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.

Saturday, August 29, 2009

Econ 326: International Economics, Fall 2009 Course Material

I will be posting course material here. As you probably noticed there is a direct link to this post on the right hand side of the blog.

The material posted here is for:

Economics 326 Section 9U3
International Economics
Sunday 9:20 - 12:05 in room PH231

I can be reached at:


Assignment #1: Chapter 2 Questions 3, 5, 6, 7, 11, 12.

Econ 215 Money and Banking, Fall 2009 Course Material

Link to final: HERE

I will be posting course material here. As you probably noticed there is a direct link to this post on the right hand side of the blog.

The material posted here is for:

Economics 215 Section 1u3a
Money and Banking
Sundays 1:00- 3:40 in room PH156

I can be reached at:


Homework #1: Due in class Oct 11th
Homework #2: Homework Assignment #2
Homework #3: Due in class Dec 6
Homework #4: Due in class Dec 13th

Edited Question TYPO IN QUESTION a. FIXED: Replaces HW#3 Q3 and HW#4 Q1

Link to final: HERE

Midterm Grades, listed by ID number:

Wednesday, August 26, 2009

J. Bradford DeLong: Why we need noyt fear that a bigger stimulus will be counter productive

Why we need not fear that a bigger stimulus will be counterproductive
J Bradford DeLong
16 March 2009

There are legitimate reasons to fear that deficit-spending fiscal boost programs will not work well enough and have high enough longer-term costs to be not worth doing. This column says we do not need to fear bottleneck-driven inflation, capital flight-driven inflation, crowding-out of investment spending, nor reaching the limits of debt capacity because we will see them coming in time.

My favourite line from Jaws is uttered police chief Martin Brody (Roy Scheider) when he finally sees the shark: “You are going to need a bigger boat.”

We are at last seeing the shape of this downturn – and we are going to need a bigger fiscal stimulus than the deficit-spending package President Barack Obama pushed through the US Congress in February. We might get lucky; maybe the next four months will be months of unreserved good luck; maybe four months from now we will think that what we have collectively done to stabilise the North American and world economies is appropriate. That is not very likely; mixed news would mean that four months from now we are going to want to do another round of government spending boosts and tax cuts to try to keep the unemployment rate from rising too much higher and capacity utilisation from falling too much lower. (And the legislative calendar means that we should start thinking about laying the groundwork for such a second round of stimulus right now; in order to be in the budget reconciliation bill that will pass the congress in August, provision for fiscal stimulus must be in the budget resolution that will pass the congress in April.) Moreover, if the next four months are months of worse-than-expected bad news – well, let’s not go there right now.

Getting another round of spending boosts and tax cuts will, however, be problematic. Partisan opposition is mounting. That there is partisan opposition is very strange. We know John McCain’s chief economic advisers – people like Douglas Holtz-Eakin, who made an excellent reputation for himself as head of the Congressional Budget Office, like well-respected forecaster Mark Zandi, like AEI’s Kevin “Dow 36000” Hassett. We know how they think. We know that had John McCain won last November’s presidential election a very similar stimulus plan (but with fewer spending increases and more tax cuts) would just have moved through congress with solid Republican support. So the current 98% Republican opposition (except by governors who have to, you know, govern) leaves us scratching our heads.

So as we get ready to try to go and buy a bigger fiscal stimulus boat to deal with this Jaws recession, whose bite pushed the unemployment rate up to 8.1% in February, it is important to be clear why we ought to be doing this. And the first point that needs to be made is that the strange right-wing talking point that a government fiscal boost would not spur the economy because... because... well, it's not sure why... is badly mistaken at best and disingenuous at worst.

Four legitimate fears

But there are legitimate reasons to fear that deficit-spending fiscal boost programs would not work well enough and would have high enough longer-term costs to be not worth doing. I classify these legitimate fears into four groups.

