Monday, December 21, 2009

ANNOUNCEMENT: The final is now a take-home exam.


Since it is still unclear when the final will be rescheduled and I would rather avoid the complications associated with rescheduling a test over winter break I am just going to give you guys a take home assignment:

It is due on Wednesday Dec 30th. The Word document is HERE

Important details:

1. This must be in my mail box in the Economics Department or emailed to me at by NOON on Wednesday December 30th. Any emails time stamped after 12:00pm on Wednesday or not in my mail box when I pick it up on Wednesday will not be graded.

2. If you email the test to me the test must be sent to me as a SINGLE attachment with NUMBERED pages. Tests submitted as multiple files or without number pages will be marked down a full letter grade. Finals submitted in person will also be marked down one full letter grade if they are not stapled.

3. Because this is a take home test the questions do not all come from the homework questions. The final is to test your understanding of the material, not your ability to copy the answers from the textbook. I am testing the same basic stuff but the examples are different than those in the homework assignments and those gone over in class.

4. Complete answers will need a clear, coherent and concise written explanation. It will be obvious if a question also needs a clearly and completely labeled graph or a clearly labeled balance sheet. Because this is a take home test and you have the time to be precise I am going to take of significant points for graphs that are not completely labeled.

Sunday, December 20, 2009

The final has been postponed.

Queens College is closed tomorrow. The final will not be held tomorrow. I will post information about when the final will be held as soon as I find out.

Wednesday, December 16, 2009

Why is there always a Burger King next to a McDonald's?

So the good people who brought you those two "This American Life" pod casts about the economy recently had a show that reminded me of on of my favorite ideas in economics. All of you are just looking at the blog to get information for the final but reading this blog post is a great way to procrastinate.

The show is from the podcast Planet Money: Episode 128, "Friend of Foe". It's easily found on ITunes.

Okay, so, we start out on a beach with two hot dog venders. They can be hot dog venders, gold merchants or Indian food restaurants. Basically the assumption here is perfect competition. That is, these hot dog venders sell the same product for the same price. That means that consumers (beach goers) are indifferent between buying goods from both hot dog venders. The reason they sell hot dogs on the beach is because the idea is easier to illustrate in two dimensions.
Now originally the two hot dog venders decide to divide up the beach equally. Assume that I have basic graphic design skills and that the blue and the red squares are the same size. By the way, those dots are the hot dog venders.

After standing on the beach for 8 hours a day 7 days a week Vender A realizes something:

If Vender A stands just to the left of Vender B a lot more customers—who only really care about how far they have to walk to get a hot dog—are closer to him than they are to Vender B.

Naturally Vender B catches on pretty quickly

Now Vender B has the bigger market share.

To save myself more embarrassing illustrations I’m going to just say that it should be clear that there is only one place on the beach where the two hot dog venders finally stop pushing their carts all over the beach:

Here they are both right next to each other. There is no reason for either vender to move further left or right since that means they will lose market share to the other vender. Basically they have the same market share they would have had if they had just agreed on the intuitively equal division of the beach and they would have saved themselves a lot of pushing their carts around.

And so you have it, it is economically rational for the always to be a Burger King next to a McDonald's.

Monday, November 9, 2009

Health insurance costs and stagnating wages.

I had mentioned in class that the real cost of employees to employers had increased by 25% during this decade and all of that increase was in health insurance costs. I tracked down who said it and where the numbers came from. It came from conservative talking head/former member of the Bush administration David Frum.

Below are two articles that sum up his point. I had originally heard this on "This American Life" which also makes the point that the cost of labor increased by about the same amount during the Clinton years but that was actual income increases.

(From A Blue View) David Frum: The GOP Needs To Understand Bush's Economic Record Was So Poor Because Exploding Health Care Costs Stole All The Wage Gains"

I might add to David Frum's surprising commentary on NPR's Marketplace that the Democrats need to remember this too (listen):

DAVID FRUM: Last week, the Census bureau delivered its report on American incomes in 2008. We can put this report together with the seven previous to reach a final verdict on the economic record of President George W. Bush. It's not good.

In terms of income growth and poverty reduction, Bush performed worse than any two-term president of the modern era. Even in the best year of his presidency, 2007, the typical American household still earned less after inflation than in the year 2000. The next year, 2008, American households suffered the worst income drop since record-keeping began six decades ago.

In my Republican party, there is worryingly little discussion of this damning trend. We do criticize ourselves for over-spending in office. But economic management gets much less, almost zero, internal discussion.

So, what went wrong? Liberals criticize the Bush tax cuts, but it's impossible to see any causation between lower taxes and the failure of incomes to gain ground. All three of the previous major tax cuts in U.S. history -- in the 1920s, 1960s, and 1980s -- were followed by very strong income growth.

The more plausible culprit is the surge in health care costs. Over the years from 2000 to 2007, the price employers paid for labor rose handsomely: on average, 25 percent. Yet for the typical worker, none of that extra cost translated into higher wages.

Between 2000 and 2007, the cost of the average health insurance policy for a family of four doubled, from about $6,000 to over $12,000. That took a big bite out of the gains available for wage increases. More than a bite: the health-care system gulped down every morsel, and forced employers to raise co-pays and deductibles for good measure.

Conservatives and Republicans need to keep this history in mind and remember that when we are debating health-care costs, we are also debating wages, incomes, and by the way, explaining the true reasons for the disappointing economic record of the Bush years.

The Bush Economic Record – Blame Healthcare
September 15th, 2009 at 1:44 pm by David Frum

Ron Brownstein ably sums up the Census Bureau’s final report on the Bush economy.

Bottom line: not good.

On every major measurement, the Census Bureau report shows that the country lost ground during Bush’s two terms. While Bush was in office, the median household income declined, poverty increased, childhood poverty increased even more, and the number of Americans without health insurance spiked.

What went wrong?

In a word: healthcare.

Over the years from 2000 to 2007, the price that employers paid for labor rose by an average of 25% per hour. But the wages received by workers were worth less in 2007 than seven years before. All that extra money paid by employers disappeared into the healthcare system: between 2000 and 2007, the cost of the average insurance policy for a family of four doubled.

Exploding health costs vacuumed up worker incomes. Frustrated workers began telling pollsters the country was on the “wrong track” as early as 2004 – the year that George W. Bush won re-election by the narrowest margin of any re-elected president in U.S. history.

Slowing the growth of health costs is essential to raising wages – and by the way restoring Americans’ faith in the fairness of a free-market economy.

Explaining the impact of health costs on wages is essential to protecting the economic reputation of the last Republican administration and Congress.

If Republicans stick to the line that the US healthcare system works well as is – that it has no important problems that cannot be solved by tort reform – then George W. Bush and the Congresses of 2001-2007 will join Jimmy Carter and Herbert Hoover in the American memory’s hall of economic failures. Recovery from that stigma will demand more than a tea party.

Sunday, November 1, 2009

Business Insider: CHART OF THE DAY: Cash-For-Clunkers MASSIVELY Distorted GDP

CHART OF THE DAY: Cash-For-Clunkers MASSIVELY Distorted GDP

CHART OF THE DAY: Cash-For-Clunkers MASSIVELY Distorted GDP
Vincent Fernando|Oct. 29, 2009, 2:13 PM | 15,653 |comment47

If anyone mentions the just-released 3.5% U.S. third quarter GDP growth, just throw this chart in their face. Cash for Clunkers clearly distorted the U.S. economic figures in an unsustainable fashion.

According to the Bureau of Economic Analysis (BEA), motor vehicle output spiked a seasonally-adjusted 157.6% quarter on quarter. This is completely unprecedented. Vehicle output is clearly going off a cliff next quarter. The question will be how low can the blue line below go.

Next quarter, we won't just be returning to business as usual for auto output. Don't forget that Cash for Clunkers pulled future auto demand, ie. some of Q4 demand, into Q3. Thus Q4 is likely to be very weak since many people who planned to buy a car in Q4 probably took advantage of Clunkers and bought in Q3.

To put this into GDP terms, according to the BEA the spike you see below added 1.66% to the U.S. GDP growth figure reported. Thus without it, GDP growth would have been only 1.89% (3.5% - 1.66%) in Q3.

Now imagine if next quarter the blue line below goes down into negative territory as it did just two quarters ago. Next quarter, not only are we unlikely to get Q3's boost, but motor vehicle output data could subtract from GDP as well. So watch out for the cliff...

Thursday, October 29, 2009

Q3 GDP +3.5% breakdown

Figure 1. Source:

Hallelujah? The consumer has come back with a bang? It kind of seems that way. However, all components of GDP are up. Even the "decline" in net exports can be read as a good sign since it's driven by the fact that imports have increased faster than exports which have increased for the first time in a year. However, proportionately inventory and residential investment--yeah, thats right, housing went positive--did a lot of heavy lifting.

Consumption, which is almost 71% of GDP contributed roughly proportionally to the increase in GDP. Investment as a whole which has fallen to just about 11% of GDP gave us almost 35% of third quarter growth.

Last quarter government spending played a big role in softening the recession. it seems to have contributed relatively little in Q3.

