Tuesday, June 30, 2009

Delong Op-Ed: Sympathy for Greenspan

J. Bradford DeLong

29 June 2009

In the circles in which I travel, there is near-universal consensus that America’s monetary authorities made three serious mistakes that contributed to and exacerbated the financial crisis.

This consensus is almost always qualified by declarations that the United States has been well served by its Federal Reserve chairmen since at least Paul Volcker’s tenure, and that those of us who have not sat in that seat know that we would have made worse mistakes. Nevertheless, the consensus is that US policymakers erred when:

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

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

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

There is, however, a lively debate about whether there was a fourth big mistake: Alan Greenspan’s decision in 2001-2004 to push and keep nominal interest rates on US Treasury securities very low in order to try to keep the economy near full employment. In other words, should Greenspan have kept interest rates higher and triggered a recession in order to avert the growth of a housing bubble? If we push interest rates up, Greenspan thought, millions of Americans would become unemployed, to no one’s benefit. If interest rates were allowed to fall, these extra workers would be employed building houses and making things to sell to all the people whose incomes come from the construction sector.

Full employment is better than high unemployment if it can be accomplished without inflation, Greenspan thought. If a bubble develops, and if the bubble does not deflate but collapses, threatening to cause a depression, the Fed would have the policy tools to short-circuit that chain. In hindsight, Greenspan was wrong. But the question is: was the bet that Greenspan made a favourable one?

Whenever in the future the US finds itself in a situation like 2003, should it try to keep the economy near full employment even at some risk of a developing bubble?

I am genuinely unsure as to which side I come down on in this debate. Central bankers have long recognised that it is imprudent to lower interest rates in pursuit of full employment if the consequence is an inflationary spiral. Some days I think that, in the future, central bankers must also recognise that it is imprudent to lower interest rates in pursuit of full employment when doing so risks causing an asset price bubble.

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

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

You can argue that Greenspan’s policies in the early 2000’s were wrong. But you cannot argue that he aggressively pushed the interest rate below its natural level. Rather, Greenspan’s mistake — if it was a mistake — was his failure to overrule the market and aggressively push the interest rate up above its natural rate, which would have deepened and prolonged the recession that started in 2001.

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

J. Bradford DeLong, a former Assistant US Treasury Secretary in the Clinton administration, is Professor of Economics at the University of California at Berkeley

In Cooperation With Project Syndicate

Economist's View: Should We Pop Bubbles?

Should We Pop Bubbles?

June 30, 2009

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

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

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

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

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

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

A model of growth, collapse, and welfare

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

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


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

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

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

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

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

Table 1


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

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

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


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

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


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

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

Posted by Mark Thoma on Tuesday, June 30, 2009 at 12:19 AM in Economics, Financial System, Regulation Permalink TrackBack (0) Comments (37)

Can the Federal Reserve Shrink the Money Stock Rapidly Now that It Can Pay Interest on Reserves?

DeLong/Pimco: Can the Federal Reserve Shrink the Money Stock Rapidly Now that It Can Pay Interest on Reserves?

[Links work]
Tyler Cowen asks:

Marginal Revolution: Paying interest on reserves, and why it should be easy to disarm future inflationary pressures. Do I believe it?

The correct answer is "maybe."

If inflationary pressure comes because banks and others regain their confidence and seek to move their excess reserve deposits into higher-yielding dollar denominated assets, then the Federal Reserve can fix that with a flick of its wrist by raising the interest rate on deposits.

If inflationary pressure comes because banks and others fear a large dollar depreciation and seek to move their excess reserve deposits into non-dollar denominated assets, then the Federal Reserve is helpless, and the situation is dire--unless the Federal Reserve has gotten the authority to issue bonds and has preemptively used that authority to mop up the excess liquidity.

Paul McCulley of PIMCO:

PIMCO - Global Central Bank Focus June 2009 Exit Strategy: Most rational investors accept the dual proposition that a Fed funds rate pinned against zero and near-$800 billion of excess reserves sloshing around the banking system are not enduringly sustainable. This is the case despite the fact that most – though a smaller most – applaud the Fed for engineering these outcomes, so as to cut off the fat tail risk of deflationary Armageddon. The consensus overwhelmingly holds that once that fat tail has been cut off and then killed, borrowing from Colin Powell’s famous description of America’s strategy for running Iraq out of Kuwait, it will be necessary for the Fed to exit its extraordinarily accommodative strategy, hiking the Fed funds rate and soaking up all those excess reserves. It’s hard to argue with the basic thrust of this exit thesis. Because it’s basically right!

I must admit, however, that I’m perplexed that so many pundits put so much emphasis on the importance of the Fed soaking up excess reserves, as if it is a necessary condition for hiking the Fed funds rate. It is not. To be sure, it used to be, before the Fed had the legal authority to pay interest on reserves, which Congress granted last fall. Before then, the only way the Fed could achieve a meaningfully positive Fed funds rate target was to constrain the supply of reserves relative to the banking system’s demand for reserves, essentially required reserves. If there were excessive excess reserves, then the Fed funds rate would fall below the Fed’s target, as banks with excess would be willing to lend them out in the Fed funds market below the Fed funds target, given that if they simply left them at the Fed, they would earn nothing. But now, the Fed pays interest on banks’ excess reserves (presently at an interest rate of 0.25%, the top of the Fed’s 0% – 0.25% target band for the Fed funds rate). Thus, logic says that banks with excess reserves will not lend them in the Fed funds market at a rate appreciably lower than the Fed pays, but simply leave them on deposit at the Fed. Accordingly, the rate that the Fed pays on excess reserves should now act as a proximate floor for the Fed funds rate, even if there are huge excess reserves in the system. Thus, by hiking the rate it pays on excess reserves, the Fed now has the ability to enforce a rising Fed funds rate target – even before it “unwinds” its bloated balance sheet....

The Federal Reserve’s approach to supporting credit markets is... credit easing... focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions.... [C]redit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing. To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally.... When markets are illiquid and private arbitrage is impaired by balance sheet constraints and other factors, as at present, one dollar of longer-term securities purchases is unlikely to have the same impact on financial markets and the economy as a dollar of lending to banks, which has in turn a different effect than a dollar of lending to support the commercial paper market.... [T]he stance of Fed policy in the current regime – in contrast to a QE regime – is not easily summarized by a single number....

