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November 28, 2012

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Posted: 28 Nov 2012 12:06 AM PST

Tim Geithner: 'Pragmatic Deal Maker'?

Posted: 27 Nov 2012 10:44 AM PST

Robert Reich is worried:

Will Tim Geithner Lead Us Over or Around the Fiscal Cliff?, by Robert Reich: I'm trying to remain optimistic that the President and congressional Democrats will hold their ground over the next month as we approach the so-called "fiscal cliff."
But leading those negotiations for the White House is outgoing Secretary of Treasury Tim Geithner, whom Monday's Wall Street Journal described as a "pragmatic deal maker" because of "his long relationship with former Treasury Secretary Robert Rubin, for whom balancing the budget was a priority over other Democratic touchstones." ...
Both Rubin and Geithner are hardworking and decent. But both see the world through the eyes of Wall Street rather than Main Street. I battled Rubin for years in the Clinton administration because of his hawkishness on the budget deficit and his narrow Wall Street view of the world.
During his tenure as Treasury Secretary, Geithner has followed in Rubin's path — engineering a no-strings Wall Street bailout that didn't require the Street to help stranded homeowners, didn't demand the Street agree to a resurrection of the Glass-Steagall Act, and didn't seek to cap the size of the biggest bank, which in the wake of the bailout have become much bigger.  In an interview with the Journal, Geithner repeats the President's stated principle that tax rates must rise on the wealthy, but doesn't rule out changes to Social Security or Medicare. And he notes that in the president's budget (drawn up before the election), spending on non-defense discretionary items — mostly programs for the poor, and investments in education and infrastructure — are "very low as a share of the economy relative to Clinton." If "pragmatic deal maker," as the Journal describes Geithner, means someone who believes any deal with Republicans is better than no deal, and deficit reduction is more important than job creation, we could be in for a difficult December.

Not sure if this will make you feel more confident, but a recent post on the Treasury's blog from Jason Furman asserted that "Increasing Taxes on Middle-Class Families Will Hurt Consumer Spending." Unfortunately, it didn't say much about Social Security and Medicare. I am worried too.

Cyberattacks on Banks Escalating

Posted: 27 Nov 2012 10:16 AM PST

President of the Atlanta Fed, Dennis Lockhart:

...A real financial stabiliy concern ... is the potential for malicious disruptions to the payments system in the form of broadly targeted cyberattacks. Just in the last few months, the United States has experienced an escalating incidence of distributed denial of service attacks aimed at our largest banks. The attacks came simultaneously or in rapid succession. They appear to have been executed by sophisticated, well-organized hacking groups who flood bank web servers with junk data, allowing the hackers to target certain web applications and disrupt online services. Nearly all the perpetrators are external to the targeted organizations, and they appear to be operating from all over the globe. Their motives are not always clear. Some are in it for money, while others are in it for what you might call ideological or political reasons.
Unlike other cybercrime activity, which aims to steal customer data for the purpose of unauthorized transactions, distributed denial of service attacks do not necessarily result in stolen data. Rather, the intent appears to be to disable essential systems of financial institutions and cause them financial loss and reputational damage. The intent may be mischief on a grand scale, but also retaliation for matters not directly associated with the financial sector.
Banks have been defending themselves against cyberattacks for a while, but the recent attacks involved unprecedented volumes of traffic—up to 20 times more than in previous attacks. Banks and other participants in the payments system will need to reevaluate defense strategies. The increasing incidence and heightened magnitude of attacks suggests to me the need to update our thinking. What was previously classified as an unlikely but very damaging event affecting one or a few institutions should now probably be thought of as a persistent threat with potential systemic implications.
I'm drawing your attention to this area of risk... But I feel the need to be measured about the potential for severe financial instability from this source. In my judgment, cyberattacks on payments systems are not likely to have as deep or long lasting an impact on financial system stability as fiscal crises or bank runs, for example. Nonetheless, there is real justification for a call to action. ...
Even broad adoption of preventive measures may not thwart all attacks. Collaborative efforts should be oriented to building industry resilience. Resilience measures would be similar to those put in place in the banking industry to maintain operations in a natural disaster—multiple backup sites and redundant computer systems, for example.

'By 2035, We Project Oil Imports into the US of Only 3.4 Million Barrels a Day'

Posted: 27 Nov 2012 10:16 AM PST

Fatih Birol, chief economist of the International Energy Agency and chair of the World Economic Forum's Energy Advisory Board, discusses his projection that "the United States will become the world's leading oil producer within a few decades":

Q. The new report has attracted great press attention for its projection that the United States may soon become the world's leading oil producer. Can you discuss what you see as the greatest implications of this change, in terms of energy security, geopolitics and carbon emissions?

A. The most striking implications concern U.S. oil imports and international oil-trade patterns. The upward trend in production is partly responsible for a sharp fall in U.S. oil imports. By 2035, we project oil imports into the United States of only 3.4 million barrels a day, which implies a substantial (60 percent) reduction in oil-import bills. North America as a whole actually becomes a net oil exporter. In international oil markets, this accelerates the shift in trade patterns toward Asia, raising the geostrategic importance of trade routes between Middle East producers and Asian consumers.

But what should attract equal attention … is the essential role played by energy efficiency. I believe that energy efficiency has been an epic failure by policymakers in almost all countries. Its potential is huge but much of it remains untapped. Compared with today, savings from more rigorous vehicle fuel-economy standards could prompt a 30 percent fall in U.S. oil demand by 2035.

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Fed Watch: Meanwhile, in Japan...