A closer look at the different components of GDP

Figure 2. Source:

I wish there was more to report here. The one thing I'm interested in is what cash-for-clunkers did. According to the BEA press release auto sales added 1.66 of the 3.5% (about 40%). Of the $44 billion increase in durable goods consumption $40 billion of it was auto (and auto parts). However, it should be noted that imported autos, engines and parts amounted to $43 billion dollars. I'm not entirely sure what that says about the stimulus effects of cash-for-clunkers. Did it stimulate the US auto industry or that Japanese auto industry? The only thing that can be said for certain is that almost the entire increase in sales of durable goods was from the sale of autos.

Figure 3. Source:

Obviously the big news in investment is the increase in residential housing construction. Residential investment has been falling since 2006Q1. How it is possible that it is growing is beyond me, but I suppose it is good if not weak news. A regional breakdown of where construction activity is taking place would be interesting.

The other thing worth talking about is the "change in inventories". It should be pointed out what what is being shown in the graph is "the change in the change in inventories". They are still allowing their inventories to sell off but at a slower rate. It is important to note that in 2009Q2 inventories were $176 billion less than they were in 2009Q1. In 2009Q3 inventories were $147 less than in 2009Q3. Essentially, the inventory liquidation is slowing down a little bit which implies an increase in production.

Figure 4 Source:

I'm putting up this graph to make it clear what exactly it is that is measured by GDP. GDP measures final goods and services bought and sold by consumers, firms and the government. What we want from GDP is an estimate of the production (and income) of the country over the quarter (or year). GDP accounting is also referred to as NIPA (National Income and Product Accounting). There are two "leaks" out of this system, imports and exports that need to be accounted for if we are to get a proper estimate of production and income. Since no one in the US buys exports we need to adjust for the extra income (and production) created by exports when they are sold abroad. We also need to account for imports, which are final goods and services that American consumers, firms and governments buy but are not produced in this country and do not produce income for Americans.

I just want to point out this is neither "good" nor "bad" from a NIPA perspective. It is just an adjustment that needs to be made for an accurate calculation of GDP. That calculation is already done for the overall GDP estimates in Figure 1, but the individual categories are not adjusted for what comes from imports.

Anyway, Exports - Imports = Net Exports. There are a couple of things worth highlighting. First, in 2008iv andd 2009i on balance it would look like we had an increase in net exports. It is important to notice that exports to the rest of the world were falling from previous periods, its just that what we imported from abroad fell by a much larger amount. While for 2009iii we had negative net exports but we had positive exports for the first time in a year. Those exports were income for Americans. However, we also increased our imports for the first time in a year.

That $117 billion in imports has to be taken out of the estimates of consumption, investment and government spending. As far as I can tell, we increased petroleum imports by $15 billion. As well, we imported about $18 billion in capital goods and as I mentioned above we also imported about $43 billion dollars in automobile supplies. The rest of the increase in imports is spread out over other categories of goods and services.

Figure 5. Source:

The interesting thing about the change in government spending is that it is half of what it was in the second quarter. That seems to suggest that the stimulus attempt has waned considerably. Although Federal spending is growing at a constant rate state and local spending increased by a tiny $2.6 billion dollars. Given the financial problems facing many state and my hunch that most of the stimulus spending should be showing up as state spending after the federal government transfers them the money it is almost kind of shocking to see the growth of state and local spending so low.

It should be noted though that the cash-for-clunkers program counts as stimulus spending though it wouldn't really show up as government spending.

Thursday, October 15, 2009

Bloomberg: U.S. Foreclosure Filings Jump 23% to Record in Third Quarter nnnn

U.S. Foreclosure Filings Jump 23% to Record in Third Quarter

By Dan Levy

Oct. 15 (Bloomberg) -- U.S. foreclosure filings climbed to a record in the third quarter as lenders seized more properties from delinquent borrowers, according to RealtyTrac Inc.

A total of 937,840 homes received a default or auction notice or were repossessed by banks, a 23 percent increase from a year earlier, the Irvine, California-based seller of default data said today in a report. One out of every 136 U.S. households received a filing, the highest quarterly rate in records dating to January 2005.

“The problem is prime loans going into foreclosure and people being underwater and losing their jobs,” Richard Green, director of the Lusk Center for Real Estate at the University of Southern California in Los Angeles, said in an interview. “It’s a really bad number.”

Mounting foreclosures mean U.S. home prices probably will resume falling, analysts from Amherst Securities Group LP in New York said Sept. 23. A “shadow inventory” of 7 million properties are in the foreclosure process or likely to be seized, up from 1.27 million in 2005, they said.

The pace of prime and so-called alt-A loan defaults is accelerating as subprime defaults slow, Standard & Poor’s analysts led by Diane Westerback said yesterday in a report. Prime loans are those made to borrowers with the best credit records while alt-A loans are considered riskier because they were often granted without documenting the borrower’s income.

Securities Losses

More than $400 billion in U.S. home mortgages that were packaged into securities and sold by companies other than government-supported Fannie Mae and Freddie Mac are in default and may be foreclosed on, S&P said. Those defaults may depress home prices for years, the analysts said.

The delinquency rate for prime loans rose to 6.41 percent in the second quarter from 6.06 percent, the Washington-based Mortgage Bankers Association said Aug. 20. The share of prime loans in foreclosure increased to 3 percent from 2.49 percent, the MBA said.

“The number of people who can’t pay their mortgages, we haven’t seen the peak of that,” David Lowman, head of JPMorgan Chase & Co.’s mortgage unit, said this week. “That’s going to weigh on us for some time to come.”

Home foreclosures will climb through late 2010, peaking after the unemployment rate reaches 10.2 percent in the second quarter, the mortgage bankers said in an Oct. 13 forecast.

RealtyTrac reported that 343,638 properties received foreclosure filings in September alone, the third-highest monthly total behind July and August of this year. The September number fell 4 percent from the previous month, though it climbed 29 percent from a year earlier.

Few Exceptions

Bank seizures rose 21 percent from the previous quarter and increased in every state except two and the District of Columbia, RealtyTrac said.

Nevada had the highest foreclosure rate: one in every 23 households, or almost six times the national average. A total of 47,925 Nevada homes got filings, up 10 percent from the previous quarter and 59 percent from a year earlier, RealtyTrac said.

In both Arizona and California, one in 53 households received filings. They were followed by Florida, at one in 56, and Idaho, at one in 97. Utah, Georgia, Michigan, Colorado and Illinois rounded out the top 10 highest rates.

New Jersey had the 15th highest rate. Connecticut was 25th and New York was 39th.

Six states accounted for more than 60 percent of total filings in the U.S., led by California’s 250,054. Filings in the most populous state rose 19 percent from the third quarter of 2008. Bank seizures jumped 12 percent from the previous quarter.

Florida Repossessions

Florida had the next highest total, with 156,924 filings, up 23 percent from a year earlier. Bank seizures rose 16 percent from the previous quarter.

Arizona had 50,342 filings, up 25 percent from the same period a year earlier. Nevada had 47,925, up 59 percent. Illinois had 37,270, a gain of 30 percent; and Michigan had 37,026, an increase of 22 percent.

Georgia, Texas, Ohio and New Jersey rounded out the top 10 states with the most filings, RealtyTrac said.

The company collects data from more than 2,200 counties representing 90 percent of the U.S. population.

Sunday, October 11, 2009

Federal Reserve Bank of Cleveland: The Yield Curve, December 2008

I've posted the article here without graphs, click on the link below for the complete article

The Yield Curve, December 2008

The Yield Curve, December 2008
Joseph G. Haubrich and Kent Cherny

In the midst of the horrendous economic news of the last month, the yield curve might provide a slice of optimism. Though the yield curve has flattened since November, with long rates falling more than short rates, the difference between the rates remained strongly positive.

This difference, the slope of the yield curve, has achieved some notoriety as a simple forecaster of economic growth. The rule of thumb is that an inverted yield curve (short rates above long rates) indicates a recession in about a year. Yield curve inversions have preceded each of the last seven recessions (as defined by the NBER), the current recession being a case in point. The yield curve inverted in August 2006, a bit more than a year before the recession started in December 2007. Two notable false positives include an inversion in late 1966 and a very flat curve in late 1998. More generally, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth. One measure of slope, the spread between 10-year Treasury bonds and 3-month Treasury bills, bears out this relation, particularly when real GDP growth is lagged a year to line up growth with the spread that predicts it.

The financial crisis showed up in the yield curve, with rates falling since last month as investors fled to quality. The 3-month rate dropped from an already tiny 0.07 percent down to a miniscule 0.02 percent (for the week ending December 12), the lowest level since the Treasury constant maturity series started in 1982.

The 10-year rate dropped from 3.38 percent to 2.67 percent. Consequently, the slope decreased by 66 basis points to 265 basis points, down from November’s 331, and October’s 360. The flight to quality and the turmoil in the financial markets may affect the reliability of the yield curve as an indicator, but projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 3.0 percent rate over the next year. This remains on the high side of other forecasts, many of which are predicting reductions in real GDP.