Yes, I know that many of your eyes are probably glazing over about now, given my (and Ben’s) wonkishness. I’m sorry about that, but this is really, really important stuff to understand, given the widespread yammering about the need for the Fed to have an exit strategy to de-create all the excess reserves it has created, as if they are intrinsically the kindling for an (eventual) rip-roaring inflationary fire. They are not.... [W]e can categorically say that the near-zero Fed funds rate is not, for the moment, fueling an inflationary pace of aggregate demand growth.... And neither is the Fed’s Credit Easing.... Yes, in the fullness of time, zero Fed funds could conceptually re-ignite borrowers’ and lenders’ mojo. Indeed, that’s precisely the Fed’s objective. And if and when that objective is achieved, the Fed funds rate will need to be hiked.... But right now, the least of my worries, and I think the Fed’s, too, is the prospect for an overheated economy, putting too many idled resources, both labor and industrial capacity, back to work too quickly... it would be delightful if that were our primary worry! But it isn’t....

Chairman Bernanke and a number of his colleagues have talked about all these various tools, stressing they have plenty of potential doors in their exit strategy. And indeed they do, even though simply hiking the rate the Fed pays on excess reserves is the cleanest way to hike the Fed funds rate...

Fed press Release: Paying interest on Reserves

Press Release

Federal Reserve Press Release

Release Date: October 6, 2008

For release at 8:15 a.m. EDT

The Federal Reserve Board on Monday announced that it will begin to pay interest on depository institutions' required and excess reserve balances. The payment of interest on excess reserve balances will give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee.

Consistent with this increased scope, the Federal Reserve also announced today additional actions to strengthen its support of term lending markets. Specifically, the Federal Reserve is substantially increasing the size of the Term Auction Facility (TAF) auctions, beginning with today's auction of 84-day funds. These auctions allow depository institutions to borrow from the Federal Reserve for a fixed term against the same collateral that is accepted at the discount window; the rate is established in the auction, subject to a minimum set by the Federal Reserve.

In addition, the Federal Reserve and the Treasury Department are consulting with market participants on ways to provide additional support for term unsecured funding markets.

Together these actions should encourage term lending across a range of financial markets in a manner that eases pressures and promotes the ability of firms and households to obtain credit. The Federal Reserve stands ready to take additional measures as necessary to foster liquid money market conditions.

Interest on Reserves
The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008.

Employing the accelerated authority, the Board has approved a rule to amend its Regulation D (Reserve Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on required reserve balances (that is, balances held to satisfy depository institutions' reserve requirements) and on excess balances (balances held in excess of required reserve balances and clearing balances).

The interest rate paid on required reserve balances will be the average targeted federal funds rate established by the Federal Open Market Committee over each reserve maintenance period less 10 basis points. Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector.

The rate paid on excess balances will be set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points. Paying interest on excess balances should help to establish a lower bound on the federal funds rate. The formula for the interest rate on excess balances may be adjusted subsequently in light of experience and evolving market conditions. The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System's macroeconomic objectives of maximum employment and price stability.

The Board also approved other related revisions to Regulation D to prescribe the treatment of balances maintained by pass-through correspondents under the new rule and to eliminate transitional adjustments for reserve requirements in the event of a merger or consolidation. In addition, the Board approved associated minor changes to the method for calculating earnings credits under its clearing balance policy and the method for recovering float costs.

The revisions to Regulation D and the other changes will take effect on Thursday, October 9, 2008. The Board recognizes that depository institutions may choose to adjust their typical liquidity management practices in light of the payment of interest on required reserve balances and excess balances; the primary credit program and other Federal Reserve liquidity facilities are available to help institutions meet temporary funding requirements.

The Board’s notice of its actions regarding the amendments to Regulation D and associated changes is attached. While the action is effective immediately, the Board will accept public comments until November 21, 2008, and the proposal will be published in the Federal Register shortly. The Board will adjust the rule as appropriate in light of comments.

Substantial Further Increases in Term Auction Facility Auctions
The sizes of both 28-day and 84-day Term Auction Facility (TAF) auctions will be boosted to $150 billion each, effective with the 84-day auction to be conducted Monday. These increases will eventually bring the amounts outstanding under the regular TAF program to $600 billion. In addition, the sizes of the two forward TAF auctions to be conducted in November to extend credit over year end have been increased to $150 billion each, so that $900 billion of TAF credit will potentially be outstanding over year end.

Exemption to Allow Limited Bank Purchases of Assets from Money Market Mutual Funds
The Board on Monday published a letter granting a request by a depository institution for an exemption from the limits on transactions with affiliates under section 23A of the Federal Reserve Act and the Board's Regulation W to allow the institution to purchase assets from affiliated money market mutual funds under certain circumstances. The Board is open to considering similar requests from depository institutions under simlar circumstances.


Saturday, June 27, 2009

Graphs and Charts for Prof Edelstien

Paul Krugman: Not Enough Audacity

Not Enough Audacity

Published: June 25, 2009

When it comes to domestic policy, there are two Barack Obamas.

On one side there’s Barack the Policy Wonk, whose command of the issues — and ability to explain those issues in plain English — is a joy to behold.

But on the other side there’s Barack the Post-Partisan, who searches for common ground where none exists, and whose negotiations with himself lead to policies that are far too weak.

Both Baracks were on display in the president’s press conference earlier this week. First, Mr. Obama offered a crystal-clear explanation of the case for health care reform, and especially of the case for a public option competing with private insurers. “If private insurers say that the marketplace provides the best quality health care, if they tell us that they’re offering a good deal,” he asked, “then why is it that the government, which they say can’t run anything, suddenly is going to drive them out of business? That’s not logical.”

But when asked whether the public option was non-negotiable he waffled, declaring that there are no “lines in the sand.” That evening, Rahm Emanuel met with Democratic senators and told them — well, it’s not clear what he said. Initial reports had him declaring willingness to abandon the public option, but Senator Kent Conrad’s staff later denied that. Still, the impression everyone got was of a White House all too eager to make concessions.

The big question here is whether health care is about to go the way of the stimulus bill.

At the beginning of this year, you may remember, Mr. Obama made an eloquent case for a strong economic stimulus — then delivered a proposal falling well short of what independent analysts (and, I suspect, his own economists) considered necessary. The goal, presumably, was to attract bipartisan support. But in the event, Mr. Obama was able to pick up only three Senate Republicans by making a plan that was already too weak even weaker.