Posted: 27 Nov 2012 12:15 AM PST

Tim Duy:

Meanwhile, in Japan..., by Tim Duy: Back in September, I wrote:

What I expect to happen is this: The Bank of Japan will be forced into outright monetization at some point; a soft default in the form of higher inflation will occur. And dramatically higher inflation, I fear. Japan has not had inflation for two decades. I suspect they will experience all that pent-up inflation in the scope of a couple of years.

Sure enough, the battle begins. Almost lost in the holiday weekend, from Reuters last week:

Japan's main opposition Liberal Democratic Party (LDP) said on Wednesday that on its return to power it would set a 2 percent inflation target with an eye to revising the law governing the Bank of Japan so as to boost cooperation between the government and the central bank...

...In its campaign platform unveiled on Wednesday, the LDP called for bold monetary easing through cooperation between the government and the central bank on debt management, but it made no mention of Abe's calls for the BOJ to buy debt to finance infrastructure projects.

The response from the Bank of Japan was swift:

But BOJ Governor Masaaki Shirakawa dismissed many of Abe's proposals, including the possible revision of the Bank of Japan law, a step critics say is aimed at clipping the central bank's independence and forcing it to print money to finance public debt that is already double the size of Japan's economy.

"Central bank independence is a system created upon bitter lessons learned from the long economic and financial history in Japan and overseas countries," Shirakawa told a news conference....

...Shirakawa was adamant the central bank would not directly underwrite government debt because bond yields would spike and hurt the economy.

"No advanced country has adopted such a policy," he said.

Shirakawa is correct. Modern central banks may have lost some control over inflation at times, but I don't think any has engaged in outright monetization of government debt. Yet despite Shirakawa's insistence to the contrary, I still think that is exactly where Japan is headed. More central bank history in the making.

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Posted: 27 Nov 2012 12:06 AM PST

'The Multiplier is at Least Two'

Posted: 26 Nov 2012 03:47 PM PST

For infrastructure spending, in particular spending on roads and highways, Sylvain Leduc and Daniel Wilson "find that the multiplier is at least two":

Highway Grants: Roads to Prosperity?, by Sylvain Leduc and Daniel Wilson, FRBSF Economic Letter: Increasing government spending during periods of economic weakness to offset slower private-sector spending has long been an important policy tool. In particular, during the recent recession and slow recovery, federal officials put in place fiscal measures, including increased government spending, to boost economic growth and lower unemployment. One form of government spending that has received a lot of attention is public investment in infrastructure projects. The 2009 American Recovery and Reinvestment Act (ARRA) allocated $40 billion to the Department of Transportation for spending on the nation's roads and other public infrastructure. Such public infrastructure investment harks back to the Great Depression, when programs such as the Works Progress Administration and the Tennessee Valley Authority were inaugurated.
One criticism of public infrastructure programs is that they take a long time to put in place and therefore are unlikely to be effective quickly enough to alleviate economic downturns. The fact is, though, that surprisingly little empirical information is available about the effect of public infrastructure investment on economic activity over the short and medium term.
This Economic Letter examines new research (Leduc and Wilson, forthcoming) on the dynamic effects of public investment in roads and highways on gross state product (GSP), the total economic output of a state. This research focuses on investment in roads and highways in part because it is the largest component of public infrastructure in the United States. Moreover, the procedures by which federal highway grants are distributed to states help us identify more precisely how transportation spending affects economic activity.
We find that unanticipated increases in highway spending have positive but temporary effects on GSP, both in the short and medium run. The short-run effect is consistent with a traditional Keynesian channel in which output increases because of a rise in aggregate demand, combined with slow-to-adjust prices. In contrast, the positive response of GSP over the medium run is in line with a supply-side effect due to an increase in the economy's productive capacity.
We also assess how much bang each additional buck of highway spending creates by calculating the multiplier, that is, the magnitude of the effect of each dollar of infrastructure spending on economic activity. We find that the multiplier is at least two. In other words, for each dollar of federal highway grants received by a state, that state's GSP rises by at least two dollars.
The Federal-Aid Highway Program
The federal government's involvement in financing road construction goes back to the early part of the past century. Although initially small, this involvement became much more significant in 1956 with the enactment of the Federal-Aid Highway Act, which authorized almost $34 billion in 1956 dollars over 13 years for the construction of the Interstate Highway System. At the time, The New York Times noted that "the highway program will constitute a growing and ever-more-important share of the gross national product … (affecting) every phase of economic life in this country."
The Interstate Highway System was completed in 1992. Since then, the federal government has continued to provide funding to states mostly through a series of grant programs collectively known as the Federal-Aid Highway Program (FAHP). The FAHP helps fund construction, maintenance, and other improvements on a wide range of public roads beyond the interstate highways. Local roads are often considered federal-aid highways and are eligible for federal funding, depending on how important the federal government judges them to be.
Because road projects typically take a long time to complete, advance knowledge of future funding sources can help smooth planning. Congress designs transportation legislation to minimize uncertainty. First, it enacts legislation that typically extends five to six years. Second, it apportions funds to states according to set formulas. Thus, a typical highway bill will specify an annual national amount for each highway program over the life of the legislation and spell out the formula by which that program's national amount will be apportioned to states. Importantly, these formulas are based on road-related metrics measured several years earlier. That means that changes to current and future highway funding are not driven by current economic conditions.
Highway bills generally include information that helps states forecast relatively accurately the amount of grants they are likely to receive while the legislation is in effect. For the past two highway bills, the Federal Highway Administration (FHWA) published forecasts of each state's annual future grants under each program.
Estimating the effects of road spending
We conduct a statistical analysis to estimate the effects of federal highway spending on state economic activity. Specifically, we construct a variable that captures revisions to forecasts of current and future highway grants to the states, based on information from highway bills since 1991. We closely follow, but also expand on, the FHWA's methodology for forecasting each state's future grants.
These forecast revisions serve as proxies for changes in expectations about current and future highway spending in a given state. In economic terms, these changes can be regarded as shocks, that is, unanticipated events that affect economic activity.
We study forecast revisions rather than changes in actual highway spending for two reasons. First, actual spending may both affect and be affected by current economic conditions, making it difficult to sort out the true causal effects of the spending.
Second, changes in actual spending are most likely to be anticipated years in advance. For that reason, some of their economic effects may be felt before the spending changes actually take place. For instance, a state government and other important players, such as construction and engineering firms, may decide to spend more today if they expect the state to receive more highway grants in the future. In this way, changes in expectations regarding future grants to the states may be important for current economic activity. Failing to account for changes in expectations may lead to incorrect conclusions about how government spending affects economic activity (see Ramey 2011a).