  • Bottleneck-driven inflation. The fear is that although more deficit spending will increase total spending, and although businesses seeing increased demand for their products will indeed try to hire more workers to boost production, they will succeed only by offering their new workers higher wages – wages higher enough that they then have to boost their prices – and by snatching scarce commodities out of the supply chain by paying more and then having to boost their prices more as well. Thus rising inflation will make the increase in real demand an order of magnitude less than the increase in nominal demand. And if the inflation produces general expectations that prices will continue to rise – well, then we are back where we were in the 1970s, with everybody focusing on changes in the overall price level rather than whether their business plan made sense given individual goods and services prices. An inflationary economy is one in which the price system does not do a very good job of telling people and businesses where to focus their energy. It is likely, over the decades, to be a slow-growth economy. Breaking an inflationary spiral would require another recession on the order of 1979-1982. It is better not to go there, and a fiscal stimulus plan that takes us there is not worth doing.
  • Capital flight-driven inflation. The fear is that the stimulus package will cause foreign holders of domestic bonds to believe that inflation is on the way and trigger a mass sell-off of US Treasuries and other dollar-denominated assets that will push the value of the dollar down. And as the value of the dollar falls, the dollar prices of imported goods and services rise – and we are off to the inflation races once again.
  • Crowding-out of investment spending. The fear is that additional government borrowing may – not will, not must, but may, for this is a fear not a certainty – push up interest rates, make financing expansion even more expensive for businesses, and so discourage private investment. The boost to spending would thus come at a high cost-benefit ratio as much additional borrowing leaves us with only a little additional demand. Moreover, it would leave us with a low productivity-growth recovery that has too little productivity-boosting private investment and too much government spending in the mix.
  • Reaching the limits of debt capacity. The fear is that the long-term costs of additional fiscal boosts via deficit spending will be very large because those from whom the US government will have to borrow the money to finance spending will only loan it on lousy terms – high and unfavourable real interest rates that impose substantial amortisation burdens and associated deadweight losses from taxation on America’s taxpayers.

All of these are legitimate fears when a government undertakes a deficit-spending plan. We can all recall historical episodes when they turned out to be not just fears but realities. We remember bottleneck-driven and wage-push inflation from the late 1960s and from the oil shock-ridden 1970s – those episodes were the first fear coming home to roost. Nobody today is happy with American fiscal policy in the late 1960s or American demand management policy in the 1970s.

The second fear became a reality in France in the early 1980s. Capital flight and anticipated-depreciation-driven inflation were the immediate result of Francois Mitterand’s attempt to institute Keynesianism in one country and drive for full employment when he became president of France in 1981.

The third fear was perhaps not a reality but it certainly was greatly feared in the winter of 1992 and 1993, back when I carried spears for Lloyd Bentsen and his subordinates Roger Altman and Lawrence Summers in the Clinton Treasury. They argued that the Clinton-era economy could not afford the crowding-out of private investment that even the steady-course deficits then projected for the mid-1990s were threatening to produce through high and rising interest rates.

And the fourth fear is an even older legitimate fear yet. It goes back to Adam Smith and his Wealth of Nations, which contains pages warning that deficit spending on the imperial adventures of George III and his ministers would produce an unsustainable debt burden that would crack the British economy like an egg – as had been the consequences of debt-financed wars in Holland, France, Spain, and the Italian city-states over the previous three centuries.

Why we need not fear

These four fears are all legitimate fears, but I believe that we, here, now do not need to fear them.

In each of the cases in which these fears are legitimate, we can see in advance that the stimulus program is going wrong. Stimulus packages produce increases in nominal but not real demand when exchange rates fall and prices rise; we can watch the exchange rates fall and the prices rise, and we can watch as financial markets anticipate these events beforehand. Stimulus packages crowd-out private investment when the government’s borrowing causes medium-term interest rates on corporate borrowings to rise. Stimulus packages impose a heavy financing burden on the government when they cause long-term interest rates on government securities to rise.