At the time, some of us warned about what might happen: if unemployment surpassed the administration’s optimistic projections, Republicans wouldn’t accept the need for more stimulus. Instead, they’d declare the whole economic policy a failure. And that’s exactly how it’s playing out. With the unemployment rate now almost certain to pass 10 percent, there’s an overwhelming economic case for more stimulus. But as a political matter it’s going to be harder, not easier, to get that extra stimulus now than it would have been to get the plan right in the first place.

The point is that if you’re making big policy changes, the final form of the policy has to be good enough to do the job. You might think that half a loaf is always better than none — but it isn’t if the failure of half-measures ends up discrediting your whole policy approach.

Which brings us back to health care. It would be a crushing blow to progressive hopes if Mr. Obama doesn’t succeed in getting some form of universal care through Congress. But even so, reform isn’t worth having if you can only get it on terms so compromised that it’s doomed to fail.

What will determine the success or failure of reform? Above all, the success of reform depends on successful cost control. We really, really don’t want to get into a position a few years from now where premiums are rising rapidly, many Americans are priced out of the insurance market despite government subsidies, and the cost of health care subsidies is a growing strain on the budget.

And that’s why the public plan is an important part of reform: it would help keep costs down through a combination of low overhead and bargaining power. That’s not an abstract hypothesis, it’s a conclusion based on solid experience. Currently, Medicare has much lower administrative costs than private insurance companies, while federal health care programs other than Medicare (which isn’t allowed to bargain over drug prices) pay much less for prescription drugs than non-federal buyers. There’s every reason to believe that a public option could achieve similar savings.

Indeed, the prospects for such savings are precisely what have the opponents of a public plan so terrified. Mr. Obama was right: if they really believed their own rhetoric about government waste and inefficiency, they wouldn’t be so worried that the public option would put private insurers out of business. Behind the boilerplate about big government, rationing and all that lies the real concern: fear that the public plan would succeed.

So Mr. Obama and Democrats in Congress have to hang tough — no more gratuitous giveaways in the attempt to sound reasonable. And reform advocates have to keep up the pressure to stay on track. Yes, the perfect is the enemy of the good; but so is the not-good-enough-to-work. Health reform has to be done right.

Tuesday, June 23, 2009

Economist's View: FRBSF: Fighting Downturns with Fiscal Policy

FRBSF: Fighting Downturns with Fiscal Policy

Sylvain Leduc of the San Francisco Fed reviews several studies on the effectiveness of fiscal policy and concludes:

The findings from the three empirical studies, particularly those of Romer and Romer and Mountford and Uhlig, suggest that the fiscal stimulus package will boost growth substantially over the next two years, partly because it includes sizeable tax cuts that can be implemented quickly and that have significant effects on output. Nevertheless, the uncertainty regarding those estimates remains high. ...

This brings up a point about tax cuts I've been meaning to make (again). The effectiveness of tax cuts depends, in part, on how hard the recession hits household balance sheets. In a recession where balance sheets are relatively unaffected, a tax cut may very well translate into spending, and do so fairly quickly.

But when balance sheets are hit hard, the result is different. In this case tax cuts may be used largely to rebuild balance sheets - to recover what was lost - rather than for new spending. Thus, in this recession the stimulative effects of tax cuts may not have as large of an immediate effect as in the past (there are also reasons to suspect the government spending multipliers shown in the table below are underestimated due to the fact that this recession is not like those in the data used to produce the estimates, e.g. for one, the historical data may overestimate the crowding out effect, but for now I want to focus on taxes).

The fact that in this recession tax cuts may not have as large of an immediate impact as in the past should not necessarily lead us to conclude that the tax cuts were a waste. That is, households will not turn back to consumption until they have saved enough to make up for what has been lost, at least in part, so how long it takes for the recession to end depends upon how quickly household balance sheets are refilled (once this is over, I expect saving rates to be higher than in the past, but I also expect that saving will fall some from where they are now once balance sheets are in better shape). The faster they are refilled, the sooner people begin to spend more, and the sooner this thing ends.

So in that sense, the tax cuts were not a waste at all. Unfortunately, however, during the time when the balance sheets are being refilled it will look like the stimulus package is not having any effect - all you see is higher savings rate - but again, the higher saving rate brings the end of the recession nearer in time, and that is important in and of itself. That's a hard effect to estimate, even if you are looking for it after the fact, but again, it shouldn't be dismissed as inconsequential.

Finally, because tax cuts are likely to be saved more than in the past, and hence have a smaller impact than tax multipliers from historical data suggest, and because there is reason to think that government spending multipliers rise as recessions get more severe (e.g. even if interest rates go up, investment is likely to be insensitive when conditions are bad), the logic of using both tax cuts and spending to stimulate the economy is sound.

Here's more:

Fighting Downturns with Fiscal Policy, by Sylvain Leduc, FRBSF Economic Letter: Should fiscal policy be used to fight recessions? Most economists would answer that, for normal economic ups and downs, business cycle stabilization should be left to monetary policy and that fiscal policy should focus on long-term goals. The main argument is that monetary policy can act quickly when output falls below an economy's potential or when inflation varies from its optimal rate, and that these actions can be reversed quickly as conditions change. By contrast, modifications to the fiscal code take a long time to enact and implement and can be very difficult to undo.

However, the current recession is clearly not a typical downturn. In particular, unlike other post-World War II U.S. recessions, monetary policy has run out of its usual ammunition to boost economic activity. The federal funds rate, the principal tool that the Federal Reserve uses to stabilize the economy, is now hovering near zero. Because interest rates cannot be negative in nominal terms, monetary policymakers are unable to lower the federal funds rate further. In this situation, the Federal Reserve has turned to unconventional tools to get around this barrier, commonly called the zero lower bound.

Because of the severity of the recession and the uncertain effects of unconventional monetary policy tools, Congress and the Obama Administration have also enacted a fiscal stimulus package. The $787 billion program approved by Congress in February includes a mix of tax and spending measures aimed at creating jobs and boosting output. Yet, economists and political leaders heatedly debate whether tax cuts or increased spending are more effective, a dispute that's hard to resolve because of the difficulty of determining the precise magnitude of fiscal policy's impact on real GDP. This Economic Letter examines some recent empirical studies analyzing data on the relative effects of higher spending and lower taxes on output.