Figure 1
Average response of state GDPs to unexpected grants

Average response of state GDPs to unexpected grants
In our analysis of how changes in forecasts of highway grants to the states affect state GSP, we control for lags in state GSP, lags in receipt of highway grants, average state GSP levels, and national movements of gross domestic product (GDP) over the sample period from 1990 to 2010.
In Figure 1, the solid line shows the average percentage change in a state's GSP following a 1% increase in forecasted future highway grants to the states. The shaded area around the line represents a 90% probability range. The horizontal axis indicates the number of years after the unanticipated change in forecasted highway grants to the states. The figure shows that changes in the forecasts have a significant short-term effect on state output in the first one to two years. This effect fades, but then increases sharply six to eight years after the forecast revisions, before declining again. This pattern holds up well with alternative estimation techniques, the inclusion of different control variables, and with different data samples.
This pattern is consistent with New Keynesian theoretical models in which public infrastructure, such as roads, are used by the private sector in the production of goods and services and take time to be built (see Leduc and Wilson, forthcoming). In this framework, the initial impact is due to a traditional Keynesian effect of an increase in aggregate demand. The medium-term effect on output arises once the public infrastructure is built, thus increasing the economy's productive capacity.
The highway grant multiplier
One concept often used to assess the effectiveness of government spending is the multiplier. The fiscal multiplier represents the dollar change in economic output for each additional dollar of government spending. Thus, a multiplier of two implies that, when government spending increases by one dollar, output rises by two dollars.
Based on the results shown in Figure 1, we find that multipliers for federal highway spending are large. On initial impact, the multipliers range from 1.5 to 3, depending on the method for calculating the multiplier. In the medium run, the multipliers can be as high as eight. Over a 10-year horizon, our results imply an average highway grants multiplier of about two.
Our estimated multipliers are noticeably larger than those typically found in the literature on the effects of government spending. For instance, in a recent survey, Valerie Ramey reports multipliers between 0.5 and 1.5 (see Ramey 2011b). One possible reason for the wide differences is that we consider a very different form of government spending. Most of the literature concentrates on the multiplier effect of military spending. But such spending is arguably nonproductive in an economic sense. By contrast, government investment in infrastructure, such as roads, can raise the economy's productive capacity. In that respect, it can have a higher fiscal multiplier. Another difference is that we concentrate on the multiplier effect on GSP, while the literature typically studies the effect on U.S. GDP as a whole.
The American Recovery and Reinvestment Act
The deep recession of 2007–09 led to the enactment of ARRA, which included a large one-time increase of $27.5 billion in federal highway grants to states. ARRA was designed to have strong short-term effects. In general, infrastructure projects are not viewed as effective forms of short-term stimulus because of the long lags between authorization, planning, and implementation. By the time the projects get under way, a recession may be over. The extra spending could ultimately end up feeding an already booming economy. To address this problem, ARRA stipulated that state governments had to fully use their share of federal highway grants by March 2010.
It is conceivable that highway spending during a major downturn, when productive capacity is underutilized, may affect output in a substantially different way than spending during more normal times. To test this, we examined whether unanticipated changes in highway spending in 2009 and 2010 had a different effect on GSP than in other years in our sample. We found that spending in 2009 and 2010 was roughly four times as large as the peak response shown in Figure 1. This suggests that highway spending can be effective during periods of very high economic slack, particularly when spending is structured to reduce the usual implementation lags.
Conclusion
Surprise increases in federal investment in roads and highways appear to have had positive effects on gross state product in both the short and medium run. The short-run impact is akin to the traditional Keynesian effect that stems from an increase in aggregate demand. By contrast, the positive impact on GSP in the medium run is probably due to supply-side effects that boost the economy's productive capacity. Infrastructure investment gets a good bang for the buck in the sense that fiscal multipliers—the dollar of increased output for each dollar of spending—are large.
References
Leduc, Sylvain, and Daniel J. Wilson. Forthcoming. "Roads to Prosperity or Bridges to Nowhere? Theory and Evidence on the Impact of Public Infrastructure Investment." NBER Macroeconomics Annual 2012.
Ramey, Valerie A. 2011a. "Identifying Government Spending Shocks: It's all in the Timing." Quarterly Journal of Economics 126(1), pp. 1–50.
Ramey, Valerie A. 2011b. "Can Government Purchases Stimulate the Economy?" Journal of Economic Literature 49(3), pp. 673–685.