While such an approach predicts when growth is above or below average, it does not do so well in predicting the actual number, especially in the case of recessions. Thus, it is sometimes preferable to focus on using the yield curve to predict a discrete event: whether or not the economy is in recession. Looking at that relationship, the expected chance of the economy being in a recession next December stands at a low 0.5 percent, up a bit from November’s miniscule 0.05 percent.

Loyal readers may note the chart above looks a bit different this month; with the NBER declaring a recession, the model now has additional recession points to work with.

The probability of recession coming out of the yield curve is very low and may seem strange in the midst of recent financial news, but one aspect of those concerns has been a flight to quality, which lowers Treasury yields. Furthermore, both the federal funds target rate and the discount rate have remained low, which tends to result in a steep yield curve. Remember also that the forecast is for where the economy will be next December, not earlier in the year. Again, though, in the spring of 2007, the yield curve was predicting a 40 percent chance of a recession in 2008, something that looked out of step with other forecasters at the time.

To compare the 0.5 percent to some other probabilities, and learn more about different techniques of predicting recessions, head on over to the Econbrowser blog.

Of course, it might not be advisable to take this number quite so literally, for two reasons. First, this probability is itself subject to error, as is the case with all statistical estimates. Second, other researchers have postulated that the underlying determinants of the yield spread today are materially different from the determinants that generated yield spreads during prior decades. Differences could arise from changes in international capital flows and inflation expectations, for example. The bottom line is that yield curves contain important information for business cycle analysis, but, like other indicators, should be interpreted with caution.

For more detail on these and other issues related to using the yield curve to predict recessions, see the Commentary, “Does the Yield Curve Signal Recession? ”

Thursday, October 1, 2009

Brad DeLong: Economic History and Modern Macro: What Happened?

Economic History and Modern Macro: What Happened?

Economic History and the Recession

If you ask a modern economic historian—like, say, me—if I know why the world is currently in the grips of a financial crisis and a deep downturn, I will say that I do know and I will give you this answer:

This is the latest episode in a long history of similar episodes of bubble—crash—crisis—recession, episodes that date back at least to the canal bubble of the early 1820s, the 1825-6 failure of Pole, Thornton, and company, and the subsequent first industrial recession in Britain. We have seen this process at work in many other historical episodes as well—1870, 1890, 1929, and 2000, for example. For some reason asset prices get way out of whack and rise to unsustainable levels. Sometimes the culprit is lousy internal controls in financial firms that overreward subordinates for taking risk; sometimes it is government guarantees; sometimes it is the selection of the market as a long run of good fortune leaves the financial market dominated by cockeyed unrealistic overoptimists.

Then the crash comes. And when the crash comes the risk tolerance of the market collapses: everybody knows that there are immense unrealized losses in financial assets and nobody is sure that they know where they are. The crash is followed by a flight to safety. The flight to safety is followed by a steep fall in the velocity of money as investors everywhere hoard cash. And the fall in monetary velocity brings on a recession.

I will not say that this is the pattern of all recessions: it isn’t. But I will say that this is the pattern of this recessions—that we have been here before.

Macroeconomic Theory and the Recession

If you ask the same question of a modern macroeconomist—like, say, the extremely sharp Narayana Kocherlakota of the University of Minnesota—you will find that he says that he does not know:

Why do we have business cycles? Why do asset prices move around so much?... [M]acroeconomics has little to offer by way of answer to these questions...

He will say that there are models that attribute economic downturns to various causes:

[M]ost models in macroeconomics rely on some form of large quarterly movements in the technological frontier. Some have collective shocks to the marginal utility of leisure. Other models have large quarterly shocks to the depreciation rate in the capital stock (in order to generate high asset price volatilities)...

That is, downturns are either the result of a great forgetting of technological and organizational knowledge, a great vacation as workers develop a sudden extra taste for leisure, or a great rusting as the speed with which oxygen in the air corrodes speeds up and so reduces the value of large things made out of metal.

But he will say that all these strike him as implausible just-so stories that do not illuminate: not to be taken seriously:

The sources of disturbances in macroeconomic models are (to my taste) patently unrealistic.... None of these disturbances seem compelling, to put it mildly...

And so nobody really believes them:

Macroeconomists use them only as convenient short-cuts to generate the requisite levels of volatility in endogenous variables...

Just What Is Going on Here?

This leads me to ask two questions:

First, it does not seem to me that it is the case that nobody really believes these just-so stories. Ed Prescott of Arizona State University really does believe that large-scale recessions are caused by economy-wide episodes of the forgetting of the technological and organizational knowledge that underpins total factor productivity—with the exception of episodes like the Great Depression, which Prescott says was caused by the extraordinary pro-labor pro-union policies of Herbert Hoover that pushed real wages far above equilibrium values. Casey Mulligan of the University of Chicago really does appear to believe that large falls in the employment-to- population ratio are best seen as “great vacations”—and as the side-effects of destructive government policies like those in place today, which are leading workers to quit their jobs so they can get higher government subsidies to refinance their mortgages. (I know; I find it incredible too.) Things that strike Kocherlakota as “patently unrealistic” are not viewed as such by many of his modern macroeconomic peers and colleagues. Why not? Why do they find these just-so stories satisfactory?

Second, whether modern macroeconomics attributes our current difficulties either to causes that I agree with Kocherlakota are “patently unrealistic” or simply confesses ignorance, why do they have such a different view than we economic historians do? Whether they have rejected our interpretations and understandings or simply have built up or failed to build up their own in ignorance of what we have done, why have they not taken and used our work?

The second question is particularly disturbing to me. There is, after all, no place for economic theory of any flavor to come from than from economic history. Someone observes some instructive case or some anecdotal or empirical regularity, says “this is interesting; let's build a model of this,” and economic theory is off and running. Theory is crystalized history—it can be nothing more. After the initial crystalization it does develop on its own according to its own intellectual imperatives and processes, true, but the seed is still there. What happened to the seed?

This situation is personally and professionally dismaying. I do not say that the macroeconomic model-building of the past generation has been pointless. I don’t think that it has been pointless. But I do think that the assembled modern macroeconomists need to be rounded up, on pain of loss of tenure, and sent to a year-long boot camp with the assembled monetary historians of the world as their drill sergeants. They need to listen to and learn from Dick Sylla about Cornelius Buller’s bank rescue of 1825 and Charlie Calomiris about the Overend, Gurney crisis and Michael Bordo about the first bankruptcy of Baring brothers and Barry Eichengreen and Christy Romer and Ben Bernanke about the Great Depression.

If modern macreconomics does not reconnect—if they do not realize just what their theories are crystallized out of, and what the point of the enterprise is—then they will indeed wither and die.

Financial Times Blog: Why the Lehman failure did change everythin

Why the Lehman failure did change everything
September 21, 2009 5:28pm
by FT

By Richard Robb

For anyone who was engaged in the financial markets during the week of September 15, 2008, Lehman changed everything. It was obvious. So what could be more tempting to finance professors than to overturn this conventional wisdom? Descartes described the man of letters who takes more pride in his speculations “the more they are removed from common sense,” and so showing that the Lehman collapse was inconsequential has spawned a minor literature.
The latest contribution by John Cochrane and Luigi Zingales, like others before them, rests partly on misunderstanding of the data. The authors deduce that Lehman wasn’t the main cause of last autumn’s turmoil by inspecting the daily movements in the spread between Overnight Interest Rate Swaps and three-month Libor, which they define as “the rate at which banks can borrow unsecured for three months.”

But a better definition of Libor under the circumstances was “the rate at which banks said they can borrow”. Libor is the result of a survey, not a measure of actual transactions. In the week of September 15 last year, big banks refused to settle foreign exchange with each other. They were not lending interbank for three month terms, so Libor during that week tells us little.

We could say the same thing for OIS. Volume was light to nonexistent in the week of September 15 last year. What we do know is that three-month T-bills traded at 0.04 per cent on September 17, down from 1.47 per cent on Friday September 12. These are real data that ought to impress the professors that the market was breaking down as fast as it knows how.

John Taylor, the father of the Lehman-was-no-big-deal thesis, wrote in a Wall Street Journal op-ed last year that spreads between T-bills and Libor “remained in that range [of the previous year] through the rest of the week” after Lehman’s demise. In fact, in the year prior to Lehman’s collapse, the peak spread was 2.05 per cent; on September 17, 2009 it reached 3.00 per cent. (Of course, any conclusions based on Libor that week are equally unreliable.)

The other principal mistake of the Lehman deniers is their assumption that the incident unfolded entirely on September 15, 2008 and any effect had to be observable by that morning. But during the final two weeks of September, the market still had to absorb the news that the Securities and Exchange Commission had no plan for an orderly transfer of client assets in the US, while Lehman Brothers International Europe would be handed over to an administration process designed for liquidating grocery stores.

Getting the story right on Lehman matters for two reasons. The first is that, if we convince ourselves that no damage results when the government plants the belief that it will rescue a huge financial firm, and then suddenly lets it fail, it is more likely this will happen again.

The second reason is the Lehman estate itself. Lehman affiliates are locked in legal combat across borders with no obvious way for existing laws to resolve the problem for many years to come. For example, at the time of its administration, Lehman Brothers International Europe had about $26bn of client securities deposited. So far, $13bn has been returned, but almost all of this was from Chinalco’s stake in Rio Tinto.

