden traps might emerge if a bank were to be closed down. The bankers know this and can exploit the fear of the unknown to press for bail-outs.

It is remarkable that such rules do not already exist. ... The crisis has shown us that the sudden unwinding of a large, complex financial institution is terrifying for the financial system. ...

A second immediate benefit would be to force bank managers to think much more carefully about the complex financial structures they have created. If bankers had to explain every single step needed (and the associated consequences) to shut down their subsidiaries in all the various jurisdictions in which they operate, they would have a big incentive to simplify their organisations. ...

Over the medium term, there would be additional benefits. The headline component of the plan would be the requirement for banks to estimate the number of days it would take to shut down. Banks that require longer to close would have to hold more capital. This would place management under serious pressure to improve their plans...

Senior members of the management team and the board would have to understand the funeral plan. Crucially, they would be forced to sign off on its accuracy. This might also lead to closer scrutiny of new products or lines of business if they jeopardised an orderly unwinding. ...

This proposal is far from a cure-all. One big problem is that resolution rules themselves, especially when multiple legal systems are involved, are quite complicated. But the plan has an extremely high benefit-to-cost ratio and could be put in place right away. ...


links for 2009-06-30


links for 2009-06-30

June 29, 2009

Economist's View - 6 new articles

An "Ethical Dilemma" in End of Life Care

This looks at the costs of extending the end of life by a short period of time and tries to draw a boundary between those cases when treatment should be applied, and those when it is not worth it to do so (the conclusion is that "studies powered to detect a survival advantage of two months or less should test only interventions that can be marketed at a cost of less than $20,000 for a course of treatment").

How do we draw this line (and if you don't think we should, how do we avoid drawing it)? Usually, I would give the standard answer that we should employ these life-extending procedures up until the point where the marginal cost of the treatment equals the marginal benefit, and let someone else worry about how to actually measure the costs and benefits. But in this case the measurement of the benefits - life itself - seems particularly hard to quantify, and trying to account for quality of life complicates it further, and it is not clear to me that a market test is even appropriate when there may not be a tomorrow and standard opportunity cost tradeoffs are missing from the evaluation (update: thinking more, I suppose this is just "cap-T" in our models, which isn't too hard to handle in the deterministic case, i.e. where T is known in advance with certainty, but the evaluation still seems problematic due to the other reasons that are cited). So I don't think there is a good answer to this question, at least not one that standard economic models can deliver:

How much is life worth? The $440 billion question, EurekAlert: The decision to use expensive cancer therapies that typically produce only a relatively short extension of survival is a serious ethical dilemma in the U.S. that needs to be addressed by the oncology community, according to a commentary published online June 29 in the Journal of the National Cancer Institute.

Tito Fojo, M.D., Ph.D., of the Medical Oncology Branch, Center of Cancer Research at the National Cancer Institute, in Bethesda, Md., and Christine Grady, Ph.D., of the Department of Bioethics, the Clinical Center at the National Institutes of Health, ... illustrate cost-benefit relationships for several cancer drugs, including cetuximab for treatment of non-small cell lung cancer, touted as "practice changing" and new standards of care by professional societies, including the American Society of Clinical Oncology. ...

According to Fojo and Grady,... 18 weeks of cetuximab treatment for non-small cell lung cancer, which was found to extend life by 1.2 months, costs an average of $80,000, which translates into an expenditure of $800,000 to prolong the life of one patient by 1 year. At this rate, it would cost $440 billion annually ... to extend the lives of 550,000 Americans who die of cancer annually by 1 year.

To address the issue, the commentators recommend that studies powered to detect a survival advantage of two months or less should test only interventions that can be marketed at a cost of less than $20,000 for a course of treatment.

Every life is of infinite value, the authors say, but spiraling costs of cancer care makes this dilemma inescapable.

"The current situation cannot continue. We cannot ignore the cumulative costs of the tests and treatments we recommend and prescribe. As the agents of change, professional societies, including their academic and practicing oncologist members, must lead the way," the authors write. "The time to start is now."