Household Services Expenditures

Posted: 26 Nov 2012 11:34 AM PST

Here's a graph of spending on discretionary services from Jonathan McCarthy of the NY Fed:

Household Services Expenditures: An Update, by Jonathan McCarthy, Liberty Street: This post updates and extends my July 2011 blog piece  on household discretionary services expenditures. I examine the most recent data to see what they reveal about the depth of decline in expenditures in the last recession and the extent of the recovery, and find that the expenditures appear to be further below the peak identified earlier. I then compare the pace of recovery for discretionary and nondiscretionary services in this expansion with that of previous expansions, finding that the pace in both cases is well below that of previous cycles. In summary, household spending continues to be constrained by a combination of credit conditions and weak income expectations. ...

Cumulative-Declines-in-Real-Discretionary-Services-PCE

The author also looks at the pace of the recovery of spending on both discretionary and non-discretionary services, and finds both to be subpar (see the last two graphs). The conclusion:

The pattern of a similarly sluggish pace of recovery for discretionary and nondiscretionary services expenditures suggests that the fundamentals for consumer spending remain soft. In particular, it appears that households—more than three years after the end of the recession—remain wary about their future income growth and employment prospects even though consumer confidence measures have improved in recent months. In addition, households may still see the need to repair their balance sheets from the damage incurred during the recession, especially if they expect that increases in asset prices will be subdued at best and that credit will continue to be constrained. Consequently, a positive resolution of these issues is likely necessary before a stronger services and overall consumer spending recovery can be sustained.
If households had gotten as much help with their balance sheet problems as banks got, the recovery would be a lot further along.

'Wreaking Havoc on the Environment with Little or No Accountability'

Posted: 26 Nov 2012 11:34 AM PST

Jeff Sachs says "polluters must pay":

Polluters Must Pay: When BP and its drilling partners caused the Deepwater Horizon oil spill in the Gulf of Mexico in 2010, the United States government demanded that BP finance the cleanup, compensate those who suffered damages, and pay criminal penalties for the violations that led to the disaster. BP has already committed more than $20 billion in remediation and penalties. Based on a settlement last week, BP will now pay the largest criminal penalty in US history – $4.5 billion.
The same standards for environmental cleanup need to be applied to global companies operating in poorer countries, where their power has typically been so great relative to that of governments that many act with impunity, wreaking havoc on the environment with little or no accountability. As we enter a new era of sustainable development, impunity must turn to responsibility. Polluters must pay, whether in rich or poor countries. Major companies need to accept responsibility for their actions. ...
I can't see the companies doing this voluntarily.

Lucas Interview

Posted: 26 Nov 2012 10:37 AM PST

Stephen Williamson notes an interview of Robert Lucas:

SED Newsletter: Lucas Interview: The November 2012 SED Newsletter has ... an interview with Robert Lucas, which is a gem. Some excerpts:

... Microfoundations:

ED: If the economy is currently in an unusual state, do micro-foundations still have a role to play?
RL: "Micro-foundations"? We know we can write down internally consistent equilibrium models where people have risk aversion parameters of 200 or where a 20% decrease in the monetary base results in a 20% decline in all prices and has no other effects. The "foundations" of these models don't guarantee empirical success or policy usefulness.
What is important---and this is straight out of Kydland and Prescott---is that if a model is formulated so that its parameters are economically-interpretable they will have implications for many different data sets. An aggregate theory of consumption and income movements over time should be consistent with cross-section and panel evidence (Friedman and Modigliani). An estimate of risk aversion should fit the wide variety of situations involving uncertainty that we can observe (Mehra and Prescott). Estimates of labor supply should be consistent aggregate employment movements over time as well as cross-section, panel, and lifecycle evidence (Rogerson). This kind of cross-validation (or invalidation!) is only possible with models that have clear underlying economics: micro-foundations, if you like.

This is bread-and-butter stuff in the hard sciences. You try to estimate a given parameter in as many ways as you can, consistent with the same theory. If you can reduce a 3 orders of magnitude discrepancy to 1 order of magnitude you are making progress. Real science is hard work and you take what you can get.

"Unusual state"? Is that what we call it when our favorite models don't deliver what we had hoped? I would call that our usual state.

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Paul Krugman: Fighting Fiscal Phantoms

Posted: 26 Nov 2012 12:24 AM PST

The deficit scolds have been wrong again and again:

Fighting Fiscal Phantoms, by Paul Krugman, Commentary, NY Times: These are difficult times for the deficit scolds who have dominated policy discussion for almost three years. One could almost feel sorry for them, if it weren't for their role in diverting attention from the ongoing problem of inadequate recovery, and thereby helping to perpetuate catastrophically high unemployment.
What has changed? For one thing, the crisis they predicted keeps not happening. Far from fleeing U.S. debt, investors have continued to pile in, driving interest rates to historical lows. Beyond that, suddenly the clear and present danger to the American economy isn't that we'll fail to reduce the deficit enough; it is, instead, that we'll reduce the deficit too much. ...
Given these realities, the deficit-scold movement has lost some of its clout. ... But the deficit scolds aren't giving up. Now yet another organization, Fix the Debt, is campaigning for cuts to Social Security and Medicare, even while making lower tax rates a "core principle." That last part makes no sense in terms of the group's ostensible mission, but makes perfect sense if you look at the array of big corporations, from Goldman Sachs to the UnitedHealth Group, that are involved in the effort and would benefit from tax cuts. Hey, sacrifice is for the little people.
So should we take this latest push seriously? No... As far as I can tell, every example supposedly illustrating the dangers of debt involves either a country that, like Greece today, lacked its own currency, or a country that, like Asian economies in the 1990s, had large debts in foreign currencies. Countries with large debts in their own currency, like France after World War I, have sometimes experienced big loss-of-confidence drops in the value of their currency — but nothing like the debt-induced recession we're being told to fear.
So let's step back for a minute, and consider what's going on here. For years, deficit scolds have held Washington in thrall with warnings of an imminent debt crisis, even though investors, who continue to buy U.S. bonds, clearly believe that such a crisis won't happen; economic analysis says that such a crisis can't happen; and the historical record shows no examples bearing any resemblance to our current situation in which such a crisis actually did happen.
If you ask me, it's time for Washington to stop worrying about this phantom menace — and to stop listening to the people who have been peddling this scare story in an attempt to get their way.