In all of these cases, that the stimulus is going to go wrong becomes very visible in advance. If the stimulus is going to be ineffective because it generates bottleneck-driven inflation, we can identify that problem as the price or wage of the bottleneck good or service spikes. If the stimulus is going to fail because of capital flight-driven inflation, we will see the value of the dollar collapse as foreign-exchange speculators front-run the capital flight – and then we will see import prices spike and put upward pressure on prices in the rest of the economy. If the stimulus is going to fail by crowding out private investment, we first will see the medium-term corporate interest rates relevant to financing plant expansion spike. And if it is going to impose a crushing debt repayment burden, we will see long-term Treasury bond interest rates spike instead.

Right now, however, we see none of these things. No signs of bottleneck-driven or wage-push inflation gathering force. No signs of approaching rapid dollar depreciation. No signs that the stimulus is pushing up medium-term interest rates on corporate borrowing. No signs that the stimulus is pushing up long-term interest rates on government bonds.

If any of these start to materialise, expect me and a number of other stimulus advocates to start backpedalling rapidly. But so far, so good.

Editors’ note: This was first posted on Reposted here with permission.

Richard Clarida: A lot of bucks, but how much bang

A lot of bucks, but how much bang?

Richard Clarida
16 March 2009

Policymakers have committed substantial sums to addressing the global recession and the global financial crisis, but there is real doubt about their effectiveness. This column explains why the fiscal stimulus might fail.

“We have involved ourselves in a colossal muddle, having blundered in control of a delicate machine, the workings of which we do not understand” - John Maynard Keynes, “The Great Slump of 1930”, published December 1930.

I recently had the privilege of participating on a panel that was part of the Russia Forum, an annual conference held in Moscow that brings together market makers, policymakers, and academic experts to discuss the state of global markets, geopolitics, and the many and varied ways that Russia factors into these complex domains. The topic assigned to our panel, not surprisingly, was the global financial crisis – causes, consequences, and policy responses. Although each speaker had his own, unique perspective, a cohesive, urgent theme did emerge, or so it seemed to me, from the two-and-half-hour session that included probing questions from a number of the audience members assembled for the event.

That theme suggests the title I’ve chosen for this column; there are, at last, a ‘lot of bucks’ now committed by policymakers to address the global recession and the global financial crisis, but there is real doubt about how much ‘bang’ we can expect from these bucks.

In the US, President Obama has just signed a nearly 800 billion dollar stimulus package and the Fed has cut the Federal Funds rate to zero. Monetary policy in the rest of the G7, while lagging behind the US, will follow the US lead and soon come close to zero. (In the case of the ECB, the policy rate may end up at 1%, but the effective interbank rate has been trading well below the official policy rate in recent weeks so a policy rate of 1% could translate into an effective interbank rate of nearly zero). Likewise for fiscal deficits – they are rising globally and headed higher, propelled by a combination of discretionary actions and automatic stabilisers.

To date, however, these traditional policies have been insufficient for the scale and scope of the task. Recall that the Obama stimulus package is actually the second such US effort in the last 12 months. The 2008 edition was deemed to be a failure because a big chunk of the rebate checks were saved or used to pay down debt and not spent. The Obama package includes tax cuts and credits that will provide a boost to disposable income, but how much of these will be spent rather than saved or used to pay down debt? The package also includes a substantial increase in infrastructure spending, as well as transfers to the states, but the infrastructure spending is back-loaded to 2010 and later, and the transfers to states will most likely just enable states to maintain public employment, not expand it appreciably.