DeLong: Sympathy for Greenspan

Brad DeLong can't decide whether or not Greenspan made a mistake when he kept interest rates low after the collapse of the dot.com bubble:

Sympathy for Greenspan, by J. Bradford DeLong, Commentary, Project Syndicate: In the circles in which I travel, there is near-universal consensus that America's monetary authorities made three serious mistakes that contributed to and exacerbated the financial crisis. ... US policymakers erred when:

-the decision was made to eschew principles-based regulation and allow the shadow banking sector to grow with respect to its leverage and its compensation schemes, in the belief that the government's guarantee of the commercial banking system was enough to keep us out of trouble;

-the Fed and the Treasury decided, once we were in trouble, to nationalise AIG and pay its bills rather than to support its counterparties, which allowed financiers to pretend that their strategies were fundamentally sound;

-the Fed and the Treasury decided to let Lehman Brothers go into uncontrolled bankruptcy in order to try to teach financiers that having an ill-capitalised counterparty was not without risk, and that people should not expect the government to come to their rescue automatically.

There is, however, a lively debate about whether there was a fourth big mistake: Alan Greenspan's decision in 2001-2004 to push and keep nominal interest rates on US Treasury securities very low in order to try to keep the economy near full employment. In other words, should Greenspan have kept interest rates higher and triggered a recession in order to avert the growth of a housing bubble? ...

Full employment is better than high unemployment if it can be accomplished without inflation, Greenspan thought. If a bubble develops, and if the bubble ... collapses, threatening to cause a depression, the Fed would have the policy tools to short-circuit that chain. In hindsight, Greenspan was wrong. But the question is: was the bet that Greenspan made a favourable one? ...

I am genuinely unsure as to which side I come down on in this debate. ... What I do know is that the way the issue is usually posed is wrong. People claim that Greenspan's Fed "aggressively pushed interest rates below a natural level." But what is the natural level? In the 1920's, Swedish economist Knut Wicksell defined it as the interest rate at which, economy-wide, desired investment equals desired savings, implying no upward pressure on consumer prices, resource prices, or wages as aggregate demand outruns supply, and no downward pressure on these prices as supply exceeds demand.

On Wicksell's definition — the best, and, in fact, the only definition I know of — the market interest rate was, if anything, above the natural interest rate in the early 2000's: the threat was deflation, not accelerating inflation. The natural interest rate was low because, as the Fed's current chairman Ben Bernanke explained at the time, the world had a global savings glut (or, rather, a global investment deficiency). ...

Greenspan's mistake — if it was a mistake — was his failure to overrule the market and aggressively push the interest rate up above its natural rate, which would have deepened and prolonged the recession that started in 2001.

But today is one of those days when I don't think that Greenspan's failure to raise interest rates above the natural rate to generate high unemployment and avert the growth of a mortgage-finance bubble was a mistake. There were plenty of other mistakes that generated the catastrophe that faces us today.

I have argued the Fed's decision to keep interest rates low contributed to the bubble, but was not itself the sole cause of it. As to whether the Fed made a mistake, I'll just note that the tradeoff wasn't quite as stark as Brad implies, i.e. there were other policy instruments that Fed could have used to limit the housing bubble. Regulation is certainly one means the Fed had to that end, but Fed communication could have helped too. If Greenspan had, for example, told people to stay away from mortgages because they were toxic rather than implicitly encouraging them to invest in housing, things might have been different.

Would limiting the bubble through regulation, communication, or other means have limited the employment response, the primary worry? I don't think so, at least not enough to matter. The money would have been invested somewhere, housing had an opportunity cost after all, so the next best alternatives would have been pursued to the extent that they were profitable (and many would have been, just not as profitable - apparently anyway - as investing in housing and mortgages). So people still would have been employed somewhere as the money was invested, just not in housing, and that would have helped to insulate us from the housing crash. (And a lot of them might still have those jobs, unlike the people who depended upon the housing markets for employment.)