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Posted: 26 Nov 2012 12:06 AM PST

Banking Must not be Left in the Shadows

Posted: 25 Nov 2012 12:37 PM PST

I agree with Gary Gorton:

Banking must not be left in the shadows, by Gary Gorton, Commentary, Financial Times: ... Addressing the details of the recent financial crisis leaves open the larger question of how it could have happened in the first place. ... One of the findings of the Financial Stability Board report is that the global shadow banking system grew to $62tn in 2007, just before the crisis. Yet we are only now measuring the shadow banking system. ...
Measurement is the root of science. Our measurement systems, national income accounting, regulatory filings and accounting systems are useful but limited. ... Now we need to build a national risk accounting system. The financial crisis occurred because the financial system has changed in very significant ways. The measurement system needs to change in equally significant ways. The efforts made to date focus mostly on "better data collection" or "better use of existing data" – phrases that, at best, suggest feeble efforts. A new measurement system is potentially forward-looking in detecting possible risks.
Another problem is conceptual. Why weren't we looking for the possibility of bank runs before the crisis? The answer is that we did not believe a bank run could happen in a developed economy. ... Why did we think that? For no good reason. But, when an economic phenomenon occurs over and over again, it suggests something fundamental... Another law, we now know, is that privately created bank money is subject to runs in the absence of government regulation.

I'll just add the periodic reminder that we do not yet have the regulation in place that is needed to address the problem of bank runs of "privately created bank money." Gary Gorton is skeptical that we can ever solve this problem, that's one of the pointsof th ecolumn, but if that's the case then we should be doing all we can to ensure that the consequences of a shadow bank run are minimized, and there is much more we can do along these lines.

Can You Beat the Market?

Posted: 25 Nov 2012 11:08 AM PST

This got more attention than I expected on Twitter, Facebook, etc., so thought I'd highlight it here:

Still think you can beat the market?, by Tim Harford: One of the most maligned ideas in economics is the efficient market hypothesis... The EMH has various forms, but in brief its message is very simple: an individual investor cannot reliably outperform financial markets. The reasoning is equally simple... Anything that could reasonably be anticipated already has been anticipated, and so markets instead respond only to genuinely unexpected news.
But the EMH has a problem: researchers keep discovering predictable patterns in the data... That is a minor embarrassment for the EMH; and it becomes a major one if the anomalies persist after they have been discovered. Yet this seems doubtful. ...
A new research paper by David McLean and Jeffrey Pontiff explicitly examines the idea that academic research into anomalies is a self-denying endeavor. They find some evidence of spurious patterns... But what is really striking is that after an anomaly has been published, it quickly shrinks – although it does not disappear.
The anomalies are most likely to persist when they apply to small, illiquid markets – as one might expect, because there it is harder to profit from the anomaly.
The efficient markets hypothesis is surely false. What is striking is that it is very close to being true. For the Warren Buffetts of the world, "almost true" is not true at all. For the rest of us, beating the market remains an elusive dream.

Don't Eliminate the Link between Social Security Contributions and Benefits

Posted: 25 Nov 2012 09:43 AM PST

Because of the way the Social Security program is funded -- through a payroll tax on workers along with an employer contribution -- many people believe there is an account for them at some government agency holding those contributions, or at least giving them credit for them, and that they will be able to collect their contributions when they retire. It's their money, collected from them monthly, and no matter their income level they have a right to get that money back when they retire. Try telling them that they don't. Even those people who understand that if their income is high enough they may not receive payments equal to all they put in get something back -- it's there for them no matter what -- and this increases support for the program.

But if we change the funding so that payments for Social Security come out of the general fund -- the money the government collects through taxes for all purposes -- and impose means testing (i.e. phase out the payments once income is high enough), the link between contributions and benefits would be broken and I fear support for the program would be broken as well. It would become another welfare program, and attacked. When programs are supported through the general fund there is competition for funding, there is never enough money to go around, and it wouldn't be long before the people in power, or with lots of influence over those in power (who don't really need Social Security in most cases) would argue that the money is best used elsewhere.

I am far from the first person to make this point:

Ross Douthat Argues that Social Security Would be Easier to Cut If It Were Changed from a Social Insurance Program to a Welfare Program, by Dean Baker: Ross Douthat argues convincingly that if we eliminated the link between contributions and benefits it would be much easier politically to cut Social Security. Of course he thinks ending the link would be a good idea for that reason, but his logic is certainly on the mark, people will more strongly protect benefits that they feel they have earned. ...
The payroll tax certainly can cover the program's expenses. In fact, had it not been for the upward redistribution of income over the last three decades, which nearly doubled the share of wage income going over the cap on taxable income, the projected 75-year shortfall would be about half of its current level.
Even with the current projected shortfall, if ordinary workers shared in projected productivity growth over the next three decades, a tax increase equal to 6 percent of their wage growth over this period would be sufficient to make the program fully solvent. The problem is clearly the policies that led to the upward redistribution of income..., not Social Security.
It is worth pointing out that when Douthat proposes "means-testing for wealthier beneficiaries," his notion of wealthy means school teachers and firefighters, not Bill Gates and Mitt Romney. ...