A simple theory of the effects of fiscal policy

Basic Keynesian theory suggests that the effect of a change in fiscal policy on real GDP is more than one-for-one. For instance, since government spending is one component of GDP, an increase in government purchases, by putting idle resources to work, boosts income one-for-one when the money is initially spent. In addition to that, though, since consumption is a function of current after-tax income in this framework, households also increase their consumption in line with their higher incomes, multiplying the effect of the initial government spending on GDP. The "multiplier effect" of government spending on GDP is thus greater than one.

This simple framework also predicts that the multiplier effect of a tax cut on GDP will be less than that for government spending. This is because a change in government spending affects GDP one-for-one, while part of a tax cut will be saved and will, at least initially, translate into a less than one-for-one increase in GDP.

Clearly, these results hinge on many underlying assumptions. One is that households are not assessing their future income when deciding how much to consume. Instead, they are assumed to spend a lot as long as their current income is high. However, households may be concerned about the impact of fiscal measures on their future tax bills. Households may not decide to consume as much if they expect taxes to rise and their future after-tax income to be lower. Moreover, this framework assumes that investment and net exports are insensitive to the change in fiscal policy. However, the response of investment will clearly depend on the behavior of interest rates, which in turn will depend on monetary policy. If monetary policy changes in response to fiscal policy, investment would be affected.

Large-scale econometric models often used in policymaking institutions make adjustments for household behavior and investment (see, for instance, Elmendorf and Reifschneider 2002). Nonetheless, the relative size of their fiscal multipliers is in line with this simple framework's predictions. For instance, earlier this year, Christina Romer, the chair of the Council of Economic Advisers, and Jared Bernstein, an advisor to Vice President Biden, estimated that the effects of permanently increasing government purchases by 1% of GDP would be to raise output by 1.5% two years after. At the same time, their model predicts that a tax cut of 1% of GDP would increase output by only 1% two years down the road.

Challenging the model

In a recent paper, Cogan et al. (2009) challenged the Romer/Bernstein estimates using an alternative New Keynesian model in which households and firms are more forward-looking than in typical large-scale econometric models. Using this model, the authors argue that a 1% increase in government spending would produce a mere 0.5% rise in output two years later.

In this framework, household and firm decisions to spend, invest, and produce are heavily influenced by their expectations of the future. Households anticipate that higher budget deficits will ultimately be financed with higher taxes, and they consume less as a result. Higher government spending thus crowds out consumption. Moreover, Cogan and his coauthors assume that, as the economy recovers following the increase in government spending, monetary policy becomes more restrictive, choking off investment. In contrast, Romer and Bernstein assume that the Federal Reserve keeps the federal funds rate constant, thus mitigating the adverse effect on investment. The crowding out of consumption and investment is relatively strong in the New Keynesian framework, offsetting much of the stimulatory impact of higher government spending.

In other words, the effects of fiscal policy on real GDP are quite sensitive to underlying modeling assumptions regarding the behavior of households, firms, and monetary policy. This creates fertile ground for good empirical work.

Recent empirical work

Empiricists interested in calculating the impact of movements in government spending and taxes on real GDP face multiple challenges, but the biggest hurdle is distinguishing fiscal policy changes that are fundamental from changes that are responses to economic conditions. Many influences other than tax and spending policy determine the trajectory of economic output. And taxation and spending vary over the course of the business cycle. The difficulty is to make sure to capture the effect of a change in fiscal policy on the economy and not the effect of changes in the economy on fiscal policy. Those fiscal policy changes that are independent of economic circumstances are called exogenous, and those that are reactions to economic conditions are called endogenous.

This is a particularly relevant issue because government spending and taxes respond endogenously to economic activity via automatic stabilizers--features built into the fiscal system to stimulate or depress economic activity automatically. Taxes automatically fall in recessions as household incomes decline. Transfer payments, such as unemployment insurance, rise. Moreover, government spending and taxes may have complex relationships with each other. For example, the payroll tax increased in 1965 to offset the costs of the new Medicare program on the federal budget (Romer and Romer 2008).

Typically, empirical studies adjust for the automatic stabilizers built into fiscal policy by taking into account movements in GDP when measuring government spending and taxes. Recent empirical analyses have taken a number of additional approaches to separate endogenous from exogenous factors.

Romer and Romer address the impact of tax changes by performing a narrative analysis of U.S. tax policy since 1945. Using the historical record, they try to isolate exogenous tax changes by identifying the key reasons underlying each modification to the tax code and rejecting those that were clear responses to economic activity. Alternatively, Blanchard and Perotti (2002) use a timing restriction to identify changes in government spending and taxes that are exogenous to unexpected movements in output. They argue that, because it takes time for legislators to understand a sudden movement in activity and then pass legislation to address it, it is reasonable to assume that, at high enough frequency, changes in taxes and government spending are independent of current output.

In contrast to these studies, Mountford and Uhlig (2005) use a mix of economic theory and time series analysis to identify exogenous movements in government spending and taxes. They build a small empirical model of the U.S. economy and look at the behavior of different "shocks" to that model, that is, disturbances that are unrelated to other variables in the system. They identify as exogenous movements in government spending those disturbances that end up raising government spending in the empirical model for a defined period of time. Similarly, exogenous movements in taxes are classified as those disturbances that end up raising tax revenues.

Table 1: Tax cut multipliers (on level of real GDP)
Table 2:

An interesting aspect of this new literature is that, notwithstanding their vastly different methodologies, they reach surprisingly similar conclusions. Regarding the impact of tax cuts on the level of real GDP one year after the change in taxes, the three studies predict a multiplier of roughly 1.2, as shown in Table 1. Moreover, Table 2 shows that, in contrast to theoretical predictions from the simple Keynesian framework, the analyses found that government spending had less bang for the buck than tax cuts. For instance, one year after the increase in spending, the impact on the level of real GDP is less than one-for-one, partly reflecting a decline in investment. There is more disagreement, however, about the effects of tax cuts on output two years after they are implemented, as Table 1 indicates. The analyses of Romer and Romer and Mountford and Uhlig find very large tax multipliers, while Blanchard and Perotti continue to find effects similar to those occurring after one year.

The stimulus package: Will it work?

Earlier this year, Congress passed a $787 billion fiscal stimulus package spread over 10 years. Of that total, $584 billion are spent in 2009 and 2010, with 19% of the funds allocated toward increases in government spending, 33.4% in transfers to the states, and 47.6% toward tax cuts. The findings from the three empirical studies, particularly those of Romer and Romer and Mountford and Uhlig, suggest that the fiscal stimulus package will boost growth substantially over the next two years, partly because it includes sizeable tax cuts that can be implemented quickly and that have significant effects on output.

