Grasping Reality with Both Hands: The Semi-Daily Journal Economist Brad DeLong

David Wessell on Dodd-Frank

David Wessel writes:

Capital - WSJ.com: The latest flash point in the debate over the nation's bursting housing bubble is this: Since so many American houses are worth less than their mortgages, should the government do more to get lenders to settle...?

Of the 80 million houses in the U.S., about 55 million have mortgages. Of those, four million are behind on payments. Foreclosure proceedings were begun on about 1.5 million homes last year, up more than 50% from 2006. This year will be worse. The Treasury, according to presentations its officials have made recently, predicts house prices could fall another 10% to 15% before touching bottom.

Moody's Economy.com estimates that one in roughly 12 American families with mortgages -- four million in all -- already... are... "underwater." The firm predicts that by early 2009 nearly one in four, or 12 million... underwater. Most will continue to pay mortgages on time. Many won't....

Lenders... prefer to avoid foreclosure if possible.... Better to cut a deal than end up with an empty, decaying house.... In ordinary times, a lender shouldn't need prodding from the government to do what's in its self-interest. But these aren't ordinary times. The drop in home prices is pervasive, mortgage markets messy and complexities caused by turning mortgages into securities many....

Mr. Frank would offer lenders and eligible borrowers a deal: If the lender agrees to cut the debt so the homeowner owes no more than 90% of the house's current value, and the Federal Housing Administration (or an outfit to whom it outsources this) determines the homeowner can afford a new loan, then the lender gets rid of the mortgage and the FHA insures a new mortgage for the remaining balance.

The lender takes a hit, but gets rid of the risk.... [T]he lender has to chip in another 5% of the property's current value. The homeowner has to surrender some profits, if any... when the house is sold.

The White House condemns this.... [T]he Treasury argued in a recent PowerPoint presentation: "Homeowners who can afford their mortgage but walk away because they are underwater are merely speculators." (It's a bit jarring to hear the Treasury vilifying people who are acting in their economic self-interest.)...

Despite the restrictions, the plan could allow some homeowners to get a deal they don't deserve; that's the unfortunate byproduct of any rescue. But the Treasury and Fed surrendered the let-the-market-work-it-out high ground when they agreed to risk nearly $30 billion of taxpayer money to shield Bear Stearns, its creditors and counterparties from losses....

[T]he Congressional Budget Office... predict[s] only 500,000 mortgages would be refinanced.... So, perhaps it's best considered a prudent experiment for coping with a bad situation that might get worse: Create a mechanism now so the bugs are worked out, in case home prices plunge more than anticipated...

The Fed Thinks About Paying Interest on Banks' Required Reserve Deposits

Steve Randy Waldmann writes:

Interfluidity :: Stock of Treasury securities at the Fed: As of April 30, the Fed's uncommitted stock of Treasuries was $382B, just under half of its December 5 stock. The Fed recently announced a $50B expansion of the TAF program, and a widening of acceptable collateral for its TSLF program. Assuming the Fed sterilizes the extra TAF funding (very likely) and that the $200B pledged to TSLF is now fully exploited (likely), the Fed's stock of uncommitted Treasuries will soon be $275.5B. Just over 64% of the Fed's stock of Treasury's will have been exhausted since the Fed began its unconventional lending programs in December.

The Fed wants to swap out Treasuries for other securities in order to reduce the risk premium--to raise the (temporary) market supply of Treasuries and reduce the supply of other securities until the crisis passes and MBSs and other securities recover their value. (If they never recover their value, then we have much bigger things to worry about.)

The Fed may also want to raise the general level of interest rates in order to fight inflation--which requires that it sell its Treasuries for safe bank reserves rather than temporarily swap them for risky MBSs.

The Fed is clearly thinking that it may run out of Treasuries with which it can accomplish these two missions. Hence it is coming up with an alternative way to raise the general level of interest rates--that is, paying interest on banks' required reserve deposits at the Fed.

Martin Feldstein Calls for Large-Scale Public Intervention in the Housing Market...