There is plenty of room to debate the larger counterfactual: if the government had never bailed out Bear Stearns and other too-big-to-fail firms that followed, would Lehman have mattered? If the government had never bailed out anyone at all, would we be better off? But given the bailouts that preceded the Lehman failure, the Lehman failure did in fact change everything. Sometimes things that are obvious turn out to be true.

Richard Robb is chief executive of Christofferson, Robb & Co., the investment management firm, and professor of professional practice at Columbia’s School of International and Public Affairs.

Thursday, September 17, 2009

Paul Krugman (NY Times Magazine): How Did Economists Get It So Wrong?

How Did Economists Get It So Wrong?

It’s hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Those successes — or so they believed — were both theoretical and practical, leading to a golden era for the profession. On the theoretical side, they thought that they had resolved their internal disputes. Thus, in a 2008 paper titled “The State of Macro” (that is, macroeconomics, the study of big-picture issues like recessions), Olivier Blanchard of M.I.T., now the chief economist at the International Monetary Fund, declared that “the state of macro is good.” The battles of yesteryear, he said, were over, and there had been a “broad convergence of vision.” And in the real world, economists believed they had things under control: the “central problem of depression-prevention has been solved,” declared Robert Lucas of the University of Chicago in his 2003 presidential address to the American Economic Association. In 2004, Ben Bernanke, a former Princeton professor who is now the chairman of the Federal Reserve Board, celebrated the Great Moderation in economic performance over the previous two decades, which he attributed in part to improved economic policy making.

Last year, everything came apart.

Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.

And in the wake of the crisis, the fault lines in the economics profession have yawned wider than ever. Lucas says the Obama administration’s stimulus plans are “schlock economics,” and his Chicago colleague John Cochrane says they’re based on discredited “fairy tales.” In response, Brad DeLong of the University of California, Berkeley, writes of the “intellectual collapse” of the Chicago School, and I myself have written that comments from Chicago economists are the product of a Dark Age of macroeconomics in which hard-won knowledge has been forgotten.

What happened to the economics profession? And where does it go from here?

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

It’s much harder to say where the economics profession goes from here. But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic “theory of everything” is a long way off. In practical terms, this will translate into more cautious policy advice — and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems.


The birth of economics as a discipline is usually credited to Adam Smith, who published “The Wealth of Nations” in 1776. Over the next 160 years an extensive body of economic theory was developed, whose central message was: Trust the market. Yes, economists admitted that there were cases in which markets might fail, of which the most important was the case of “externalities” — costs that people impose on others without paying the price, like traffic congestion or pollution. But the basic presumption of “neoclassical” economics (named after the late-19th-century theorists who elaborated on the concepts of their “classical” predecessors) was that we should have faith in the market system.

This faith was, however, shattered by the Great Depression. Actually, even in the face of total collapse some economists insisted that whatever happens in a market economy must be right: “Depressions are not simply evils,” declared Joseph Schumpeter in 1934 — 1934! They are, he added, “forms of something which has to be done.” But many, and eventually most, economists turned to the insights of John Maynard Keynes for both an explanation of what had happened and a solution to future depressions.

Keynes did not, despite what you may have heard, want the government to run the economy. He described his analysis in his 1936 masterwork, “The General Theory of Employment, Interest and Money,” as “moderately conservative in its implications.” He wanted to fix capitalism, not replace it. But he did challenge the notion that free-market economies can function without a minder, expressing particular contempt for financial markets, which he viewed as being dominated by short-term speculation with little regard for fundamentals. And he called for active government intervention — printing more money and, if necessary, spending heavily on public works — to fight unemployment during slumps.

continue (its quite a long article)

John Quiggin: The Macro Wars

The macro wars
September 17th, 2009

Paul Krugman’s piece on “Why did economists get it so wrong” has attracted a vitriolic response from John Cochrane, reproduced here. Krugman’s piece was strongly worded, but the reply ups the ante, and I expect further escalation. Economics conferences in the next few years are going to be interesting events.

Given that, as Krugman himself notes, disagreements between economists were notably mild until the crisis erupted, what is going on here?

I’m visiting Berkely at present and just had a chat with Brad DeLong. These are some of the thoughts I had about the great macroeconomics wars as a result.

One important element that can’t be ignored is the effect political partisanship, which is much more bitter in the US now than in most other places. It’s not so much Republicans vs Democrats as Republicans vs anti-Republicans. Krugman has been a leading figure in rejecting the idea that the Republican party represents a serious viewpoint that should be accorded respect, even in disagreement. Not surprisingly, the members of the intellectual class still associated with the Republican Party (relatively few, these days, but still dominant in Chicago) intensely dislike Krugman’s writing for the NYT.

But more important, I think, is the hole in the intellectual landscape opened up by the crisis. As regards macroeconomics, the pre-crisis near-consensus described by Krugman included a lot of “freshwater” macroeconomists whose intellectual roots go back to the New Classical/Real Business Cycle literature of the late 1970. This literature initially suggested that there was no possible role for monetary or fiscal policy unless people had mistaken expectations and drew the implication that a sufficiently credible and determined government could eliminate inflation without any serious cost in terms of output and employment, a theory tested to destruction by the Thatcher government.

Given the empirical difficulties encountered by strong forms of these views, most of the freshwater economists were prepared to make some concessions. As regards monetary policy, they were willing to accept some use of interest rates to target inflation, while arguing against “fine tuning” designed to stabilise the economy – during the Great Moderation it was easy enough to conclude that macro instability was a problem of the past, a claim made explicitly by Robert Lucas.

Similarly, it was easy enough to accept the implication that, in certain extreme circumstances like those of the Great Depression, the standard tools of monetary policy might prove ineffective necessitating direct use of fiscal policy to expand the money supply. In the absence of any perceived risk of a Depression, it was easy enough to make this concession while arguing against any use of active fiscal policy.

In the wake of the crisis, this position was untenable. If you supported fiscal policy at all, it was clear that a massive stimulus was needed. In fact, the arguments of Barro and others that Keynesians had overestimated the multiplier effects of fiscal stimulus implied that the required stimulus was even larger than Keynesian estimates would suggest.

Moreover, there is, as Brad DeLong and others have pointed out, no coherent position under which fiscal policy is totally ineffective while monetary policy is at least partly effective. And the only plausible conditions under which policy is totally ineffective is if the macroeconomy is always in (or close to) equilibrium. So, it’s essentially impossible to believe in recessions and unconditionally oppose fiscal policy.[1]

So we see Cochrane forced all the way back to Say’s Law, the claim that it is logically impossible for (planned) supply to exceed (planned) demand, since willingness to supply, say, labour implies willingness to demand goods. Cochrane accuses Krugman of wanting to scrap the macroeconomics of the last forty years[2] but then makes it clear enough that he wants to dump Keynes and everything that has been written since.

Arguments about Say’s Law are unlikely to be resolved by logical disputation. The only way to address them is to look at the historical record of the economy over the last couple of centuries. If you see stability, interrupted only by the occasional ill effects of government policies, you’ll accept Say’s Law. If you see regular crises, except for a few exceptional periods when macroeconomic stabilization policies have appeared to work, you’ll reject it.

fn1. Except for those who can always find some government program or another to blame, even for a case as clear cut as the 1890s Depression in Australia.

fn2. This charge is broadly correct, but I think the correct answer is the one anticipated by Cochrane. Economics did indeed take a wrong turn in the 1970s, responding to the breakdown of (one version of) Keynesianism. We need to find a new and better response, and much of the work of the past 40 years will have to be be discarded or reinterpreted as a result.

Monday, August 31, 2009

Naked Capitalism: Guest Post: “The Savings Rate Has Recovered…if You Ignore the Bottom 99%”

Guest Post: “The Savings Rate Has Recovered…if You Ignore the Bottom 99%”

By Andrew Kaplan, a hedge fund manager:

It has become fashionable among equities managers of the bullish persuasion to argue that a strong recovery in GDP will occur in 2010 because the “structural adjustment period” of moving back to a more normal savings rate has been completed. We’ve gone from a savings rate of barely 1% in 2008 up to 4.2% in July (ok, so the argument sounded better when the number was 6.2% in May, but still…).

The story goes something like, “consumers took a little time to recognize that their home equity had disappeared, but now they’ve adjusted their savings rates toward the desired level to reflect the fact that they need to save a larger proportion of income for retirement…so this effect will no longer be a drag on growth in coming quarters.”

This is the kind of conventional wisdom which could only emerge among folks in the 99th income percentile who spend their time primarily with other folks in the 99th income percentile. You don’t have to look at the data (mortgage delinquencies, foreclosures, credit card defaults, bankruptcies) all that hard to see a very different picture. In fact, it is almost certainly true that the savings rate for 99% of the US population is negative. These people (a/k/a “all of us”) are drowning. And to the extent that our savings rate is less negative than it was one or two years ago, that simply reflects the reality of reduced home equity and unsecured credit lines rather than any conscious effort to reach a “desired level” of savings.