Peggy Noonan said today that Republicans will accept tax increases if there is significant entitlement reform. Assuming she can be believed (a rather heroic assumption), and that she speaks for a significant portion of the Republican Party in saying this (which is probably true, so I'm a bit less embarrassed about quoting her), it's clear that Republicans are going to demand cuts to programs like Social Security as a condition of raising taxes.

Democrats need to remember who won the election, and that despite their act to the contrary, the Republicans are not the ones calling the shots at this point. Democrats have considerable leverage, and they need to use it to protect programs their core constituency values highly. Social Security is at the top of the list.

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Posted: 25 Nov 2012 12:06 AM PST

Fed Watch: Stop The Holiday Shopping Media Circus

Posted: 24 Nov 2012 12:30 PM PST

Tim Duy:

Stop The Holiday Shopping Media Circus, by Tim Duy: I feel as if every December I need to mentally prepare myself for the onslaught of inane media coverage of the holiday shopping season. This year, however, we seem to have a few more voices of reason and common sense. Barry Ritholtz, a long-time veteran of the Black Friday Media Wars, sees signs of hope:

Over the years, I have been rather annoyed (perhaps too much) at the annual foolishness over Black Friday forecasts. Each year, we hear breathless predictions of ridiculous increases in consumer spending — holiday shopping rises 16% this season! — which turn out to be wildly over-optimistic, and are never confirmed by the actual data....

....This year, the idea seems to have spread into the mainstream: Lots of coverage about it, with a few choice quotes from you know who tossed in for good measure.

Ritholtz provides a host of links on the subject, but a recent entrant is missing. Neil Irwin at the Washington Post delivers the truth about Black Friday:

Black Friday is here, and if you happen to derive pleasure from streaming around big box stores or mega malls as part of a teeming horde, well, who am I to judge another person's sources of enjoyment.

Let's just not pretend that it means anything...

...sales over Thanksgiving weekend tell us virtually nothing about retail sales for the full holiday season—let alone anything meaningful about the economy as a whole.

So if it is a meaningless event from an economic perspective, what explains the media obsession?

For the media, it is a ready-made story. It takes place at a time that there is little other news, and it is known in advance, so editors and TV news directors can plan in advance for coverage. And there's no doubt that video of people stampeding through the doors of a Wal-Mart in hot pursuit of a new Wii makes for great television. That is even putting aside more cynical possibilities, such as that media depend on retail advertising and thus have a vested interest in creating a sense of hype and anticipation around an orgy of consumerism.

Nothing more than another media manufactured trend. Bookmark the Irwin piece and refer back to it each morning before you get sucked into the inevitable Bloomberg stories detailing the ups and downs of the holiday season. And remember that everyone will be looking for a quick sound bite to leverage off the holiday mania. Sarah Kliff includes one such bite in a piece on the latest Reuters/Michigan Consumer Sentiment numbers:

...the latest round of economic indicators suggest that economic gloom is finally starting to set in with the general public, and the austerity crisis may have something to do with it. The Reuters/University of Michigan Consumer Sentiment Index fell 2.2 points from the preliminary reading early in November to the final reading after the election...They're still more optimistic about the current state of the economy, but consumers have become more pessimistic about what's ahead—a change that IHS Global Insight chalks up to "increased awareness by many Americans of the fiscal cliff."

"If the political rhetoric and finger pointing reaches a fever pitch similar to that of the debt ceiling crisis in the summer of 2011 then consumer confidence is likely to take a very serious hit, and this holiday season will not be very cheerful," the IHS analysis concludes.

Aside from the pointlessness of attempting to gain deep understanding about the economy from a minor blip in the confidence numbers, before you start huddling in the corner for fear of imminent economic collapse, please refer back to last summer's dive in confidence numbers:

While the budget talks did undermine confidence last summer, the impact on spending was essentially nil. I doubt very much that US households will focus much on the fiscal cliff until the new year, choosing instead to focus on holiday parties, egg nog, and gift giving. And if they do give some thought to the cliff, they won't change their spending measurably; they have already set their budgets for the year. That will only happen if going over the fiscal cliff undermines the job market, something that would not be evident until much deeper into 2013. For now, consumer sentiment is only catching back up to where we would expect it to be given the pace of spending. Nothing more, nothing less. For economic trends more relevant to the path of spending, see Neil Irwin's reasons to be thankful this season.

Bottom Line: Black Friday hype - just say no.

Interview with Reinhart and Rogoff

Posted: 24 Nov 2012 11:40 AM PST

Found this interview of Reinhart and Rogoff via Barry Ritholtz (I had to search the title in Google to get past the paywall):

Top Culprit in the Financial Crisis: Human Nature, by Lawrence Strauss: ... What are your thoughts about the steps taken to foster fiscal and monetary policy?