He writes:

FT.com / Comment & analysis / Comment - Misleading growth statistics give false comfort: Macroeconomic Advisers... [estimates monthly GDP] using the same conceptual approach as the government uses for its quarterly estimates.... Its most recent estimates... show that real GDP rose from an annual $11,649bn [real 2000 dollars] last October to $11,701bn in December and $11,777bn in January but fell to $11,686bn in March, a decline of about $100bn in two months.... The misstatement that the economy expanded in the first quarter creates an inappropriately sanguine view of the months ahead....

Although the tax rebates now under way may provide some temporary help, the combination of falling real incomes, declining household wealth and a dramatic drop in consumer confidence suggests further falls in consumer spending and GDP. But the most serious risk is that the rapid fall in house prices – down more than 12 per cent in the past year and falling at a 25 per cent rate in the past three months – will raise the number of negative-equity mortgages, leading to widespread defaults and foreclosures.

Because US mortgages are “no-recourse”... individuals with negative equity have an incentive to default. There are now an estimated 8m negative-equity mortgages – more than 15 per cent of all outstanding mortgages.... A downward spiral in house prices would cause a fall in household wealth and in the capital of financial institutions, potentially resulting in a deeper and longer recession than any seen in the past several decades.

Now is the time for policy action to forestall such a house price collapse. There is nothing more the Federal Reserve can do by lowering short-term interest rates or by creating new credit facilities.... What is missing is action to prevent positive-equity mortgages from becoming negative-equity mortgages. The federal government could achieve that by providing low-interest loans with full recourse that would allow any homeowner to pay down a significant fraction of his mortgage. Homeowners would be in effect giving up the potential to default on their mortgage loans in exchange for lower interest costs...

Different from the more typical proposal these days of having the Federal government guarantee private mortgages (in exchange for warrants on the upside), but different in ways that I suspect are minor...

Brad DeLong Interviewed by Philippe Gohier

In Macleans magazine:

The Macleans.ca Interview: Brad DeLong | Macleans.ca - Canada - Features: Q: As a general rule, Republicans say the U.S. isn't in a recession, while Democrats say it is. In your opinion, is the U.S. in or headed for a recession?

A: We’re saying it looks like it’s the weakest possible not-recession. Come July, the Commerce Department is going to revise the GDP numbers and that’s going to change things. It could make things either look less recessionary, or it could push us into determining we’re in a recession. The odds are about 50/50.

Q: In simple terms, what does a recession mean for Americans?

A: It means it’s a lot harder to get jobs. A lot more people are unemployed and without income. People who are employed are scared and eager to settle for much lower increases in real wages, or even accept real wage cuts. It means a lot of people who could be doing something useful are unable to get themselves matched with firms that can use their talent. [A recession is] something you would definitely rather avoid, even if [avoiding it] does produce some costs. It's better to have some investment flowing into the wrong sectors than it is to have all your investment proportions exactly what they should be and a whole bunch of people who could be working and want to work sitting at home, feeling poor.

Q: The Bush administration has already dealt out a pretty expensive stimulus package.

A: I a $13-trillion economy, we’re at about $150-billion of fiscal stimulus this year. That’s only one per cent. Together with what the Federal Reserve has done, everyone hopes this is going to be enough to keep us near full employment without creating an inflation problem for the longer run. But that’s just a hope at the moment.

Q: Has the sputtering economy been properly managed?

A: One way to look at it is this all starts back in 1995, when Alan Greenspan said, ‘It looks like this new economy stuff may really be there. I’m going to ignore all my staff who’s telling me about limits to growth and likelihood of inflationary pressures. I’m not going to raise interest rates and see how much high-tech investment we can get going on the grounds that this might be an opportunity for a serious boom.' Indeed, there was a lot of irrational exuberance. A lot of the world's richest people invested in Internet startups and communications companies. They paid for an enormous amount of dark fibre out of which they never got any dividends, but which did give the rest of us very cheap phone calls and data for half a decade or so.

Then comes 2000 and 2001, and it becomes clear, not that the technology has been oversold, but that the ability to use the Internet to actually make huge profits has been oversold. The Federal Reserve’s response was, ‘We need another leading sector. How about if we drop interest rates and see if we can get a construction boom going?' So, Greenspan does this and it works. In fact, it works beyond his wildest dreams. Then, there’s the irrational exuberance that comes out of the financial bubble, as [some] mortgage companies stop checking people’s loan.