So narrowly, keeping interest rates low and employment high was the right thing to do. The mistake was letting all of the action brought about by those low rates, or most of it anyway, occur in a single sector, housing, rather than using regulation and other means to limit the flow of resources into the housing market in pursuit of profits based upon the misperception of risk. Those resources could have been redirected into other sectors and put to productive use rather than wasted building houses nobody wants, and achieving this result did not require the Fed to aggressively raise the target rate, it only needed to use the other tools it already had available.

Unfortunately, however, those tools were not used, and the ideology Greenspan brought to the Fed played a large role in this outcome.


Paul Krugman: Betraying the Planet

Are the arguments against the need to act to prevent climate change based upon a morally defensible position grounded in science, or, given the predicted consequences of inaction, a morally indefensible position based upon ideology and political interests?:

Betraying the Planet, by Paul Krugman, Commentary, NY Times: So the House passed the Waxman-Markey climate-change bill. In political terms, it was a remarkable achievement.

But 212 representatives voted no. A handful of these no votes came from representatives who considered the bill too weak, but most rejected the bill because they rejected the whole notion that we have to do something about greenhouse gases.

And as I watched the deniers make their arguments, I couldn't help thinking that I was watching a form of treason — treason against the planet.

To fully appreciate the irresponsibility and immorality of climate-change denial, you need to know about the grim turn taken by the latest climate research.

The ... planet is changing faster than even pessimists expected: ice caps are shrinking, arid zones spreading, at a terrifying rate. And according to a number of recent studies, catastrophe — a rise in temperature so large as to be almost unthinkable — can no longer be considered a mere possibility. It is, instead, the most likely outcome if we continue along our present course.

Thus researchers at M.I.T., who were previously predicting a temperature rise of a little more than 4 degrees by the end of this century, are now predicting a rise of more than 9 degrees. ...

Temperature increases on the scale predicted by ... researchers ... would create huge disruptions in our lives and our economy. As a recent authoritative U.S. government report points out, by the end of this century..., Illinois may have the climate of East Texas, and ... deadly heat waves ... may become annual or biannual events.

In other words, we're facing a clear and present danger to our way of life, perhaps even to civilization itself. How can anyone justify failing to act?

Well, sometimes even the most authoritative analyses get things wrong. And if dissenting opinion-makers and politicians ... had carefully studied the issue, consulted with experts and concluded that the overwhelming scientific consensus was misguided — they could at least claim to be acting responsibly.

But if you watched the debate..., you didn't see people who've thought hard about a crucial issue, and are trying to do the right thing. What you saw, instead, were people who ... don't like the political and policy implications of climate change, so they've decided not to believe in it — and they'll grab any argument, no matter how disreputable, that feeds their denial.

Indeed, if there was a defining moment in Friday's debate, it was the declaration by Representative Paul Broun of Georgia that climate change is nothing but a "hoax" ... "perpetrated out of the scientific community." ... Mr. Broun's declaration was met with a round of applause from his Republican colleagues.

Given this contempt for hard science, I'm almost reluctant to mention the deniers' dishonesty on matters economic. But in addition to rejecting climate science, the opponents of the climate bill made a point of misrepresenting ... studies of the bill's economic impact, which all suggest that the cost will be relatively low.

Still, is it fair to call climate denial a form of treason? Isn't it politics as usual?

Yes, it is — and that's why it's unforgivable.

Do you remember ... when Bush administration officials claimed that terrorism posed an "existential threat" to America,... [so] normal rules no longer applied? That was hyperbole — but the existential threat from climate change is all too real.

Yet the deniers are choosing, willfully, to ignore that threat, placing future generations of Americans in grave danger, simply because it's in their political interest to pretend that there's nothing to worry about. If that's not betrayal, I don't know what is.