Nevertheless, the uncertainty regarding those estimates remains high. Several economists remain skeptical that fiscal multipliers--whether from spending or taxes--are very large (see, for instance, Barro 2009). Moreover historical relationships may prove much less reliable during this downturn. Faced with a large decline in wealth and tight credit availability, households may very well respond differently to tax cuts today than they have in the past.


[URL accessed June 2009.]

Barro, Robert J. 2009. "Government Spending Is No Free Lunch." Wall Street Journal, January 22.

Blanchard, Olivier, and Roberto Perotti. 2002. "An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output." Quarterly Journal of Economics (November) pp. 1329-1368.

Cogan, John F., Tobias Cwik, John B.Taylor, and Volker Wieland. 2009. "New Keynesian versus Old Keynesian Government Spending Multipliers." Unpublished manuscript.

Elmendorf, Douglas W., and David Reifschneider. 2002. "Short-Run Effects of Fiscal Policy with Forward-Looking Financial Markets." National Tax Journal 55(3, September) pp. 359-386.

Mountford, Andrew, and Harald Uhlig. 2005. "What Are the Effects of Fiscal Policy Shocks?" SFB 649 Discussion Paper 2005-039.

Romer, Christina, and Jared Bernstein. 2009. "The Job Impact of the American Recovery and Reinvestment Plan." Manuscript.

Romer, Christina, and David Romer. 2008. "The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks." Manuscript.

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System.

Monday, June 22, 2009

Naked Capitalism: Geithner's Plan to Have a Reform Plan Skewered by Senate

Geithner's Plan to Have a Reform Plan Skewered by Senate

What amounted to a statement of principles and a very few stakes in the ground from Timothy Geithner on financial reform got a largely hostile reaction from Congress (see Ed Harrison here and here for further detail) [these links work -A].

The main criticism was that the notion of making the Fed the uber stability regulator/financial system overseer (officially, the systemic risk regulator, or SRR). was misguided. We agree with this concern, but even this criticism fails to engage the deeper issues, namely the lack of critical expertise anywhere in the regulatory apparatus, and the failure to do enough examination of the roots of the crisis to devise sound measures.

Those shortcomings are almost certainly features, not a bugs. As we have observed repeatedly, Obama is not inclined to spent his political capital engaging still-powerful financial lobby to push for root and branch reform. And picking Geithner and Summers, both badly captured by the industry, assures that outcome even if he were not predisposed to take at most modest steps here.

First to the role of Fed. Members on the Senate Banking Committee from both parties were unusually pointed in questioning whether the Fed as the right candidate for the job. For instance:
Mr. Dodd described himself as “open on the issue.” But, borrowing a quote from an economics professor, he went on to wonder aloud if giving the Federal Reserve more authority “is like a parent giving his son a bigger, faster car right after he crashed the family station wagon.”
"The Federal Reserve system was not designed to carry out the systemic risk oversight mission the administration proposes to give it," Senator Richard Shelby, the top Republican on the U.S. Senate Banking Committee, said at a hearing.

Concluding that the Fed is better qualified than any other government agency to handle such a job "represents a grossly inflated view of the Fed's expertise."

Shelby, unlike many other Republicans (at least until recently) has the sensibilities of an old-fashioned banker and believes in regulation to assure bank soundness. And his key point is well taken. The Fed is full of economists who worry about interest rate policy. What little enforcement and supervisory culture the Fed ever had was killed via neglect under Greenspan. Even the bank-friendly Office of the Comptroller of the Currency was far more serious about implementing the few and far between strictures imposed on banks pre-crisis, such as the Home Owners' Equity Protection Act.

I am far less troubled by the skill gaps at the Fed (considerable) than its culture and priorities. It is, as Willem Buiter tartly observed, a victim of cognitive regulatory capture. Just as the Treasury-led stress tests were a charade, obviously too thinly staffed to make an independent assessment of what the banks served up, it's almost a given that oversight by the Fed would be largely a matter of form. Supervisors at the Fed would continue to be second-class citizens, and too few in number to boot.

The second line of criticism of the idea of expanding the Fed's powers is that it would compromise the Fed's independence. This concern would be more accurately stated as "further compromise the Fed's independence." Greenspan traded on his Fed chairmanship; Bernanke constrained Fed autonomy further by allowing th Fed to be used by the Administration to circumvent budgetary limits and the need to seek Congressional approval for expenditures to rescue banks. Again, per Buiter, the Fed became a quasi-fiscal agent of the Treasury.

Former Fed economist Richard Alford wrote earlier about how much times had changed:
We have a Fed that is willing to incur short-term costs if it reduces inflation, but will not incur short-term costs to achieve financial stability or external balance. This would be less of a problem if another agency or agencies had the willingness and ability to insure financial and external balance, but it is clear that we do not. The Fed was granted independence and insulated from political pressure in order to accept short-term costs in order to enhance the prospects for long term growth. However, the current Fed, like the Fed of the 1970s, failed to use the freedom it was granted. ....

Compare the behavior of the Chairmen of the 1950s and Volcker to that of Greenspan. Chairman Eccles and McCabe both lost their Chairmanships because they wouldn’t compromise Fed independence. They stood their ground even after being summoned to the White House. Martin, appointed by Truman, was in later life referred to by Truman as “the traitor” presumably for taking the punch bowl away. The public image of Volcker is that of a man who twice a year endured public Congressional assaults, resisted political pressure, and enabled the Fed to stay the course.

Greenspan, on the other hand, jumped at the chance to meet Clinton, traveling to Little Rock before the inauguration. Bob Woodward in his book “Maestro” quotes Clinton telling Gore after the pre-inauguration meeting: “We can do business.” Woodward also quotes Secretary of the Treasury Bentsen telling Clinton that they had effectively reached a “gentleman’s agreement” with Greenspan. The agreement evidently involved Greenspan’s support for budget deficit reduction financed in part by tax increases. It is not clear what Greenspan received.