Right now, we have an interesting game going on. As the housing boom unwinds, it's become clear the U.S. built perhaps three million more houses than would be supportable at 2007 housing prices. Construction employment is collapsing and the hope is that, once again, you can replace a leading sector that’s had a boom and a bubble with another one. This time the sector that’s growing is exports and import-competing manufacturing, especially as the dollar falls, first against the Europeans and against the Canadians and hopefully soon against the Asians. But the U.S. economy is already, relative to trend labour force growth, down three-quarters of a million jobs relative to last December. So even if it’s not a recession, it feels like a recession.

Q: American economist Joseph Stiglitz has made the argument that the U.S. economic problems are in part due to the war in Iraq.

A: The war has certainly pushed up oil prices a bunch, directly and indirectly. And I think the war has made us significantly weaker. A trillion dollars that could have been spent doing something useful has been spent creating a situation that, for most Iraqis, has been worse than living under the cruel, semi-totalitarian dictatorship of Saddam Hussein. It still seems to be a much more minor contribution to the current macroeconomic puzzle. I think Joe’s letting his view about the future and the likely good course of U.S. foreign policy lead him to overstate the case a bit. The argument against our adventure in Iraq would still be there even if we were still in the housing boom.

Q: Economic figures for the month of February were recently released in Canada and they showed the country's economy shrank 0.2 per cent. There’s some worry we’re on the brink of recession here.

A: If U.S. demand for Canadian exports keep falling and the U.S. goes into a recession, it seems highly likely.

Q: The federal government in Canada has taken a laissez-faire approach and promoted aggressive tax cuts as a solution. Do you have any thoughts on that?

A: I learned my macroeconomics at the knee of Martin Feldstein, back when the Republican Party in the United States was still the party of sound money and fiscal surpluses. I was just running through my class the argument Marty made around 1980: that basic utilitarian calculations suggest the United States should be saving half again as much as it is and investing it into the future. Unfunded tax cuts take what would otherwise be national savings and divert them into government deficits. While I do see a very small and limited role for tax cuts in a recession to try to prevent mass unemployment, I’m still with Marty--or at least with the old, unmuzzled Marty. Developed countries ought to be running substantial government surpluses because the opportunities for saving and investment are great, because aging populations are going to require debt capacity in the future, and because the technological revolution in medical care is going to produce a huge future demand for governments to spend money keeping people healthy. I have this instinctive, allergic reaction to unfunded tax cuts, even in recessions. And we’re not quite in a recession, yet.

Q: The presidential candidates in the U.S. have had a lot to say on the economy. How would you rate their economic platform?

A: We were sitting around here in the lounge yesterday, all feeling sorry for Douglas Holtz-Eakin, McCain’s economic guy. He is a sensible guy who’s now saying extremely silly and stupid things. He seems to have lost an internal struggle about what the McCain economic policy for the campaign should be. Phil Gramm, another of McCain's economic advisers, is smart as a whip and is a serious person for whom we have to have respect--even if he is a right-wing hyena of a magnitude rarely seen. Our hope is that everything McCain is saying about the economy right now is for shoring up [his support on] the right, [is] for campaign purposes only. Paul Krugman, on the other hand, is out there saying all of us who have hopes for the McCain economic policy are deluding ourselves.

The candidates’ economic policy [proposals] on the Democratic side [pretty much all] looked like sensible attempts to approach very hard problems--or so I thought until Hillary Clinton came out in favour of [McCain's] temporary gas tax holiday. Global warming says you want to increase gas taxes rather than diminish them, and income distribution suggests you don’t want temporary holidays because they're quickly over and have no effect on supply. To boost gasoline supply takes a long time. The McCain gas tax holiday for the summer seems to simply be a ‘let’s transfer a lot of money from the government to the oil companies while doing something that sounds like it’ll help driving consumers but actually won’t.’ Clinton’s plan is to have a gas tax holiday and pay for it by a tax on refineries; as Paul Krugman wrote, this had the effect of making the proposal pointless rather than evil. Maybe you have to give Clinton’s economic policy people credit for coming up with something that sounds good and manages to turn an economic minus into an economic zero. But it wasn’t a terribly good sign...