A little data might help here. Unfortunately, there really IS no good data on PCE (personal consumption expenditure) and savings stratified by income percentile. There are a couple of surveys, the triennial “Survey of Consumer Finances” by the Federal Reserve and the “Consumer Expenditure Survey” by the Bureau of Labor Statistics, but the self-reported data is laughable. For 2007, the Consumer Expenditure Survey showed a personal savings rate of 18.4%. In the same year, the Bureau of Economic Analysis, which calculates the savings rate as a residual from actual income and expenditure data, showed a savings rate of 1.7%. Either the Consumer Expenditure Survey does a poor job of sampling, or people who fill out surveys are really big liars.

Fortunately, there IS some pretty good data on income stratification in the United States, and a few assumptions can help shed some light. Economists Thomas Piketty and Emmanuel Saez have made careers of studying US income inequality using IRS data, which goes back to 1913. The most recent data available (for 2007) showed that the top 14,988 households (0.01% of the population) received 6.04% of income, the highest figure for any year since the data became available. The top 1% of households received 23.5% of income (the second highest on record, after 1928), while the top 10% received 49.7% of income (the highest on record).

The fortunate 14,988 had an average income in 2007 of $35,042,705. They had an average federal tax burden, according to Piketty and Saez, of 34.7%, leaving them after tax income of $22.9 million. If you assume a 50% savings rate among this group, you get total savings of $171.5 billion. This is nearly ONE HALF of the total savings for the entire country implied by a savings rate of 4.2% ($365 bn) reported in this month’s Bureau of Economic Analysis data.

I’ve never actually had an after tax income of $22.9 million, so I couldn’t say for sure whether a 50% savings rate is a reasonable assumption, but I’m going to go out on a limb and say that it is, just based on the pure physics of spending money. Buying cars, clothes, and fancy dinners, even at Masa, won’t get you there…the math doesn’t work. Buying a private jet could get you there, but most people, even rich people, don’t buy one of those every year. The only EASY way to spend more than 50% of $22.9 million on an annual basis is to buy lots of houses…but the definition of “personal consumption expenditure” used by the BEA specifically excludes purchases of real estate. They use an imputed rent calculation instead. So I’m going to stick with my 50% number.

If we expand our survey to the top 1% of all households, we find an average income of $1.36 million for 2007. These folks had an average federal tax burden of just under 33%, so their after tax income averaged $916 thousand. If you assume this group had a savings rate of 33%, you get total savings of $452 billion (remember, $171.5 bn of this comes from the top 0.01%, we’re assuming a savings rate of around 25% of after tax income for the “poorer” 99% of the top 1%) This is more than 100% of the personal savings of the entire population, according to the BEA data. It implies that 99% of the US population still has, on average, a negative savings rate of around 1.3%. If you subtract the next nine percent, which likely still has a positive savings rate, the data for the bottom 90% becomes even more depressing, implying a negative savings rate of close to 5%.

Sunday, August 30, 2009

Simple explanations for global financial instability and the cure: Keep it simple

13 August 2009

Why is there so much disagreement about the causes of the crisis? This column says that lax monetary policy and excessive leverage are to blame. It argues that many alleged causes are simply symptoms of these policy errors. If that is correct, then the recommended corrective is remarkably simple – there is no need for intrusive regulatory measures constraining non-bank intermediaries and innovative financial instruments.
A remarkable feature of the burgeoning literature on the global financial crisis is vast disagreement about its main causes. Symptoms are often treated as autonomous developments requiring separate correction. There is thus a high risk that the legitimate pursuit of a more stable financial system will lead to a potpourri of excessive and damaging regulatory restrictions. In hope of reducing that risk, we offer a simplified reading of the factors leading to the financial crisis and accordingly simple policy recommendations (Carmassi, Gros, and Micossi 2010).
The ingredients of speculative bubbles
Recent events feature three main ingredients that are persistently observed in bubbles. First, there was abundant liquidity in world capital markets, fed by large payment imbalances, notably a large and persistent current account deficit in the US financed by ample flows of capital from emerging and oil-exporting countries. These “global” imbalances fostered an unsustainable explosion of financial assets and liabilities.
The second main ingredient was a credit boom leading to unsustainable leverage (the ratio of debt to equity), and the third was financial innovation, including the explosion of securitisation and derivatives and the “originate to distribute” model, which led to a significant deterioration in lending standards. The key point is that the innovations were instrumental in allowing an increase in leverage, as they moved risks still borne by the originators off of their balance sheets, reduced capital requirements with risk mitigation techniques such as credit derivatives, and embedded leverage in the “equity” tranches of structured products.
Leverage in Europe
Higher aggregate leverage generally indicates less capacity to absorb losses. It is not possible to establish a universal benchmark for excessive leverage, as different financial systems can support quite different ratios of credit to GDP. However, rapid increases in this ratio have been identified as reliable predictors of financial crises.
This warning signal was certainly audible in Europe before 2007-08. First, the increase in economy-wide leverage (measured by the debt-to-GDP ratio) was higher in the euro area than in the US. The increase between 1999 and 2007 amounted to 100% of GDP for the euro area, while in the US it was “only” 80% of GDP. Households’ leverage increased strongly in the US (40% of GDP) and much less so in the euro area. Financial sector leverage, however, increased more in the euro area (about 70% of GDP compared to 40% in the US).
As may be seen from the upper quadrant of Figure 1, large EU cross-border banks had an average leverage ratio close to 35; there were peaks of 70 and even 80 for some British, German, and Swiss banks.

Figure 1. Leverage and exposure to market risk of the largest EU and US banks, 1998-2008

Leverage: total liabilities/net tangible equity. Exposure to market risk: total securities/net tangible equity. Data on 2008 are estimates. Source: R&S - Mediobanca 2009.
Monetary anchors for ever-rising asset prices

Monetary policy in the US was accommodating throughout the 1990s and became aggressively expansionary in the 2000s; nominal interest rates fell below levels recommend by the Taylor rule (and below the inflation rate in 2003-04).

A key feature of a speculative bubble is the attendant anomalous convergence of expectations that occurs when a growing share of investors believes that prices can only go up and that the risk of reversal somehow disappears. The phenomenon of convergent expectations in the stock market was documented by Robert Shiller’s surveys of investor sentiment. Shiller believes that convergence of expectations is a natural, endogenous phenomenon engendered by such things as a long-established benevolent economic environment and economic innovations announcing a new era of prosperity. In his view, monetary policy is driven by the same psychological forces that feed the bubble and cannot be considered exogenous (Shiller 2000).

However, a straightforward alternative is that monetary policy itself provided the anchor for the convergence of expectations, based on the consistent record that any decline in asset prices would be countered by the Federal Reserve with vigorous monetary expansion. Indeed, Alan Greenspan had just arrived at the Federal Reserve at the time of the 1987 stock market crash; he promptly reacted by aggressively lowering policy interest rates. He did it again in 1998 at the time of the LTCM crisis that followed the East Asian and Russian crisis, and even more aggressively after the end of the bubble in 2000. In all these episodes, there were no adverse effects of falling asset prices on economic activity and subsequently stock prices recovered.

The pattern is clear – the Fed repeatedly and systematically intervened to counter “negative bubbles”, while it remained passive when confronted with accelerating credit and asset prices. This policy approach, long established and clearly announced for over a decade, must have played an important role in bringing about convergent expectations of ever-rising asset prices, which eventually destabilised financial markets and the economy. Such an asymmetric monetary policy creates a gigantic moral hazard problem, whereby all agents expect to be rescued from their mistakes. This is where excessive leverage and excessive maturity transformation become relevant.

Banks and leveraged credit booms

A feature of banks that has traditionally justified special regulation is that deposits can be withdrawn on demand at par value. Banks normally do not keep sufficient liquidity to pay back all depositors at the same time, which exposes them to the risk of a run when depositors start to doubt their solidity. Bank runs are contagious and may generate systemic instability.
Non-bank intermediaries do not pose an equal threat to financial stability, since their liabilities are not redeemable on demand at par. They are not exposed to the risk of customer runs since their liabilities are market-priced like their assets. When financial intermediaries that raise money from capital markets by issuing securities make wrong investment decisions, their investors will lose their money without further repercussions for the financial system at large.
US investment banks raised a growing share – eventually, up to a quarter of their total liabilities – of their funds in the wholesale money market but without banks’ public safeguards and prudential constraints. When confidence collapsed, their liquidity evaporated and pushed them over the brink, without much regard for the quality of their assets.

An apparent puzzle is the behaviour of European universal banks, which combine commercial and investment banking activities within the same organisation, that managed to become not only overleveraged, but also overexposed to toxic assets as much as the riskiest Wall Street investment banks, despite prima facie more stringent regulation (Figure 1). This was partly due to lax oversight by national regulators who wanted their national champions to take larger market shares and participate in the great gains of finance. However, the key factor in explaining EU banks’ leverage was risk-mitigation techniques made possible, and indeed encouraged, by the Basel capital rules.