Yves here. One must presume it was reappointment. Back to Alford:
Even if the deal with Clinton contributed to a good policy mix, Greenspan should never have entered into that agreement/deal/understanding or another agreement/deal/understanding. The very act of negotiating and injecting the Fed into a discussion of budget decisions compromised Fed independence. Why shouldn’t Bush have expected the same? Why shouldn’t every succeeding President expect the Fed Chairman to be a “business” partner? Refusal to deal on the part of the Fed can no longer be attributed to principle and precedent. Refusal “ to do business” will now be viewed as a rejection, partisan or otherwise. The Fed is no longer able to stand apart from political battles. Greenspan severely compromised the Fed standing as an agency insulated from the short-sighted and partisan politics of Washington DC.

While these are legitimate concerns, the contretemps about the Fed masks more serious issues. The first is, as mentioned above, the powers that be lack the competence to supervise the industry well. That is not insurmountable, particularly now that that Wall Street has shed jobs, particularly in the complex products that were the source of the trouble. But pretending the Fed as it is is competent will assure the needed skills are not developed. Note that regulators do not have to be state-of-the-art, but they do need to be sufficiently well versed to know where the dead bodies might lie, and confident enough not to be deterred by less than complete answers.

But the biggest gap is that the US is embarking on a program of reform without having done sufficient diagnosis of where the problems and vulnerabilities lie. By contrast, the securities laws passed in 1933 and 1934 were based on a detailed understanding of the chicanery and follies of the Roaring Twenties, and provided many specific mechanisms to prevent their recurrence. By the time the Bear Stearns crisis hit, it was clear that the financial system was not going to heal quickly, and that the eruptions were symptoms of far deeper problems. Yet every time, the authorities tried patching the patient up and hoping for the best in place of making a real diagnosis.

For instance, one of the assumptions of the current programs is that Something Must Be Done about too-big-to-fail institutions simply because we've just had to throw a lot of money at them. That may be a necessary part of any reform program, but is is complete? Doubtful. Bear Stearns would not have been on any list of systemically important institutions (it did not make the grade in the Bank of England's April 2007 roster of "large complex financial institutions" deemed crucial for credit market intermediation). Yet the concern that it might be a big enough credit default swaps writer to take down a lot of the financial grid along with it led to Fed backstoping of its unwind. LTCM and AIG would not have been on a TBTF list prior to their implosions either.

That suggests that there needs to be not just an institution-based view of the financial markets, but probably also a product-based persepctive and increased attention to system dymanics. For instance, repos are very big source of non-bank funding for the investing community, and there is evidence that suggests that much higher haircuts on repo collateral played a significant role in the contraction of liquidity. Yet there are no official figures on the size of the repo market, and perilous little consideration of how it played into the crisis. As I read them, the proposals would not address this funding source, which some experts estimate at $10 trillion, comparable in size to the total assets of regulated banks (note there may be some double counting in the repo market size estimates, since it probably includes reverse repos).

Similarly, despite the rosy view we now have of exchanges being great ways to create separate centers of activity that can fail without taking down the financial system (yes, Virginia, exchanges do fail), that idea isn't accurate. Fro instance, in the 1987 crash, the Chicago options exchange was within three minutes of failing, saved only by the personal intervention of Chase CEO Tom Theobald, who authorized a badly-needed overdraft. The equity exchanges, which were separate organizations, came to function as a single market in the crisis. If Chicago had failed, it is pretty certain the NYSE would not have opened. And many observers believed that if it did not open, enough specialists would fail, it might never open (this is a simplification of a discussion from Donald MacKenzie's book An Engine, Not a Camera).

But economists don't do systems dynamics. Nor do they have a theory of financial systems (they have theories that address particular elements, like financial economics, and some relevant constructs, like principal-agent and information asymmetry).

It's bad enough that policy is typically made by looking at a rear-view mirror. But in this case, the authorities haven't even bothered adjusting it to get a good look at the roadkill behind them.

Tuesday, June 16, 2009

Naked Capitalism: Do the Treasury Proposals on Securitization Reform Go Far Enough?

This is a nice outline of the incentives for securitizing debt instead of making traditional loans:

Do the Treasury Proposals on Securitization Reform Go Far Enough?

The Treasury Department's plans for securitization reform are being bandied about in the press. A key question is whether it can or will fix the now-broken private securitization process.

Credit became more dependent on securitization than many realize. By pretty much any metric, the role of banks relative to other players has declined since 1980, by some measures as much as a 50% drop in market share. Securitization, which is the process of putting loans into pools and often slicing and dicing the cash flows to create instruments that are more appealing to investors, has been the big culprit.

In case you missed it, securitization has slowed down to a trickle. In the US, non-agency securitization was $900 billion in 2007, $150 billion in 2007, and a mere $16 billion through April. Now some of that was dodgy CDOs and other subprime spawn that is better off not coming back. However, if the securitization machine remains impaired, the alternative is on-balance sheet bank lending, and the authorities do not appear interested to going back to banking circa 1980. As the Financial Times notes today:
Securitised markets – which financed more than half of all credit in the US in the years immediately preceeding the crisis – are essential for the US economy. Without a recovery in these markets, the flow of credit will not return to more normal levels, even if US banks overcome their problems.

The reason securitization became so widespread is that it is cheaper than on-balance-sheet bank lending. Traditional lending requires banks to recoup their cost of equity and FDIC insurance premiums. For assets that can be packaged, securitization is more attractive.

From a policy standpoint, therefore, the desire to restart securitization is two-fold. First, it in theory produces more abundant and cheaper credit (although any reduction in yield depends on whether the banks and other participants keep all the cost savings in the form of increased profit or pass some of them on to borrowers). Second, going back to old-fashioned lending wold require banks to have much larger balance sheets, hence more equity. The banks are having enough trouble coming up with enough capital to support their current footings that raising even more equity would seem to be a non-starter.

However, it is not clear that the ideas floated by the Treasury will do the trick. It has two components: the first is requiring that the party that originates the loans to be securitized retain 5% of the deal. The second is to eliminate gain-on-sale accounting, which increased the attractiveness of securitization considerably. Again, from the FT:
The authorities plan to force lenders to retain part of the credit risk of the loans that are bundled into securities and to end the gain-on-sale accounting rules that helped spur the boom of the markets at the heart of the financial crisis...

The Treasury plans to force lenders to retain at least 5 per cent of the credit risk of loans that are securitised, ensuring that they have what investors call “skin in the game”. The 5 per cent rule – which looks set to be applied in Europe as well – is less draconian than some bankers feared. The proposed elimination of “gain on sale accounting” is to prevent financial companies from booking paper profits on loans – packaged into securities – as soon as they were sold to investors.