Jeffrey Sachs Communes with His Inner Hayek

Jeff writes:

The roots of crisis | Comment is free: The US federal reserve's desperate attempts to keep America's economy from sinking... do not seem to be effective. Although interest rates have been slashed and the Fed has lavished liquidity on cash-strapped banks, the crisis is deepening. 

To a large extent, the US crisis was actually made by the Fed.... [I]n 2001... the Fed turned on the monetary spigots to try to combat an economic slowdown... pumped money into the US economy and slashed its main interest rate.... The Fed held this rate too low for too long....

What was distinctive this time was that the new borrowing was concentrated in housing... commercial and investment banks created new financial mechanisms to expand housing credit to borrowers with little creditworthiness. The Fed declined to regulate these dubious practices....

[T]he home-lending boom... became self-reinforcing... buying pushed up housing prices, which made banks feel that it was safe to lend money to non-creditworthy borrowers.... [T]he Fed, under Greenspan's leadership, stood by as the credit boom gathered steam.... At a crucial moment in 2005... Bernanke described the housing boom as reflecting a prudent and well-regulated financial system, not a dangerous bubble. He argued that vast amounts of foreign capital flowed through US banks to the housing sector because international investors appreciated "the depth and sophistication of the country's financial markets (which among other things have allowed households easy access to housing wealth)."...

The housing bubble was bursting by last fall, and banks with large mortgage holdings started reporting huge losses, sometimes big enough to destroy the bank itself, as in the case of Bear Stearns.... [T]he Fed... has been cutting interest rates.... But... credit expansion is... flowing into... commodity speculation and foreign currency. The Fed's easy money policy is now stoking US inflation rather than a recovery....

Having stoked a boom, now the Fed can't prevent at least a short-term decline in the US economy, and maybe worse. If it pushes too hard on continued monetary expansion, it won't prevent a bust but instead could create stagflation - inflation and economic contraction...

I confess, I don't see why the Fed can't prevent a recession. Push the value of the dollar down far enough and export and import-competing manufacturing will grow fast enough to prevent a recession. The Fed may not like the inflation that this generates. But I don't see why monetary expansion will necessarily be ineffective in boosting output and employment.

Econ 101b: April 30: "Conservative" Central Bankers

April 30: "Conservative" Central Bankers

Notes: Lecture Audio

Readings:

• Macroeconomics, review 10.3, review 12.4, 13, 14, 16.1-16.4.
• "Central Bank Consistency and Credibility: The Analytics"

Michael Mussa on the Liquidity Tsunami

Michael Mussa argues that this is one slowdown in which nobody can claim that the Federal Reserve has been "behind the curve" as far as its response to the slowdown in the pace of real spending, demand, and production is concerned. Indeed, the liquidity tsunami the Federal Reserve and its companions have unleashed upon global credit markets is truly extraordinary:

• Dropping nominal interest rates on the Treasury assets truly free of nominal risk to levels at times only a fraction of a percent per year.
• Guaranteeing the unsecured debt of every major investment bank in America.
• Guaranteeing (or, rather, somehow inducing the Bank of America to guarantee) the unsecured debt of Countrywide.
• Unleashing Fannie Mae and Freddie Mac to borrow an extra half a trillion dollars or so, and spend it buying up and managing mortgages and so profiting from the spread between mortgages and Treasuries.

If all this isn't enough to keep the flow of funds to finance investment steady and so save America from large-scale cyclical unemployment, I will be genuinely surprised.

Michael:

Michael Mussa (2008), "Global Economic Prospects 2008/2009: Hoping for a Global Slowdown and a US Recession": The extent of this crisis in credit markets is even more remarkable in view of the exceedingly aggressive actions taken by the Federal Reserve and the important but less aggressive actions of other leading central banks. Contrary to the nonsense spoken by many financial-market commentators, the Federal Reserve has not been "behind the curve" in its policy response. In fact, the easing of US monetary policy in the present possible recession has far outstripped the pace of easing in past actual recessions. On top of this, the Federal Reserve has recently taken truly extraordinary actions to extend specific liquidity support to a wide range of US financial institutions.

The official explanation for these extraordinary actions is not that they are motivated primarily by the desire to protect financial institutions from losses but rather to head off the risk of major damage to the general economy spreading from difficulties in the financial sector. So far, however, there is little indication that the general economy is suffering much damage from the credit market turmoil—beyond some deepening of the downturn in US residential investment. In particular, the present slowdown in the US economy and around the world is not much more than what we would normally have expected in view of falling home values, higher food and energy prices, and other developments aside from the turmoil in credit markets.

