The Great Moderation:
Squared Deviations of the Employment-to-Population Ratio from a Ten-Year Trailing Moving Average Trend
- Johann Carl Friedrich Gauss said that when you are analyzing variability, you should measure it by squaring deviations from the average and then averaging those squared deviations.
- That is what this figure does.
- When you measure trends with a trailing ten-year moving average and look at the employment-to-population ratio, four features over the past third of a century jump out at you:
- The steep economic downturn of the Volcker disinflation around 1980.
- The rapid rise in the employment-to-population ratio as American feminism took full hold in the late 1980s.
- The "Great Moderation" that ended just a few short years ago.
- Our current "Lesser Depression".
The Shift of Leading Sectors in the 2000s:
Equipment and Residential Construction Investment as Shares of Potential GDP
- The dot-com boom of the Clinton years in the later 1990s was driven by great optimism about and a very strong willingness to invest in equipment and software (the blue line)--primarily in the information and communications technologies of Silicon Valley.
- That came to an end in 2000--not because the technologies turned out to be a bust, but because it was very hard to figure out how to use them to make large profits.
- Most of the benefits of the new technologies flowed to consumers.
- Many investors--especially in telecommunications--found that the businesses they had invested in had no sustainable business models.
- What would replace the lessened share of investment in equipment and software (the blue line)?
- The answer was investment in housing (the red line) made possible by low interest rates produced by the "global savings glut" and by better "risk management" made possible by derivatives.
Equipment Investment, Residential Construction Investment, and Exports
- Exports also had a potential role to play as a leading sector--but not in the context of the global imbalances of the 2000s.
The Housing Boom and Bubble:
Number of Houses Built in America
- Figure that the long-run trend is that, with growing population and with increasing wealth leading more people to want second homes, the trend is for us to build about 1.4 million houses a year.
- The magnitude of the housing boom: 7 years x 800,000/year in peak excess housing construction x 1/2 because the boom is a triangle gives us about 3 million excess houses built between 1998 and 2007, with the bulk of them built after 2004.
- Figure $150,000 in mortgage debt on these houses that isn't going to be repaid on average, and we have a $450 billion investment loss from the housing bubble.
Price of Houses Divided by the Consumer Price Index
- The price of houses went up a lot in the early 2000s.
- By how much should it have gone up?
- Lower interest rates ought to raise the price of housing.
- Higher energy prices ought to raise the price of conveniently-located housing.
- An exhaustion of opportunities for transportation improvements ought to raise the price of conveniently-located housing.
- But by how much?
- The market's current judgment is that nearly all of house price rises over and above CPI inflation in the 2000s were unsustainable, and a bubble.
The Federal Reserve:
The Money Market
- The Federal Reserve controls the short-term interest rate on 3-Month Treasury Bills--it buys and sells them for cash until that interest rate is where it wants it to be.
- At least, it controls that interest rate as long as it wants the interest rate to be zero or above.
- The interest rate more relevant for businesses is the ten-year bond rate--which is best thought of as an average of expected future Treasury Bill rates plus a risk premium.
- (And because businesses cannot borrow at the Treasury rate and may not be able to borrow at all, there are still further complications we will consider in future weeks.)
- The Federal Reserve tries to fulfill its "dual mandate" in normal times by nudging interest rates around--by making it easier or harder, cheaper or more expensive for private businesses and households to borrow.
- Question: Why have a Fed at all? Why this island of central planning in the middle of the economy? Why not just let the market take care of interest rates?
Federal Reserve Policy and Inflation
- It is probably best to evaluate the Fed's policy stance by comparing the interest rate it controls--the three-month Treasury Bill rate--to the current rate of inflation.
- During the downturn of the early 1990s, the Fed reduced the Treasury Bill rate to the rate of inflation and kept it there for two years.
- It then concluded that the recovery had become "well established", and rapidly raised interest rates to get them back to a normal spread vis-a-vis the inflation rate.
- At the end of the 1990s the Federal Reserve raised the Treasury Bill rate as it grew nervous about upward-creeping inflation.
- But then after the collapse of the dot-com boom and 9/11 it lowered the Treasury Bill rate below the inflation rate and kept it there for quite a while.
- And then restored a normal spread.
- As the housing bubble collapsed and the financial crisis began the Federal Reserve lowered the Treasury Bill rate to about 2 percent, and then played wait-and-see.
- And in late 2008 as the global economy collapsed it lowered the Treasury Bill rate to zero--and now says it will keep it there for two more years, unless things change.
- Even though some members of the FOMC are very nervous about a Treasury Bill rate so far below the inflation rate.
"Animal Spirits"--or, If You Prefer, Investor Confidence:
The Value of the S&P 500 Index Divided by Potential GDP
- This is the right way to look at whether the stock market is high or low if you think that the capital stock of the S&P 500 firms is a more-or-less constant share of the capital stock of the economy.
- The long pessimistic slide in relative stock market values during the inflationary 1970s.
- What we at the time thought was a big stock market boom in the 1980s.
- The dot-com bubble of the late 1990s.
- The dot-com and 9/11 crash of the 2000s.
- "Normalcy" more-or-less in the mid-2000s.
- A second stock market crash with the financial crisis--very upsetting: such things are supposed to come once a generation, not twice in a decade.
Readings for September 2:
The Great Moderation and the Global Savings Glut:
- Ben Bernanke (2005), "The Global Savings Glut and the U.S. Current Account Deficit" http://tinyurl.com/dl20110827g
- Stefan Gerlach and Laura Moretti (2011), "Monetary Policy Before the Crisis" http://tinyurl.com/dl20110827a
The Housing Boom:
- Edmund Andrews (2005), "Greenspan Says Lower Rates Tempt Investors to Risk More" http://tinyurl.com/dl20110827d
- Edmund Andrews (2009), "My Personal Credit Crisis" http://tinyurl.com/dl20110827i
Economists Try to Understand the Economy: Paul Krugman:
- July 18, 2001: "Interview on Moneyline" http://tinyurl.com/dl20110827j
- May 20, 2005: "The Chinese Connection" http://tinyurl.com/dl20110827l
- August 8, 2005: "That Hissing Sound" http://tinyurl.com/dl20110827n
- August 7, 2006: "Intimations of Recession" http://tinyurl.com/dl20110827k
- August 24, 2006: "Housing Gets Ugly" http://tinyurl.com/dl20110827m
Economists Try to Understand the Economy: J. Bradford DeLong:
- October 5, 2005: "Grading the Greenspan Fed" http://tinyurl.com/d20110827b
- September 17, 2007: "Review of Alan Greenspan, The Age of Turbulence" http://tinyurl.com/dl20110827c October 1, 2007: "Alan Greenspan on the Scales" http://tinyurl.com/dl20110827f October 27, 2008: "The Republic of the Central Banker" http://tinyurl.com/dl20110827h
- December 19, 2008: "Greenspan Roundtable: Is $250 Billion [to Recapitalize the Banks] Enough?" http://tinyurl.com/dl20110827e