Banks would only be able to record income from securitisation over time as payments are received. Brokers’ fees and commissions would also be disbursed over time rather than up front, and would be reduced if an asset performed badly due to bad underwriting.

The US authorities also plan to stop credit rating agencies from assigning the same types of ratings to structured credit products that are assigned to corporate and sovereign

The proposal to change accounting and allow for clawing back of profits if a deal goes bad is probably far more meaningful than having banks retain 5%. 5% is simply not significant enough, in and of itself, to change behavior much.

However, there is an unrecognized contradiction here. The reason securitization became pervasive was both a real improvement in economics (bona fide cost savings per above) which were then compounded by efforts of banks to streamline costs further by scrimping on vetting loans (why bother if all you needed to on-sell the stuff was FICO scores and other simple metrics?). And the favorable accounting also was a considerable impetus.

Thus any activity that changes the incentives meaningfully will also reduce the attractiveness of the economics to banks. Some of this is salutary and necessary. The point is to discourage banks from selling dreck. But effective measures may reduce the size of the securitization market more than the powers that be anticipate. There may be no free, or even cheap lunches here. For instance, it might take a more meaningful retention (20%? 30%) to change originator incentives, but a proportion that lare would make securitiation a far more marginal activity and might require the move the powers that be are hoping to avoid, namely considerably more on-balance sheet lending.

Personally, I'd stick with the changes in accounting treatment proposed, but would increase liability considerably in the event of deficient due diligence and mis-selling (ie, burned investors could go after banks and rating agencies tooth and nail). However, it would take some effort and thought to come up with the right framework.

Sadly, the US seemed able to do that in the Great Depression. The provision of the securities laws of 1933 and 1934 were astute and durable. I wonder why devising good regulatory regimes has become a lost art.

Monday, June 15, 2009

Eichengreen and O'rourke: A Tale of Two Depression.

I Left out the country by country graphs. Click on the title below for the full post.

A Tale of Two Depressions

Barry Eichengreen Kevin H. O’Rourke
4 June 2009

This is an update of the authors' 6 April 2009 column comparing today's global crisis to the Great Depression. World industrial production, trade, and stock markets are diving faster now than during 1929-30. Fortunately, the policy response to date is much better. The update shows that trade and stock markets have shown some improvement without reversing the overall conclusion -- today's crisis is at least as bad as the Great Depression.

Editor’s note: The 6 April 2009 Vox column by Barry Eichengreen and Kevin O’Rourke shattered all Vox readership records, with 30,000 views in less than 48 hours and over 100,000 within the week. The authors will update the charts as new data emerges; this updated column is the first, presenting monthly data up to April 2009. (The updates and much more will eventually appear in a paper the authors are writing a paper for Economic Policy.)

New findings:

* World industrial production continues to track closely the 1930s fall, with no clear signs of ‘green shoots’.
* World stock markets have rebounded a bit since March, and world trade has stabilised, but these are still following paths far below the ones they followed in the Great Depression.
* There are new charts for individual nations’ industrial output. The big-4 EU nations divide north-south; today’s German and British industrial output are closely tracking their rate of fall in the 1930s, while Italy and France are doing much worse.
* The North Americans (US & Canada) continue to see their industrial output fall approximately in line with what happened in the 1929 crisis, with no clear signs of a turn around.
* Japan’s industrial output in February was 25 percentage points lower than at the equivalent stage in the Great Depression. There was however a sharp rebound in March.

The facts for Chile, Belgium, Czechoslovakia, Poland and Sweden are displayed below; note the rebound in Eastern Europe.

Updated Figure 1. World Industrial Output, Now vs Then (updated)

Updated Figure 2. World Stock Markets, Now vs Then (updated)

Updated Figure 3. The Volume of World Trade, Now vs Then (updated)

Updated Figure 4. Central Bank Discount Rates, Now vs Then (7 country average)

Start of original column (published 6 April 2009)

The parallels between the Great Depression of the 1930s and our current Great Recession have been widely remarked upon. Paul Krugman has compared the fall in US industrial production from its mid-1929 and late-2007 peaks, showing that it has been milder this time. On this basis he refers to the current situation, with characteristic black humour, as only “half a Great Depression.” The “Four Bad Bears” graph comparing the Dow in 1929-30 and S&P 500 in 2008-9 has similarly had wide circulation (Short 2009). It shows the US stock market since late 2007 falling just about as fast as in 1929-30.
Comparing the Great Depression to now for the world, not just the US

This and most other commentary contrasting the two episodes compares America then and now. This, however, is a misleading picture. The Great Depression was a global phenomenon. Even if it originated, in some sense, in the US, it was transmitted internationally by trade flows, capital flows and commodity prices. That said, different countries were affected differently. The US is not representative of their experiences.

Our Great Recession is every bit as global, earlier hopes for decoupling in Asia and Europe notwithstanding. Increasingly there is awareness that events have taken an even uglier turn outside the US, with even larger falls in manufacturing production, exports and equity prices.

In fact, when we look globally, as in Figure 1, the decline in industrial production in the last nine months has been at least as severe as in the nine months following the 1929 peak. (All graphs in this column track behaviour after the peaks in world industrial production, which occurred in June 1929 and April 2008.) Here, then, is a first illustration of how the global picture provides a very different and, indeed, more disturbing perspective than the US case considered by Krugman, which as noted earlier shows a smaller decline in manufacturing production now than then.

Figure 1. World Industrial Output, Now vs Then

Source: Eichengreen and O’Rourke (2009) and IMF.

Similarly, while the fall in US stock market has tracked 1929, global stock markets are falling even faster now than in the Great Depression (Figure 2). Again this is contrary to the impression left by those who, basing their comparison on the US market alone, suggest that the current crash is no more serious than that of 1929-30.

Figure 2. World Stock Markets, Now vs Then
Source: Global Financial Database.

Another area where we are “surpassing” our forbearers is in destroying trade. World trade is falling much faster now than in 1929-30 (Figure 3). This is highly alarming given the prominence attached in the historical literature to trade destruction as a factor compounding the Great Depression.

Figure 3. The Volume of World Trade, Now vs Then

Sources: League of Nations Monthly Bulletin of Statistics, http://www.cpb.nl/eng/research/sector2/data/trademonitor.html
It’s a Depression alright

To sum up, globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimise this alarming fact. The “Great Recession” label may turn out to be too optimistic. This is a Depression-sized event.