Fed Watch: A Tangled Policy Web

Tim Duy:

A Tangled Policy Web, by Tim Duy: Incoming data continues to confirm an emerging period of relative economic tranquility following the financial storm of 2008. Importantly, the bleeding in consumer spending has been staunched, despite ongoing job losses that look likely to remain a feature of the American economic landscape for months to come. But incoming data also point to America's sustained and perplexing dependence on foreign capital inflows - a dependence that suggests an underlying economic vulnerability that has yet to be addressed. Whether it needs to be addressed next month, next year, or next decade is still a question that continues to haunt the followers of global macro trends.

The most recent Personal Income and Outlays report, for May 2009, highlights many of the trends currently impacting the evolution of economic activity. The headline jump in incomes, like that of the previous month, was driven by federal stimulus. Declining private wage and salary disbursements are a more telling indicator of the health of household finances, and are consistent with ongoing labor market weakness. The best bet is the that private wage gains remain subdued, even as conditions stabilize. Although the apparent peak of initial claims is in the rearview mirror, persistent high levels of claims points to a jobless recovery.

Of course, in the absence of federal stimulus, the underlying weak income growth indicates sustained pressures on consumer spending power. Indeed, the numbers tell a clear story of stabilization, but little to suggest that a V shaped recovery for consumer spending is at hand:

FED063009

In addition, the report adds further credence to the claims that American's long affair with spending has ended in a bitter divorce, with the saving rate climbing to its highest level in 15 years. To be sure, some of the increase is likely not sustainable in the short run, as it partly reflects a time lag between federal stimulus and the spending it was meant to encourage. That said, the underlying saving increase is tempering the impact of stimulus spending, as households sock some of it away for the next rainy day and/or pay down crippling debt loads, effectively turning private debt into public debt. And note that large shifts in consumer behavior are not required to have significant macroeconomic implications. Small changes across households - a little less, percentage wise, spending here and there adds up. From Bloomberg:

Saks Fifth Avenue is cutting orders 20 percent after posting losses in the last four quarters. Kia Harris says some customers at the Washington shoe store where she works are buying one pair rather than three.

In the recession following a borrowing binge that sent consumer debt to the highest level ever, Americans are shutting their wallets and building their nest eggs at the fastest pace in 15 years.

While the trend will put the country's finances in better balance and reduce its dependence on Chinese investment, it may also restrain economic growth in 2010 and beyond, said Lyle Gramley, a senior economic adviser with New York-based Soleil Securities Corp. and a former Federal Reserve governor.

The interesting line here is the implication that increased savings will jointly improve national finances and lessen dependence on foreign capital inflows. To be sure, the increase in household saving or, equivalently, the decrease in household borrowing serves as the offset for increase federal borrowing. Indeed, the data is supportive of those who argue the importance and necessity of deficit spending to support economic activity. Given that low interest rates are insufficient to spur spending and, instead, households rapidly increase the pool of available saving, the federal government is best positioned to step up as the economic engine, and can do so without significantly impacting interest rates and crowding out private investment. Case closed.

Or is it? In a closed economy, this story works. In an open economy, the tangled webs of international finance are spun into a more complex tale. Why, if rising households saving justifies deficit spending, are foreign central banks increasingly important again in financing a US capital shortfall? From Brad Setser:

Over the last 13 weeks of data, central banks added $160 billion to their custodial accounts, with Treasuries accounting for all the increase.

$160 billion a quarter is $640 billion annualized — a pace that if sustained would be a record. Of course, $640 billion in central bank purchases of Treasuries would still fall well short of meeting the US Treasuries financing need. The math only works if Americans also buy a lot of Treasuries. That is a change.

The annualized inflow of $640 billion is nothing to sneeze at; at that rate, foreign central banks are supporting US spending to the tune of 4.5% of GDP. Without those inflows, I find it difficult to think that US interest rate would have anywhere to go but up - an increase that would be necessary to resolve what remains a persistent element of the American economic landscape - a smaller but still significant current account deficit. A deficit that could perhaps be dismissed if it was being financed by individual investors in Shanghai looking to be shares in Apple to capture the profit potential of the US economic engine. A deficit that is difficult to dismiss if it requires foreign central banks to continually compensate for the absence of interest from private investors.