The fundamental problem with these rules is that they create room for reducing capital requirements by choosing counterparties or tailoring operations to legal features so as to economise capital; moreover, once Basel requirements were met, management felt exonerated from any further scrutiny of actual risks. Capital requirements came to be wholly misinterpreted; during the long upswing in stock prices, keeping a buffer of capital over the minimum was seen as a waste of resources, so that the floor became a ceiling.
anagement demands for tools to reduce capital requirements were met by Wall Street – eager to find outlet for the new breed of structured securities – by multiplying the offer of credit default swaps on those securities and securing Triple-A rating for their senior tranches. Besides, Basel capital rules directly encouraged the explosion of the interbank market, later a major source of instability, since they assigned a low ranking to assets such as interbank deposits and bonds held vis-à-vis other banks.

The problem was compounded by a definition of capital that made as many items with little resemblance to equity – such as subordinated debt and other hybrid capital instruments – eligible instruments. As a result, while the target ratio between regulatory capital and risk-weighted assets for European banks was 8%, the ratio between cash and equity and the same assets did not exceed 2%.

Therefore, the key to avoiding repeating this crisis is setting adequate capital requirements that cannot be circumvented for all intermediaries able to raise funds redeemable on demand at par. The simple way of doing it is to set capital requirements with reference to total assets, with no further distinction – 8% should be 8% in cash and equity, with no gimmicks allowed. All risks effectively borne by a bank, regardless of their legal attribution or geographical location, should be included in the asset definition, and accounting principles should be modified accordingly.
Legally separating commercial and investment banking activities or prohibiting banks from undertaking particular activities would not be necessary, which is advantageous considering the enormous hurdles involved in implementing such separation for large cross-border banking groups. At most, one could instead envisage higher capital charges on proprietary trading and lending to highly leveraged financial organisations, so as to reduce their profitability, as currently explored by the Financial Stability Board.


We have argued that the massive financial instability of 2007-8 was primarily the result of lax monetary policy, mainly in the US. The regulatory system compounded this error by tolerating excessive leverage and maturity transformation by banks in the US and Europe. Innovation did contribute to credit expansion and instability, but in all likelihood, without lax money and excessive leverage, reckless bets on asset price increases would have been much reduced.
The logical conclusion is that a repeat of this instability could be avoided in the future by correcting those two policy faults. By and large, there is no need for intrusive regulatory measures constraining non-bank intermediaries and innovative financial instruments. Our main message in designing the new rules for the global financial system is “keep it simple”.

Carmassi, Jacopo, Daniel Gros and Stefano Micossi (2010). “The Global Financial Crisis: Causes and Cures”, forthcoming in the Journal of Common Market Studies, Vol. 48, No.1, January 2010, Special Issue on Europe and the Global Financial Turmoil.

Shiller, Robert J. (2000). “Measuring Bubble Expectations and Investor Confidence” Journal of Behavioral Finance, 1542-7579, Volume 1, Issue 1, 2000, Pages 49 – 60.

VoxEU: The timing of fiscal interventions: Don’t do tomorrow what you can do today

The composition and timing of the fiscal stimulus is a major concern for policymakers. This column presents research showing that anticipated tax cuts result in reduced economy activity before they take effect. During the current downturn, that constitutes a strong argument against stimulus policies that phase in tax cuts over time.

The current macroeconomic downturn has sparked repeated calls for fiscal stimuli to combat the ensuing decline in activity and labour market conditions (e.g. Blanchard and Cottarelli 2008; Corsetti 2008; Krugman 2008). Common to the proponents of a fiscal intervention has been the appeal for the immediate use of fiscal levers. The prime reasons for this are the fact that the current downturn has been unusually deep (and probably associated with tightening financial constraints) and the view that fiscal policy changes have their fullest effect on the economy only with a considerable delay. Procrastination therefore runs the risk of stimulating the economy when it – we hope – is already recovering.

Anticipation of tax changes

But, there are other aspects of procrastination that also may matter. Not only may a delay in the application of fiscal measures end up stimulating a recovering economy, but anticipation effects may actually depress the economy until the fiscal changes are implemented. Anticipation effects arise when policy makers announce – or legislate – future fiscal interventions. This phenomenon is quite common as far as tax changes are concerned. Tax laws often contain pre-announced changes in future tax rates because of phase-ins and due to the not so infrequent use of sunsets associated with temporary tax changes.

To the layperson, it would seem obvious that the announcement of a low future price of a good may delay its purchase. A supermarket wishing to sell beer today at good profit margins would probably be ill advised to announce a reduction in the price of beer next week. Such principles of forward-looking behaviour and intertemporal choice are deeply rooted in much of macroeconomic theory and apply also to the impact of tax changes (see Hall, 1971, for an early example of the impact of pre-announced tax changes). Yet, empirical investigations have failed to purport the idea that anticipated tax changes affect current choices. Indeed, a number of studies of consumption behaviour have indicated that consumption appears to react little to announcements of future changes in taxes and that consumption does adjust to the implementation of tax changes that were known in advance.

Some economists have concluded on this basis that a substantial fraction of households are liquidity-constrained (or fail to be able to make simple forward-looking decisions). In a provocative and influential piece, Mankiw (2000) argues that perhaps up to half of US households may be described as rule-of-thumb consumers that simply consume their current income due to the presence of binding liquidity constraints. For that reason, the fact that tax changes may often be pre-announced matters little – the tax changes simply affect the economy when they are implemented.

Procrastination: Does it matter?

Nonetheless, while there is little evidence that consumption choices are affected by announcements of future changes in taxes, other key macroeconomic aggregates do react to such policy announcements. Figure 1 shows the dynamics of aggregate output, consumption, investment, and hours worked following announcements of changes in tax liabilities six quarters in the future, which we estimate for the US post-1945 (Mertens and Ravn 2009). The vertical scale show percentage deviations from trend and the size of the change in taxes is normalised to one percent tax liability cut relative to GDP. The announcement dates correspond to the dates at which tax laws were signed by the president relative to the implementation dates stated in the tax legislations.

Figure 1. The response of output, consumption, investment, and labour to announced tax changes

The figure makes it clear that pre-announced tax changes cause important adjustments in aggregate activity, hours worked, and investment. Announcing a cut in taxes six quarters out leads to a steep drop in aggregate investment, a decline in aggregate output, and a gradual slide in hours worked. Once the tax cut is implemented, each indicator recovers and peak responses are reached about 2-2.5 years thereafter. Thus, while aggregate consumption appears relatively insensitive to announcements of future tax changes, this is certainly not shared by other main macroeconomic indicators. This evidence challenges the view that lack of consumption responses to anticipated tax changes is evidence for rule-of-thumb behaviour or the absence of forward-looking economic agents.

To take one example, the Reagan tax cut of 1981 (the Economic Recovery Tax Act of 1981) introduced new depreciation guidelines and major cuts in personal marginal income tax rates and corporate tax rates. Signed by President Reagan in August 1981, it included changes in taxes that were phased-in from August 1981 until the first quarter of 1984. In fact, the largest change in tax liabilities was the cut of more than $57 billion in 1983, dwarfing the $9 billion tax liability cut of 1981. Therefore, the Economic Recovery Tax Act of 1981 was associated with major anticipation effects. According to our estimates, these expectations of future tax cuts actually contributed to the recessionary impact of the Volcker disinflation that took its course during the early 1980s. Once the economy was back on track in the mid-1980s, the tax cuts were being implemented and therefore further stimulated the uptake in aggregate activity.

Relying on news effects

So, if this evidence is correct, why do policy makers use phased-in policies, temporary tax changes, and other means of tax changes that introduce anticipation effects? After all, Reagan probably did not intend to deepen the early 1980s recession. Potential reasons likely include concerns about government debt or a desire that economic policy appear predictable rather than haphazard so that households and firms can adjust to changes in taxes (even if some theories of optimal taxes call for the opposite), and one can even write down theories that call for gradual changes in taxes.
Another potential reason is the idea that current good news about future economic fundamentals stimulates current activity. Such news effects, if true, would imply that the promise of future tax cuts lead to an uptake in activity even before they are implemented. If this was true, then you can almost “eat your cake and have it too” as the pre-implementation boom that should follow the announcement of future lower taxes would lower government debt through higher tax revenues and therefore help paving the way for a cut in taxes without having to cut spending (at least partially).


The evidence presented here suggests that there may be good reasons for phasing-in tax changes – relying on news effects, however, does not seem to be one of them. Thus, in the present environment, a good advice to governments is that the use of phased-in tax policies, temporary tax cuts, and other tax policies associated with anticipation effects should be used with great care.
Whether the same also holds true for changes in government spending is another question that is still not clear.
Blanchard, Olivier and Carlo Cottarelli (2008), "IMF Spells Out Need for Global Fiscal Stimulus", interview in IMF Survey magazine, 29 December.
Corsetti, Giancarlo (2008), “The rediscovery of fiscal policy?”, 11 February. Hall, Robert E. (1971), “The Dynamic Effects of Fiscal Policy in an Economy with Foresight”, Review of Economic Studies 38, 229-44.
Krugman, Paul R. (2008), “Optimal Fiscal Policy in a Liquidity Trap”, Princeton University mimeo.
Mankiw, N. Gregory (2000), “The Savers-Spenders Theory of Fiscal Policy”, American Economic Review 90(2), 120-25.
Mertens, Karel and Morten O. Ravn (2009), “Empirical Evidence on the Aggregate Effects of Anticipated and Unanticipated U.S. Tax Policy Shocks”, CEPR Discussion Paper no. 7370.This article may be reproduced with appropriate attribution. See Copyright (below).