Bucks without bang

What is the source of this concern that the US fiscal package will not deliver a lot of ‘bang’ for the ‘bucks’ committed? Because of the severe damage to the system of credit intermediation through banks and securitisation, policy multipliers are likely to be disappointingly small compared with historical estimates of their importance. Recall the Econ 101 idea of the Keynesian multiplier – the impact traditional macro policies are ‘multiplied’ by boosting private consumption by households and capital investment by firms as they receive income from the initial round of stimulus. It important to remember why and how policy multipliers actually come about. Policy multipliers are greater than 1 to the extent the direct impact of the policy on GDP is multiplied as households and companies increase their spending from the increased income flow they earn from the debt-financed purchase of goods and services sold to meet the demand from the initial round of stimulus.

Historically, multipliers on government spending are estimated to be in the range of 1.5 to 2, while multipliers for tax cuts can be much smaller, say 0.5 to 1. But these estimates are from periods when households could – and did – use tax cuts as a down payment on a car or to cover the closing costs on a mortgage refinance. For example, in 2001, the economy was in recession, but households took advantage of zero-rate financing promotions – as well as ready access to home equity withdrawal from mortgage refinancings – to lever up their tax cut checks to buy cars and boost overall consumption. With the credit markets impaired, tax cuts and income earned from government spending on goods and services will not be leveraged by the financial system to nearly such an extent, resulting in (much) smaller multipliers.

There is a second reason while the bang of the fiscal package will likely lag behind the bucks. Even if the global financial system soon restores some semblance of order and function, the collapse in global equity and housing market values has so impaired household wealth that private consumption (which represents 60% to 70% of GDP in G7 countries) is likely to lag – not lead – economic growth for some time, as households rebuild their balance sheets the old-fashioned way – by boosting their saving rates. Just in 2008 alone, I estimate that the net worth of US households fell by some 10 trillion dollars, with much of this concentrated in older demographic groups who, in our defined contribution world, must now be focused on building back up their wealth to finance retirement, which is not that far away. This means more saving, less consumption, and smaller multipliers.

Global challenges

Outside of the G7, many of the major countries (certainly including Russia) are commodity exporters. The global recession has triggered a collapse in commodity prices, turning 2007’s fiscal surpluses into deficits and turning property and capital spending booms into busts in a matter of months. For example, as I am writing this, a headline has just popped up confirming that Dubai has received a “10 billion dollar bailout” from the UAE central bank to help provide financing for the rollover of debt backed by thousands of unfinished and unsold houses and apartment projects. Immense reserve stockpiles, which only months ago were criticised by some as excessive and without any purpose other than to manipulate national currencies so as to prevent appreciation are now, in Russia and some prominent other countries, being drawn down rapidly in a futile attempt to slow speculative depreciation of their currencies.

In Russia’s case, Deputy Prime Minister Shuvalov spoke at the conference and made very clear that 2009 will be a year of hard choices for the Russian government. Most importantly, Shuvalov made clear that Russia is unwilling to spend more than the 200 billion (a third) of the reserves they have already spent in what has turned out to be a futile attempt to support the Ruble. This will mean that companies and some banks will be allowed to fail, and that fiscal outlays will be scaled back and not funded at previous levels through a further draw down of reserves. So in Russia’s case, and I suspect some others, a lot of ‘bucks’ remain in reserve coffers, but they will be mostly saved, not spent to finance a major discretionary expansion in fiscal policy.

Will the Fed pull it off?

So where does this leave us? A LOT is riding on the efforts of the Fed and other central banks to stabilise the financial system and restore the flow of credit.

Officials recognising these challenges are now seriously considering “non-traditional” policies that combine monetary and fiscal elements. Cutting rates to (near) zero has not been a mistake, but it has been ineffective – really the most striking example of ‘pushing on a string’ I have witnessed in my lifetime. The reason, again, is the impaired credit intermediation system. The private securitisation channel, which at its peak was intermediating nearly 50% of household credit in the US, has been destroyed. Banks are hunkering down in the bunker, hoarding capital as a cushion against massive losses yet to be recognised on the trillions of dollars of ‘legacy’ assets that they have been unable or unwilling to sell at the deep discount required to attract private investors. For this reason, the Fed and Bank of England – with many other central banks likely to follow suit in some form or fashion – are filling the vacuum by directly lending to the private sector. The Fed aims to purchase 600 billion dollars worth of mortgage-backed and agency securities this year and, via the soon to be launched Term Asset-Backed Securities Loan Facility (TALF), to finance without recourse up to one trillion dollars worth of private purchases of credit cards, auto loans, and student loans. Since last fall, the Fed has also been supporting the commercial paper market via the Commercial Paper Funding Facility (CPFF).