That said, we are only one year into the current crisis, whereas after 1929 the world economy continued to shrink for three successive years. What matters now is that policy makers arrest the decline. We therefore turn to the policy response.
Policy responses: Then and now

Figure 4 shows a GDP-weighted average of central bank discount rates for 7 countries. As can be seen, in both crises there was a lag of five or six months before discount rates responded to the passing of the peak, although in the present crisis rates have been cut more rapidly and from a lower level. There is more at work here than simply the difference between George Harrison and Ben Bernanke. The central bank response has differed globally.

Figure 4. Central Bank Discount Rates, Now vs Then (7 country average)

Source: Bernanke and Mihov (2000); Bank of England, ECB, Bank of Japan, St. Louis Fed, National Bank of Poland, Sveriges Riksbank.

Figure 5 shows money supply for a GDP-weighted average of 19 countries accounting for more than half of world GDP in 2004. Clearly, monetary expansion was more rapid in the run-up to the 2008 crisis than during 1925-29, which is a reminder that the stage-setting events were not the same in the two cases. Moreover, the global money supply continued to grow rapidly in 2008, unlike in 1929 when it levelled off and then underwent a catastrophic decline.

Figure 5. Money Supplies, 19 Countries, Now vs Then

Source: Bordo et al. (2001), IMF International Financial Statistics, OECD Monthly Economic Indicators.

Figure 6 is the analogous picture for fiscal policy, in this case for 24 countries. The interwar measure is the fiscal surplus as a percentage of GDP. The current data include the IMF’s World Economic Outlook Update forecasts for 2009 and 2010. As can be seen, fiscal deficits expanded after 1929 but only modestly. Clearly, willingness to run deficits today is considerably greater.

Figure 6. Government Budget Surpluses, Now vs Then

Source: Bordo et al. (2001), IMF World Economic Outlook, January 2009.

To summarise: the world is currently undergoing an economic shock every bit as big as the Great Depression shock of 1929-30. Looking just at the US leads one to overlook how alarming the current situation is even in comparison with 1929-30.

The good news, of course, is that the policy response is very different. The question now is whether that policy response will work. For the answer, stay tuned for our next column.

Eichengreen, B. and K.H. O’Rourke. 2009. “A Tale of Two Depressions.” In progress.

Bernanke, B.S. 2000. Bernanke, B.S. and I. Mihov. 2000. “Deflation and Monetary Contraction in the Great Depression: An Analysis by Simple Ratios.” In B.S. Bernanke, Essays on the Great Depression. Princeton: Princeton University Press.

Bordo, M.D., B. Eichengreen, D. Klingebiel and M.S. Martinez-Peria. 2001. “Is the Crisis Problem Growing More Severe?” Economic Policy32: 51-82.

Paul Krugman, “The Great Recession versus the Great Depression,” Conscience of a Liberal (20 March 2009).

Doug Short, “Four Bad Bears,” DShort: Financial Lifecycle Planning” (20 March 2009).

Friday, June 12, 2009

Contributions to the Change in Nonfarm Payroll Employment

From Economist's View:
June 8, 2009

The graph is from "Are there green shoots in the labor market?" by Melinda Pitts and Menbere Shiferaw of the Atlanta Fed. They say "it is promising that the labor market is at least producing some variation from the negative trends." However, see also Jobless Recovery Redux? from Mary Daly, Bart Hobijn, and Joyce Kwok of the SF Fed. They say "Our analysis generally supports projections that labor market weakness will persist, but our findings offer a basis for even greater pessimism about the outlook for the labor market."

Update: Jeff Frankel, a member of the NBER Business Cycle Dating Committee, says we haven't hit bottom yet:

The labor market has NOT yet signaled a turning point: The rate of decline in employment fell abruptly in May, according to the BLS figures released June 5, to about half the monthly rate of job loss recorded over the preceding six months (345,000 vs. 642,000). The news was received in a variety of ways.

First, the cynics. They tend to wax sarcastic at the idea of “things are not getting worse quite as fast as they were” as a good-news proposition. But a wide variety of recent data indicate that the economy is no longer in the state of free-fall that it entered last September, and this is indeed good news. ...

Second, the academics note (correctly) that there is little information in each individual monthly statistical fluctuation that is measured, because the data are inevitably noisy. Still, the public wants to know, in real time, what is the best we can glean from the information we have.

Third, the financial press, in particular, had been asking whether this quarter could turn out to have be the bottom of the recession. The May employment report encouraged speculation that the answer was “yes.” The stock market went up.

The members of the NBER Business Cycle Dating Committee (of which I am one) will be responsible for calling the trough when the time is right. We have a range of views... But all of us agree, on the one hand, that a decline in economic activity is a decline in economic activity, and therefore still a state of recession, even if the rate of decline has moderated a lot. But I believe that we also agree, on the other hand, that employment is usually a lagging indicator of economic activity. (For example, the economy continued to lose jobs long after the ends of the 1991 and 2001 recessions. Hence the “jobless recoveries.”)

Speaking entirely for myself, I like to look at the rate of change of total hours worked in the economy. Total hours worked is equal to the total number of workers employed multiplied by the average length of the workweek for the average worker. The length of the workweek tends to respond at turning points faster than does the number of jobs. When demand is slowing, firms tend to cut back on overtime, and then switch to part-time workers or in some cases cut workers back to partial workweeks, before they lay them off. Conversely, when demand is rising, firms tend to end furloughs, and if necessary ask workers to work overtime, before they hire new workers. (The hours worked measure improved in April 1991 and November 2001 which on other grounds were eventually declared to mark the ends of their respective recessions.) The phenomenon is called “labor hoarding” and it is attributable to the costs of finding, hiring and training new workers and the costs in terms of severance pay and morale when firing workers.

Unfortunately, as reported by Forbes, pursuing this logic leads to second thoughts about whether the most recent BLS announcement was really good news after all. The length of the average work week fell to its lowest since 1964 ! The ... rate of decline (0.7%) was very much in line with the rate of contraction that workers have experienced since September. Hours worked suggests that the hope-inspiring May moderation in the job loss series may have been a minor aberration. If firms were really gearing up to start hiring workers once again, why would they now be cutting back as strongly as ever on the hours that they ask their existing employees to work? My bottom line: the labor market does not quite yet suggest that the economy has hit bottom.

He has a graph of hours worked. Also see: The ‘part-timezation’ of America at FT Alphaville.