Brad DeLong: Herbert Hoover: The working man's hero - How

Herbert Hoover: A Working Class Hero Is Something to Be

Oh Noes! Andrew Leonard reads Lee Ohanian:

Herbert Hoover: The working man's hero - How the World Works - I did not need a cup of coffee to wake up this morning -- I just checked my e-mail, and saw the subject header: "Hoover's pro-labor stance helped cause Great Depression, UCLA economist says."

Without reading the message, I knew instantly who the economist must be -- Lee Ohanian.... Last we saw of Ohanian... he was arguing that FDR's New Deal policies extended the Great Depression and resulted in "less work than average" for American workers. Which might be true, if you don't count anyone who got a job through "the Works Progress Administration (WPA) or Civilian Conservation Corps (CCC), or any other of Roosevelt's popular New Deal workfare programs." Makes sense -- if you don't count Roosevelt's pro-labor programs, he doesn't end up very pro-labor!

So now we have "What -- or Who -- Started the Great Depression?," a 68-page paper Ohanian has been working on for four years that is sure to become a never-to-be-extinguished talking point for New Deal haters, union-busters, and opponents of all kinds of government intervention in the economy. Here are some key points, taken from the press release pushed out by UCLA.

Pro-labor policies pushed by President Herbert Hoover after the stock market crash of 1929 accounted for close to two-thirds of the drop in the nation's gross domestic product over the two years that followed, causing what might otherwise have been a bad recession to slip into the Great Depression, a UCLA economist concludes in a new study. "These findings suggest that the recession was three times worse -- at a minimum -- than it would otherwise have been, because of Hoover," said Lee E. Ohanian, a UCLA professor of economics.

According to Ohanian, these pro-labor policies including pressure for job-sharing and propping up wages handcuffed industry's ability to respond flexibly to the post-crash economic contraction.

After the crash, Hoover met with major leaders of industry and cut a deal with them to either maintain or raise wages and institute job-sharing to keep workers employed, at least to some degree, Ohanian found. In response, General Motors, Ford, U.S. Steel, Dupont, International Harvester and many other large firms fell in line, even publicly underscoring their compliance with Hoover's program. "By keeping industrial wages too high, Hoover sharply depressed employment beyond where it otherwise would have been, and that act drove down the overall gross national product," Ohanian said. "His policy was the single most important event in precipitating the Great Depression."

Hoover as the pro-labor liberal! Never mind that Hoover spent decades after his spectacularly failed presidency bemoaning the country's New Deal turn to Bolshevism. And never mind that the definitive conservative economic treatment of the Great Depression, Milton Friedman and Anna J. Schwartz's "A Monetary History of the United States," pinpoints monetary policy mistakes by the Federal Reserve as the crucial catalyst that turned a stock market crash and recession into a Depression. Never mind the now-fading cultural memory of the United States, which somehow remembers Hoover as being bad for labor, and Roosevelt being good. All that pales against the necessity of making a key political point relevant to today's financial crisis.

There is a germ of information buried in the pile: Hoover did urge business leaders to be gentle to their workers because, he assured them, the Great Depression would soon be over.

But Hoover's interventions do not appear to have had much effect. If you take the degree of government-sponsored union power and wage rigidity in post-WWII Europe to be 100, then FDR's New Deal counts as a 30 and Herbert Hoover's "can't we all just get along?" White House meetings count as a five. If Hoover's inviting businessmen to the White House could push the unemployment rate up from 4% to 23%, simple extrapolation would then suggest that Roosevelt's labor-market policies ought to have pushed unemployment up to 118%--and unemployment in post-WWII Europe ought to have averaged 384%.

It simply does not appear as if Hoover's exhortations had much effects. Average wages in manufactuing stood at $0.55 in 1930, at $0.51 in 1931--an 8% cut--and $0.44 in 1932--a 20% cut. Coal miners' hourly wages went from $0.66 in 1930 to $0.63 in 1931 to $0.50 in 1932--a 25% cut. Skilled male manufacturing workers' wages went from $0.66 an hour in 1930 to $0.63 in 1931 and $0.56 in 1932. You had the same 20% cut in nominal wages over 1930-1932 as you had over 1920-22 (but a 50% decline in industrial production in total in the 1930s and only a 30% decline in industrial production in the 1920s). The argument would have to be that if not for Hoover, firms would have cut wages much, much faster than they in fact did.

In 1996 Ben Bernanke and Kevin Carey, in their "Nominal Wage Stickiness and Aggregate Supply in the Great Depression," plotted real wages and industrial production levels in 1932 relative to 1929 for 22 countries:


Four countries--Australia, Argentina, Hungary, and New Zealand--have low relative real wage levels in 1929 not because employers have cut wages but because they are small open economies and had already undergone massive currency develuation by 1932: wages were more or less where they were in 1929 but the domestic price level was much higher because the currency was worth less. the rest of the countries were still on or not yet far off the gold standard. Some--Germany and the U.S.--had relatively low real wages and were doing horribly. Some--Norway and Japan--had relatively low real wages and were doing well. And some--Belgium, France, the Netherlands, the United Kingdom, and Switzerland--had relatively high real wages and were doing middling. The scatterplot strongly suggest that Hoover's interventions (a) were too feeble to make the U.S. a more-than-average country in the downward rigidity of its nominal wages, and (b) that at least as of the end of Hoover's term, how deep the Great Depression was in your country had very little to do with whether your internal nominal wages level had fallen far or not.

As Eric Rauchway points out, to blame the Great Contraction of 1929-1932 on government interference in the labor market creates a very strong presumption that thereafter the Great Depression should have gotten much worse rather than eased--for the interferences in the 1930s, starting with the NIRA, were much larger deviations from laissez-faire:

[H]ere's the thing: if you want to say, "I'll take 'Causes of the Great Depression', Alex," you have to be prepared with an explanation for (a) why things got so bad under Hoover and (b) why they then got better under Roosevelt.

Monetarist models explain this: the gold standard was deflationary, and going off the gold standard helped countries out of the Great Depression. Hoover didn't go off the gold standard. FDR did. Things got better.

Keynesian models explain this: Hoover didn't do enough to stimulate demand. Roosevelt did more (though still not quite enough).

Ohanian's model doesn't explain this.

And I would like to raise a further caution. Ohanian is working in a framework in which nominal demand--the total dollar flow of spending--is constant. In such a framework lower wages lead businesses to cut their prices and so the same flow of demand buys more goods, and that induces firms to hire more people and produce more. Jacob Viner, Milton Friedman's teacher, strongly cautioned against this line of argument in 1933 because a decline in wages was part of an "unbalanced deflation." Wages fell, but debt principal and interest paymenst did not.

In Viner's view, and in mine, if wages had fallen faster and further, goods prices and real estate prices would have fallen further and faster, more banks would have gone into bankruptcy, the bank failures would have shrunk the money supply even more, the velocity of money would have fallen even further, and the Great Depression would have been even worse.

Larry Summers and I wrote a paper about this back in the 1980s.

Milton Friedman's teacher Jacob Viner always argued that it was "unbalanced deflation" -- i.e., declines in asset prices and wages and incomes while debts remained the same -- that was the cause of the Great Depression. So did monetarist school founder Irving Fisher.

Ask yourself: if everybody's salary in America were to be cut right now by 25 percent -- but everyone's mortgage payment, everyone's credit card balance and interest payment, and every corporation's debt interest payments remained the same--would we see a recovery or another chain of financial bankruptcies that would push the economy down further?

Naked Capitalism: Party Time! Wall Street Back to Its Old Highly Levered Ways

Party Time! Wall Street Back to Its Old Highly Levered Ways

Bloomberg reports that Wall Street is back to its free-wheeling, high-levered ways. This is a classic example of moral hazard in action. Why worry about blowing up the bank when you know the taxpayer will bail you out?

From Bloomberg (hat tip DoctoRx):

Banks are increasing lending to buyers of high-yield company loans and mortgage bonds at what may be the fastest pace since the credit-market debacle began in 2007.

Credit Suisse Group AG and Scotia Capital, a unit of Canada’s third-largest bank, said they’re offering credit to investors who want to purchase loans. SunTrust Banks Inc., which left the business last year, is “reaching out to clients” to provide financing, said Michael McCoy, a spokesman for the Atlanta-based bank. JPMorgan Chase & Co. and Citigroup Inc. are doing the same for loans and mortgage-backed securities, said people familiar with the situation.

“I am surprised by how quickly the market has become receptive to leverage again,” said Bob Franz, the co-head of syndicated loans in New York at Credit Suisse. The Swiss bank has seen increasing investor demand for financing to buy loans in the past two months, he said.

Federal Reserve data show the 18 primary dealers required to bid at Treasury auctions held $27.6 billion of securities as collateral for financings lasting more than one day as of Aug. 12, up 75 percent from May 6.

The increase suggests money is being used for riskier home- loan, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by Washington-based Fannie Mae and Freddie Mac of McLean, Virginia or Ginnie Mae in Washington. Broader data on loans for investments isn’t available.