Altogether, between the MBS, CPFF, and TALF programs, the Fed is committing nearly 2 trillion dollars of financing to the private sector. While these sums may be necessary to prevent an outright economic collapse that extends and deepens into 2011 and beyond, it is not clear to me that they are sufficient to turn the economy around so that it returns to robust growth. Moreover, based on the Fed’s just released economic forecast and Chairman Bernanke’s recent testimony to the Senate Banking committee, the Fed is also not convinced that these policies are sufficient to turn the economy around. On 24 February, knowing that an 800 billion stimulus had passed, that the Fed has committed nearly 2 trillion dollars of lending to the private sector, and that the Treasury’s Public Private Investment Fund will aim to support up to one trillion dollars of private purchases of bank legacy assets, Chairman Ben Bernanke said,

If actions taken by the administration, the Congress, and the Federal Reserve are successful in restoring some measure of financial stability – and only if that is the case, in my view – there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery,”

As I said in my remarks at the conference, I think of myself as an optimist, and that outlook on life has served me well. However, the last nine months have severely tested that mindset, at least as it pertains to my professional endeavours. But old habits are hard to break, so I am casting aside the contrary evidence and putting my ‘bucks’ on the Fed. But it is a close call.

Richard Clarida ©

Monday, August 24, 2009

Expected Returns: Death of the Consumer

Monday, August 24, 2009

Death of the Consumer

Moving forward, the most critical indicator of the viability of our economy will be consumer spending. Simply put, without a buoyant consumer, there will be no recovery. Due no doubt to the negative characteristics of consumer data. the death of the consumer is receiving scant coverage.

America is a nation whose growth in recent decades has been predicated on a model of consumption. From a nation that used to save to invest, we now borrow to consume. As buying power in Treasuries from foreign entities wanes, we will be forced to fund our consumption through currently non-existent savings. An increased savings rate will put pressure on consumption, which will in turn pressure GDP. In the following chart, notice how consumption as a percent of GDP remains above historical norms. Consumption would have to contract another $800 Billion for personal consumption expenditures as a percent of GDP to revert to historical levels.

It is important to realize that what we are experiencing now isn't a classic inventory-led downturn, but a structural debt deflation. Since Americans have been wont to save, consumer credit has played an outsized role in our economic growth. As such, it is critical to be keen on developments in the availability of credit, which can be measured by consumer credit outstanding.

Consumer credit outstanding, a measure of short and intermediate-term credit, is falling precipitously. Banks are, quite justifiably, not willing to service loans to deteriorating credit risks. Until the unemployment picture improves, banks are unlikely to rapidly increase the extension of credit.

Notice that consumer credit outstanding has rebounded off of every single downturn besides the recession of 2001. Before we can realistically call for an end to the recession, we need to see a halt in the decline of consumer credit outstanding, and eventually a rebound. We are experiencing nothing of the sort yet.

Retail Sales

Consumption in the past decade, as reflected by retail sales, has enjoyed an impressive and inexorable rise. Year over year E- commerce sales growth remained robust even in the midst of the recession of 2001.; in fact, the rate of growth accelerated. As you can see from the following chart, E-commerce retail sales are declining dramatically.

The consumer is conspicuously missing in this supposed "green shoot" environment. At the very least, the V-shaped recovery thesis is not corroborated by data on the consumer front. Hopes of recovery must therefore be regarded as mere presumption until the outlook for the consumer improves.