The ongoing US dependence on foreign central banks, long chronicled by Brad Setser, has another implication. If foreign CBs only provided temporary financing, we could rightly view their actions as addressing a temporary liquidity crisis in the US. No harm done, good stabilization policy. The persistence of those flows, however, suggests something much darker…the US does not face a liquidity challenge. It faces a solvency challenge. From the Washington Post:

The nation's long-term budget outlook has darkened considerably over the past six months, and President Obama's plan to extend an array of tax cuts and other policies adopted during the Bush administration has the potential to "create an explosive fiscal situation," congressional budget analysts reported yesterday.

In a new report, the Congressional Budget Office found that extending the Bush administration tax cuts, reining in the alternative minimum tax and canceling a scheduled reduction in payments to Medicare doctors would dramatically slash tax collections at a time when federal spending would be "sharply rising." The resulting budget gap would drive the nation's debt over 100 percent of gross domestic product by 2023, the report says, and past 200 percent of GDP by the late 2030s.

Quite honestly, I find the implementation of temporary fiscal spending to fill an economic hole something of a no brainer at the current time; the likely persistence of deficit spending long into the future is cause for concern. It is cause for concern because it is a problem that likely just builds so long as there is no market mechanism to signal a need for meaningful change. The obvious signal would be rising interest rates. But so long as foreign central banks are willing to be the buyers of last resort for US Treasuries, interest rates will remain in check; external policymakers will ensure that the US continues to receive the financial support to keep the dynamic in play.

When will this dynamic be brought to an end? That's still the multi-billion dollar question. Chinese policymakers see the writing on the wall, as they played no small part in sustaining US spending prolificacy:

The dollar declined the most against the euro in a month and dropped versus the yen after China repeated its call for a new global currency.

The Swiss franc declined against the euro and dollar this week as foreign-exchange analysts said the central bank sold its currency three times to support the economy. The greenback fell against most of its major counterparts after the People's Bank of China said yesterday the International Monetary Fund should manage more of members' foreign-exchange reserves.

"The dollar's status as a reserve currency is being questioned," said Benedikt Germanier, a foreign-exchange strategist in Stamford, Connecticut at UBS AG, the second- largest currency trader. "There are reasons to sell the dollar."

This, however, does not appear to be a realistic stab at the bringing about greater balance to the global economy. China wants to sustain large current account surpluses while avoiding any portfolio risk on the offsetting rise in official reserves. Ironically, the US wants the opposite - steady inflow of cheap goods without the risks associated with a large build up of external assets. All players want upside without risk. We are all well versed at this point with the wisdom of pretending that everyone can shed risk. It doesn't disappear in those situations; it becomes concentrated. Think AIG.

In any event, for now Chinese angst appears to be meaningful saber-rattling, as each threat to change behavior is quickly retreated from. Bloomberg this morning:

People's Bank of China Governor Zhou Xiaochuan said the nation won't change its currency reserve policy suddenly, helping the dollar to snap a two-day decline.

"Our foreign-exchange reserve policy is always quite stable," Zhou told reporters at a central bankers' meeting yesterday in Basel, Switzerland. "There are not any sudden changes."

Sudden changes in the Dollar's status as a reserve currency serve no purpose. Best instead to use a pattern of outright threats and changes in patterns in bond purchases to keep American policymakers aware of the ultimate cost of Dollar hegemony. Given that as of yet, there is no realistic alternative to holding Dollars, policymakers globally slavishly heed to past behaviors that have entrenched global imbalances, hoping the problem spontaneously disappears. But instead, it only grows, looming like a dark shadow over the global macroeconomy.