Reinhart: We can always go back and figure out a way in which the fiscal and monetary policy could have been made sharper, to do more. But the thrust in a deep financial crisis, when you throw in both monetary and fiscal stimulus, is to come up with something that helps raise the floor. That's why the decline wasn't 10% or 12%. However, one area where policy really has left a bit to be desired is that both in the U.S. and in Europe, we have embraced forbearance. Delaying debt write-downs and delaying marking to market is not particularly conducive to speeding up deleveraging and recovery. Write-downs are not easy. On the whole, write-offs have been very sluggish.
Rogoff: ... Look at Europe. A lot of policies are directed at keeping European banks afloat, and it is crippling the credit system. You could have said the same about the U.S., where a lot of policies are about recapitalizing the financial system. The policy makers were very, very cautious about breaking eggs. The thinking was, "We just have got to hold out for a year, and it is going to be fine." ...
Is there a regulatory framework that would prevent severe financial crises?
Reinhart: Of course there is. But can we get there?
Rogoff: And stay there?
Reinhart: That's the question. Getting there is one thing, staying there is a different matter. And that's where the memory, or the dissolution of memory, kicks in. This comes out very clearly in our chapter in the book about banking crises. Devastated by what happened in the 1930s, the architects of the Bretton Woods System at the end of World War II, including John Maynard Keynes, were very leery of financial markets. This was an era of financial repression. Trade boomed. Not trade in finance, but trade in goods and services. And this very tight system, with all its distortions and problems, still delivered decade after decade of no systemic crisis. Between 1945 and 1980, it was an unusually quiet period. But then, by the late-1990s, the regulations seemed passé. The financial system found ways of circumventing regulation. It was outmoded. It was discarded, and we started anew.
Rogoff: It's important to channel some financing into safer instruments. If banks were to finance themselves like normal firms by raising a significant share of their lendable capital through issuing equity or retained earnings, we would have much, much safer financial system. So that's a very simple change. ...
Reinhart: You go through history and, in good times, the tendency is to liberalize. Then a crisis happens, and you retrench. But the retrenchment lasts only as long as your memory does, and memory is not that great. Not the memory of the policy makers and not the memory of the markets. So as you start putting time in between where you are now and your last crisis, complacency sets in, and you begin to be more cavalier about what your indicators or warning signals are showing. That's the essence of the this-time-is-different syndrome. The debt ratios are X, but we really don't have to worry about that; the price-earnings ratios are Y, but that's not a concern.
And so, given that this is so grounded in human nature, I'm extremely skeptical that we will overcome financial crises in any definitive way. We may have longer stretches [without a major crisis], as we did after World War II during the era of financial repression, which grew out of the crisis of the early 1930s. Back then, you had a lot more regulation and clamps on risk-taking, both domestically and cross-border. But then we outgrew it. It was passé. Who needed Glass-Steagall? ...

I mostly agree with what they say in the interview, but they are still too hawkish on short-run fiscal policy for my taste. I believe their work and statements in interviews such as this helped to drive the harmful austerity movement in Europe and that should at least bring caution. Reinhart's argument was that yes, immediate austerity makes things worse. But the failure to invoke immediate austerity brings about even bigger problems down the road, so big that the pain now is worth it. She has backed off a bit relative to where she was a few years ago, but as the following quote shows Reinhart will only say "the idea of withdrawing stimulus in what is still a frail environment is not an easy one to tackle" -- notice that she doesn't say it is the wrong policy for a country line the U.S.:

this is not the time to be an inflation hawk. I would rather see the margin of error favor easing too much, rather than too little, for many reasons. The frailty of the recovery is still an issue. The amount of debt that is still out there for households, the financial industry, and the government is still large.
The fiscal side is more complicated, because the idea of withdrawing stimulus in what is still a frail environment is not an easy one to tackle. However, over the longer haul, a comprehensive, credible fiscal consolidation is very much needed, because as much as we allude to the level of public debt, the level of private debt, external debt, and so on are even higher. And we also have a lot of unfunded liabilities in our pension scheme, a long-term issue that needs addressing.

The last statement is annoying. It's health care costs, not unfunded pension liabilities that is the problem for the long-run federal budget. Maybe she has unfunded state and local pension liabilities in mind as well, don't know, but a bit more care when making these kinds of statements would be helpful since this will be interpreted by most as a call for big cuts in Social Security. It was enough to aid and abet the failed austerity movement, do they want to similarly aid and abet the dismantling of Social Security with careless statements such as this?

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Posted: 24 Nov 2012 12:06 AM PST

Fed Watch: Why We Can't Take Inflation Hawks Seriously

Posted: 23 Nov 2012 10:46 AM PST

Tim Duy:

Why We Can't Take Inflation Hawks Seriously. by Tim Duy: Peter Coy at Bloomberg reports on the Shadow Open Market Committee. Not surprisingly, the SOMC fears an outbreak of inflation is just around the corner.

Conservative economists are paying attention to the man behind the curtain and not liking what they see. At a meeting in a Manhattan hotel on Nov. 20, the so-called Shadow Open Market Committee criticized Federal Reserve Chairman Ben Bernanke for an ultra-easy monetary policy that will, in their opinion, lead ultimately to dangerously higher inflation.

It is almost comical that those who profess to be experts on monetary policy appear to almost never listen to what Federal Reserve officials say. Case in point:

Marvin Goodfriend, an economist at Carnegie Mellon University, said the Federal Reserve "appears to be walking away" from a commitment it made last January to keep the inflation rate at or near 2 percent. In September, when it announced a new round of bond buying to bring down unemployment, the Fed made no mention of the 2 percent target, merely saying it would pursue its growth target "in a context of price stability."

Made no mention of the 2 percent target? Really? Let's go to the tape:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.

I think they were pretty clear about the 2 percent target, which is the Fed's definition of price stability. If Goodfriend can't remember this, he should bookmark the appropriate page on the Board's website:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.

The only way this isn't clear is if you are deliberately ignoring what the Fed is saying. The SOMC also fears any policy that allows inflation to drift even temporarily above 2 percent:

Jeffrey Lacker, the hawkish president of the Federal Reserve Bank of Richmond, was the Shadow Open Market Committee's invited keynote speaker. He shared the committee members' concerns about letting inflation drift much above the 2 percent target in the name of growth, even for a short while.