Yves here. That is a big increase in repo lending. Greenspan used to look at repos as a proxy for hedge fund leverage. And when repo lending contracts, as it did in the crisis, it tends to do so across a wide range of collateral as banks increase haircuts, leading to synchronized downturns.

And we get these tidbits:

The increase over that 14-week stretch is the biggest since the period that ended April 2007, three months before two Bear Stearns Cos. hedge funds failed because of leveraged investments....

Yields on top-ranked debt backed by auto loans and credit cards have fallen by as much as 2 percentage points relative to benchmark rates. The yield premium has shrunk to less than 1 percentage point since TALF began in March, according to Charlotte, North Carolina-based Bank of America Corp. data. The average interest rate on loans for new cars declined to 3.88 percent in June, from 8.23 percent in January, Fed data show.

Yves again. Note how auto lenders, who are mainly out to subsidize sales, are passing on the improvement in terms, while banks are instead using the fatter margins on credit cards to boost profits.

We clearly have not learned the lessons of the crisis, that leverage increases risk and fragility, period. We've thrown massive backstops against the financial system with no checks on risk-taking, and we are getting precisely the sort of behavior you'd expect. Worse, everyone assumes any problems would arise gradually, when shifts tend to be suddenly, more like phase changes. As an op-e, "This Economy Does Not Compute," by Mark Buchanan in the New York Times last year noted:

For example, an agent model being developed by the Yale economist John Geanakoplos, along with two physicists, Doyne Farmer and Stephan Thurner, looks at how the level of credit in a market can influence its overall stability.

Obviously, credit can be a good thing as it aids all kinds of creative economic activity, from building houses to starting businesses. But too much easy credit can be dangerous.

In the model, market participants, especially hedge funds, do what they do in real life — seeking profits by aiming for ever higher leverage, borrowing money to amplify the potential gains from their investments. More leverage tends to tie market actors into tight chains of financial interdependence, and the simulations show how this effect can push the market toward instability by making it more likely that trouble in one place — the failure of one investor to cover a position — will spread more easily elsewhere.

That’s not really surprising, of course. But the model also shows something that is not at all obvious. The instability doesn’t grow in the market gradually, but arrives suddenly. Beyond a certain threshold the virtual market abruptly loses its stability in a “phase transition” akin to the way ice abruptly melts into liquid water. Beyond this point, collective financial meltdown becomes effectively certain. This is the kind of possibility that equilibrium thinking cannot even entertain.

Now this is admittedly just a model, but it seems far more descriptive of what we've just been through than anything the Fed appears to be using. And if it proves valid, relevering will proceed until we hit a trigger point again.

Naked Capitalism: Rogoff Shreds "When in Doubt Bail It Out" Policy

Naked Capitalism: Rogoff Shreds "When in Doubt Bail It Out" Policy

Grr. It was so obvious and it never occurred to me...:"When in doubt, bail it out." I am jealous.

Kenneth Rogoff, who among other things has (with Carmen Reinhart) has created a large dataset on financial crises through history, today takes on the exceedingly permissive posture the US has adopted to the banking industry, simply handing over fistfulls of money with virtually no strings attached, then occasionally making a great show about boxing their ears a bit over private jets. In the meantime, the banks get to run very large risks on the taxpayer nickel and pay themselves handsomely, assured of another rescue if they do screw up. You couldn't do a better job of writing a prescription for another train wreck.

This piece by Rogoff, is actually refreshingly pointed, and shreds the conventional wisdom that supports the policy of enabling banks that had been engaged in reckless policies. From the Financial Times:
"When in doubt, bail it out,” is the policy mantra 11 months after the September 2008 collapse of Lehman Brothers. With the global economy tentatively emerging from recession, and investors salivating over the remaining banks’ apparent return to profitability, some are beginning to ask: “Did we really need to suffer so much?”

Too many policymakers, investors and economists have concluded that US authorities could have engineered a smooth exit from the bubble economy if only Lehman had been bailed out. Too many now believe that any move towards greater financial regulation should be sharply circumscribed since it was the government that dropped the ball. Stifling financial innovation will only slow growth, with little benefit in terms of stemming future crises; it is the job of central banks to prevent bank runs by reacting forcefully in a potential systemic crisis; policymakers should not be obsessed with moral hazard and should forget trying to micromanage the innovative financial sector.

Yves here, OK, I have to stop. Even though this is a straw man, reading that list makes me ill. Back to Rogoff:
This relatively sanguine diagnosis is tempting, but dangerous. There are three basic problems with the view that the costs of greater bank regulation outweigh the benefits, and that the whole problem was the botched Lehman bail-out.

First, the US economy was not exactly cruising along at warp speed in the run-up to September 2008. The National Bureau of Economic Research has the US recession beginning at the end of 2007. Financial markets had begun to exhibit distress from the subprime problem by the summer of 2007. The epic housing bubble had begun to burst six months earlier. Given that the US consumer had been propelling the global economy for a quarter of a century, was it reasonable to think that the inevitable collapse of the US housing market would be a non-event? As Carmen Reinhart and I argue in our forthcoming book This Time is Different: Eight centuries of financial folly, by most quantitative measures, the US economy was heading towards a deep post-war financial crisis for several years before the subprime crisis. Indeed, in related papers, we argued the case long before Lehman hit.

Second, the view that reining in the financial sector jeopardises future growth needs to be nuanced. Certainly enhanced financial development is integral to achieving greater growth and stability. But economists have less empirical evidence than we might care to admit on which financial sector activities are the most helpful. In general, the links between growth and financial development are complex. Mortgage “innovation” in the US was supposed to be helpful by lowering interest rates to homebuyers. Yet, as the crisis revealed, innovation was also a mechanism for levering implicit taxpayer subsidies. More generally, financial innovation was supposed to bring diversification and stability. But in a system-wide breakdown, it also fuelled contagion.

Third, it is dangerous to point to the nascent restoration of profits in the financial sector as clear evidence of a corresponding benefit to the economy. There is an element of arbitrage, as banks borrow at low rates against the implicit guarantee of a government bail-out in the event of a crisis. Do people really believe, as some argue, that moral hazard is a non-issue? Why should large systemically critical financial institutions be allowed to heavily leverage themselves with short-term borrowing? What would be lost if regulators placed stricter capital requirements to discourage arbitrage activities that excessively expose too-big-to-fail banks to systemic risk? Certainly economists have models of why it can be efficient for lenders to keep borrowers on a short leash. Yet these models do not explain why the leash has to be wrapped around borrowers’ necks three dozen times, as in the case of a highly leveraged bank.

The fact is that banks, especially large systemically important ones, are currently able to obtain cash at a near zero interest rate and engage in risky arbitrage activities, knowing that the invisible wallet of the taxpayer stands behind them. In essence, while authorities are saying that they intend to raise capital requirements on banks later, in the short run they are looking the other way while banks gamble under the umbrella of taxpayer guarantees.

If the optimists are wrong, does this mean that the pre-Lehman financial system was one big Sodom and Gomorrah, inevitably condemned to doom? We will never know. Again appealing to my work with Ms Reinhart, theory and history both tell us that any economy that is excessively leveraged with short-term borrowing – be it government, banking, corporate or consumer – is highly vulnerable to crises of confidence. Accidents that are waiting to happen usually do, but when? Neither statistical analysis of history, nor economic theory offer tight limits on the timing of collapses, even to within a year or two.

Certainly the US and global economy were already severely stressed at the time of Lehman’s fall, but better tactical operations by the Federal Reserve and Treasury, especially in backstopping Lehman’s derivatives book, might have stemmed the panic. Indeed, with hindsight it is easy to say the authorities should have acted months earlier to force banks to raise more equity capital. The March 2008 collapse of the fifth-largest investment bank, Bear Stearns, should have been an indication that urgent action was needed. Fed and Treasury officials argue that before Lehman, stronger measures were politically impossible. There had to be blood on the streets to convince Congress. In any event, given the system’s manifest vulnerabilities, and the impending tsunami of the housing price collapse, it is hard to know if deferring the crisis would have made things better or worse, particularly given the obvious paralysis of the political system.

Economists will conduct post-mortems of the crisis for decades. In the meantime, common sense dictates the need for stricter controls on short-term borrowing by systemically important institutions, as well as regularly monitored limits on oversized risk positions, taking into account that markets can be highly correlated in a downturn. Better macroprudential action is needed, particularly in reining in sustained, large current account deficits. While such deficits can sometimes be justified, prolonged imbalances fuel leverage and can give the illusion that high growth and asset prices are sustainable. There should also be more international co-ordination of financial supervision, to prevent countries using soft regulation to bid for business and to insulate regulators from political pressures.

It is good that the economy appears to be stabilising, albeit on the back of a vast array of non-transparent taxpayer subsidies to financial institutions. But this strategy must not be relied on indefinitely because it risks compromising the fiscal credibility of rich-country governments. The view that everything would be fine if Hank Paulson, then US Treasury secretary, had simply underwritten a $50bn bail-out of Lehman is dangerously misguided. The financial system still needs fundamental reform, and not just starting in five years.