What are the policy options? Short of imposing capital controls, open capital markets implies we can't stop foreign central banks from accumulating US assets. Long needed has been an international agreement that brings sanity to the seemingly insane equilibrium in which poor nations finance the spending of rich nations. Such a voluntary, multilateral withdrawal from the current regime, however, remains little more than a bedtime story.

Domestically, the optimal path is to meaningfully address the long term budget challenge. Does this mean cutting programs and boosting taxes now? No, quite frankly, at this juncture that would be an almost insane policy response, one that would not be appropriate for either the US or our trading partners. In the short run, such as policy response would be needlessly disruptive (indeed, that potential disruption is what keeps foreign central banks in the game of buying US Treasuries). Instead, you need to examine the policy space to find an obvious candidate for controlling the growth of aggregate spending in the US. And that exercise always leads you back to health care, and the realization that we spend an extra $1 trillion more than other industrialized nations, and we don't get much if anything for it. A trillion dollars is a lot of money; more in fact, than the recent pace of foreign central bank Treasury purchases. If you can meaningfully "bend the curve" on health care spending, you can see a light at the end of the tunnel. If you can't or are not willing to bend the curve, I fear waning global patience in sustaining US spending will result in a rude awakening that the tunnel of US fiscal policy ends at a hard wall.


links for 2009-06-29


links for 2009-06-29

June 28, 2009

Economist's View - 5 new articles

Old Economy/New Economy

How did people survive without Google? A colleague, Bill Harbaugh, emails:

I stink, and I needed a Laundromat in Lyon. Google translate says that's called a laverie in French. Google maps says there's one 4 blocks away. Is it open on Sunday? Laundromats don't have websites. But Google street views shows the front door - Ouvert 7 Jours.

Lyon-Laundry

Then the washing machine swallowed my last Euros.


What's behind Recent Changes in Long-Term Interst Rates?

Martin Feldstein says we need to cut social programs so that we don't "weaken demand in the near term and hurt economic incentives in the long run":

The Fed must reassure markets on inflation, by Martin Feldstein, Commentary, Financial Times: The interest rate on 10-year US Treasury bonds almost doubled in six months, rising from 2.26 per cent last December to 3.98 per cent in mid-June, before decreasing slightly in recent days. This sharp rise happened despite the Federal Reserve's ... policy aimed at lowering long-term rates by buying $300bn of Treasuries and promising to buy more than $1,000bn of mortgage securities. ...

There is no single reason for the sharp rise in rates... The simplest explanation for the higher 10-year rate is that many investors now expect inflation to rise. ... The prospective decline of the dollar is also a potential source of inflation. ...

But such an explanation is deceptively easy. ... Those scared by Lehman Brothers' collapse wanted the safety and liquidity of ordinary Treasury bonds, causing their yields to fall sharply...

Treasury yields rose this month to their level a year earlier because improving market conditions meant investors were no longer willing to pay for the extreme liquidity of Treasuries. Inflation was thus not the only, and perhaps not even the main, reason for the rise in rates.

Why did the Fed's massive buying of long-term Treasury bonds not hold down the bond rate? The answer is that bond markets are less impressed by the $300bn of Fed purchases than by the official projection of $10,000bn of government borrowing over the next decade... The resulting crowding out of private investment will require higher future interest rates, and that is reflected in current long-term rates.

A further reason long rates remain high is a fear that foreign buyers may not be willing to continue buying dollar bonds to finance a large US current account deficit.

In short, higher long-term interest rates reflect investors' concern about future inflation, future fiscal deficits and the future willingness of foreign investors to purchase US bonds. ...

It would be wrong for the Obama administration and Congress to reduce the fiscal stimulus in 2009 or 2010, since there is no clear evidence of a sustained upturn. But it would be equally wrong to allow the national debt to double to 80 per cent of GDP a decade from now. Increasing taxes even more than proposed would weaken demand in the near term and hurt economic incentives in the long run. The fiscal deficit should therefore be reduced by curtailing the increases in social spending that the president advocated in his election campaign.