"At the very least, the precedent set by an opportunistic attempt to raise inflation temporarily is likely to cloud our credibility for decades to come," Lacker said.

First, actual inflation outcomes would be expected to fall in a symmetric pattern around 2 percent. When Lacker argues against allowing even a temporary drift above 2 percent, he is effectively saying that 2 percent is a ceiling, not a target, so that on average, inflation will be less than 2 percent over time (all the errors would be on the low side of the target). Thus, he is actually trying to enforce a price stability standard stricter than the current standard. Second, this whole discussion is something of a strawman to begin with. Realistically, only Chicago Federal Reserve Chairman Charles Evans supports any meaningful drift over 2 percent. Even Minneapolis Federal Reserve President Narayana Kocherlakota, much lauded for his move to the dovish side of the FOMC, sets an upward bound of just 2.25 percent before the Fed should consider a policy shift. And Federal Reserve Vice Chair Janet Yellen, also a well-noted dove, describes an optimal path for policy that foresees inflation just barely kissing 2.25 percent at best. In short, within the Fed there is very little support for any inflation drift that would "cloud our credibility for decades to come." This is simply a nonsensical fear on Lacker's part.

Next, we have the argument that we will never see inflation coming because of the Fed's large scale asset purchase program:

Mickey Levy, chief economist for Bank of America and an SOMC member, said that the Fed "has neutralized the bond vigilantes" by keeping rates low. In other words, even if bond traders are worried that inflation will heat up, they don't dare bet that way by driving interest rates higher, because the Fed will swat them away by pushing rates back down. "The adage 'Don't fight the Fed'? It's in full force," Levy said.

Do people forget that both the BLS and the BEA publish monthly reports on prices? That the Fed would not incorporate this data into their decision making process? That the Fed can control inflation expectations as measured by the TIPS market, the very same expectations the Fed uses as a policy guide?

There will still be plenty of data and market indicators even within the context of bond purchases. Here is my expected sequence of events: If growth or inflation accelerates to the point that the Fed will be expected to change policy, bond market participants will bid down the price of Treasuries holding constant a given pace of asset purchases (that "all else equal" thing). The Fed will then have a choice - either prepare to tighten as the market expects, or accelerate the pace of asset purchases to hold rates down. If they choose the second route, the bond sell-off will accelerate as participants begin to suspect the Fed is not committed to the 2 percent target. That would be the signal the Fed is clearly moving in the wrong direction. And you should expect inflation to move higher. In other words, the Fed's bond purchase program does not by itself eliminate inflation signals should such signals emerge. The bond vigilantes have not been neutralized by the Fed; they have been neutralized by reality.

Finally, back to the 2 percent target:

The Shadow Open Market Committee meeting wrapped up just before Bernanke spoke a few blocks away at a meeting of the Economic Club of New York. Harvard University economist Martin Feldstein, who attended the SOMC symposium, was given the privilege of asking Bernanke questions at the Economic Club luncheon. He did not choose to ask the chairman whether the Fed was walking away from its 2 percent inflation target.

Right after the luncheon, though, Bloomberg TV's Mark Crumpton asked Feldstein, who was President Ronald Reagan's chief economic adviser, if he was concerned that the Fed hadn't been talking about the 2 percent target lately. "Absolutely," Feldstein said. "It's very important for the Fed to reaffirm those goals."

Notice that Feldstein claims the Fed is not discussing the target moments after Bernanke spoke. But what did Bernanke actually say? To the tape:

But with longer-term inflation expectations remaining stable, the ebbs and flows in commodity prices have had only transitory effects on inflation. Indeed, since the recovery began about three years ago, consumer price inflation, as measured by the personal consumption expenditures (PCE) price index, has averaged almost exactly 2 percent, which is the FOMC's longer-run objective for inflation. Because ongoing slack in labor and product markets should continue to restrain wage and price increases, and with the public's inflation expectations continuing to be well anchored, inflation over the next few years is likely to remain close to or a little below the Committee's objective.

How has the Fed not been talking about the 2 percent target? They repeatedly emphasize the target. Bernanke does so virtually every time he speaks. Cleveland Federal Reserve President Sandra Pianalto basically says the 2 percent target is so concrete that there should no longer be a distinction between hawks and doves. How can Feldstein sit through Bernanke's speech and completely miss the part that addresses Feldstein's concerns? How can he not say "the Fed talks about 2 percent every chance they get"? The only explanation: He simply does not want to recognize any information that departs from his pre-conceived view of the world.

Bottom Line: Inflation hawks continue to operate in a parallel universe.

'Imagine Economists had Warned of a Financial Crisis'

Posted: 23 Nov 2012 10:21 AM PST

Chris Dillow:

... Imagine economists had widely and credibly warned of a financial crisis in the mid-00s. People would have responded to such warnings by lending less and borrowing less (I'm ignoring agency problems here). But this would have resulted in less gearing and so no crisis. There would now be a crisis in economics as everyone wondered why the disaster we predicted never happened. ...
His main point, however, revolves around Keynes' statement that "If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid":
I suspect there's another reason why economics is thought to be in crisis. It's because, as Coase says, (some? many?) economists lost sight of ordinary life and people, preferring to be policy advisors, theorists or - worst of all - forecasters.

In doing this, many stopped even trying to pursue Keynes' goal. What sort of reputation would dentists have if they stopped dealing with people's teeth and preferred to give the government advice on dental policy, tried to forecast the prevalence of tooth decay or called for new ways of conceptualizing mouths?

Perhaps, then, the problem with economists is that they failed to consider what function the profession can reasonably serve.