The Fed must also be careful not to tighten too soon. But it needs to reassure markets that it will prevent the excess reserves of the banks from financing a surge of inflationary lending when the economy begins to expand. It must make clear now that it will be willing to do so even if that involves big rises in short-term rates.

Here's (my interpretation of) Paul Krugman's argument about the source of recent movements in long-term interest rates:

There are two reasons long-term rates might rise, first more worries about the debt and inflation in the future would drive rates up, and second the prospect of better economic conditions in the future would have the same effect, rates would go up.

Suppose we receive bad news about the current state of the economy. That should cause expectations of lower output growth in the future, and hence lower tax revenues and higher spending on social programs than would exist with a stronger economy. So the bad news should cause an expectation of a larger deficit and more inflation worries, and that would drive long-term interest rates up (these worries would also make foreign central banks less likely to fund US borrowing which would reinforce the increase in long-term interest rates).

But if it is future economic conditions that are driving the changes in long-term interest rates, bad news about the economy should drive rates down.

Last week, we received bad news about the economy. If the debt/inflation/foreign lending story is correct, long-term rates should have gone up. If the state of the economy story is driving rates, rates should have fallen. What did long-term rates actually do? They fell.


A Public Plan

[I'm hoping this education example will give some insight into the public health care plan, or at least give you another way to think about it.]

Suppose that education is only available from private sector schools, and that education within this system is very expensive. Because of the expense, millions of people do not have access to education. Further suppose that due to the characteristics of the education market, there is reason to believe that the private institutions are bloated with excess costs (and, in addition to all the other excess costs, 30% of their expenditures came from competition for students rather than delivering education). To make matters worse, the already too high costs are expected to escalate rapidly in the future and further limit access to education. (And there's more. If costs aren't controlled, the government's Educare program for the very young will begin to eat up a huge share of the federal budget.)

Now suppose the government decides to solve both the access and cost problems by setting up a public plan for education. Here's how it works.

The government will build schools, staff them, purchase supplies, and so on, but there's a catch. The schools will have to run without any government subsidies, none at all, not a dime (so this is different than what we actually do since some or all of the education bill is subsidized, some for college, all for lower grades).

If these schools provide exactly the same education as the private sector schools but cost less to attend, then that would either force the private sector schools to find a way to compete by bringing costs down, and they ought to be able to match the government run institution, or they would go out of business. It's true that the public institutions might have an advantage in buying books in bulk, that sort of thing, and they could probably get books and other supplies for less than individual private schools could get them, but what's wrong with scale economies? And to the extent that it is the power that comes from their size as public institutions rather than actual efficiencies, it's important to remember that the publishers aren't without their own countervailing market power, so this makes the playing field more level.

As to access, one option is to do as we do with schools now and implicitly subsidize everyone who attends, rich and poor alike, by giving government subsidies to the schools (tuition falls by the amount of the subsidy, to zero for public elementary and high schools, part way to zero for colleges). But that would violate the no government help rule we imposed above. The other way to do this is to take the money that would have been used to subsidize the schools and instead give it out to individuals who couldn't attend school otherwise (perhaps graduated by income). That avoids giving subsidies to those who don't need them, and the subsidies can then be concentrated on those who do. The additional help available to those who need it would, in turn, allow more people access to education, a key goal of the policy.

So, the idea is to build government schools that must run without any help from taxpayers, and the public schools will compete side by side with the private schools. Rather than limiting choice, this adds one more choice, and it's a choice nobody has to make if the public schools turn out to be more expensive than than the competing private schools. Then, to increase access to education, give individuals the tuition subsidies they need to make it possible for them to attend the public school. Finally, for any conservatives opposed to the public plan, notice that if individuals can use the subsidy on either a public or a private sector school, this is basically a voucher system. However, in this case the goal of the voucher system is to reduce costs in the overly expensive private sector rather than to discipline the public institutions, something the private sector shouldn't fear if, in fact, it is the least cost provider of education.


links for 2009-06-28


links for 2009-06-28