Does this imply that the Federal Reserve, in its efforts to protect the financial sector, has overreacted to the credit market turmoil? Has it eased too aggressively, unduly raising the risk of inflation down the road? Has its rescue of the financial sector by cutting massively the cost of funds and the provision of specific liquidity support generated far too much moral hazard relative to the value of the protective effect of these actions against real hazards faced by the general economy?

At this point, the answers to these questions are not entirely clear, but two conclusions can be reached with high confidence. First, given the massive easing already undertaken by the Federal Reserve and the likelihood of some modest further easing, the US economy now needs to undergo at least a near recession if the Federal Reserve's easing is not to be excessive. Second, if the Federal Reserve's highly aggressive actions have really been warranted to protect the economy from substantial harm, then deep reforms of the financial system, including the Federal Reserve's policies and practices, are clearly needed to reduce the likelihood of such problems in the future. The Federal Reserve cannot pose only as the hero riding to the rescue of the economy and the financial system. Its role as one of the villains whose earlier actions and inactions contributed to the present crisis needs to be fully and carefully assessed.

Why Is It Good for Central Bankers to Look Fierce?

• "Central Bank Consistency and Credibility: The Analytics"

Twenty First-Century Central Banking

The problem of dealing with moral hazard in twenty first-century central banking has taken an interesting twist. Twice in the past decade the Federal Reserve has intervened in cases in which specific institutions have gotten into serious trouble--specific institutions that the Federal Reserve, or at least the New York Federal Reserve Bank (lines of authority are somewhat unclear) has concluded are too big to be allowed to fail through standard processes. The two institutions are the hedge fund Long Term Capital Management--LTCM--in 1998, and the bank Bear-Stearns in 2008.

In 1998 LTCM had suffered major losses on a mark-to-current-market basis (although its long-term prospects in the event of global financial recovery from the crisis looked correspondingly good), and appeared both illiquid and--if forced to liquidate its positions at then-current values, especially if liquidation induced significant price pressure against it--insolvent. Alan Greenspan and Peter Fisher at the New York Fed gathered all of the Federal Reserve's major creditors in a room, told them that they had a problem, and told them that they should solve it: that systemic risk would be created by an LTCM bankruptcy and liquidation and that the Fed did not want to go there. The creditors agreed to cooperate and split both the liability and the upside (with the exception of Bear Stearns, that declined), and they made LTCM an offer. The only alternative bidder was said to be Warren Buffett, who claims to have not been focused on the situation because he was fishing in Alaska. With only one potential bidder, the equity of LTCM's principals and investors was confiscated--to the dismay of LTCM's principals and investors, some of whom believe that they would have been able to get a much better split of the upside had they been allowed to play their creditors off against each other.

In 2008 Bear Stearns had suffered major losses on a mark-to-current-market basis (although its long-term prospects in the event of global financial recovery from the crisis looked correspondingly good), and appeared both illiquid and--if forced to liquidate its positions at then-current values, especially if liquidation induced significant price pressure against it--insolvent. Ben Bernanke and Tim Geithner at the New York Fed declared that systemic risk would be created by a Bear Stearns bankruptcy and liquidation, that the Fed did not want to go there, and that the only deal they would fund and support would be a deal that sold Bear Stearns to J.P. MorganChase at $2 (later raised to $10) a share, and the Federal Reserve kicked into the deal a put on Bear Stearns assets that one might speculate had a full-information liquid-market value of perhaps $3 billion. Various speakers for principals and investors in Bear Stearns protested that this effective confiscation of their equity value was unfair and inappropriate, and that a better split of the upside or at least a payment of more than $2 a share was appropriate.

We now have two precedents. If the Federal Reserve judges that a major financial institution:

• is too big to fail in that its failure will generate systemic risk
• has followed portfolio strategies that have produced inappropriate and excessive leverage
• requires immediate action

then the Federal Reserve will intervene to structure and support a deal that leaves principals and investors in the offending systemic risk-creating institution with effectively zero equity. Counterparties will be rescued. Principals and investors will not--even if normal more lengthy legal and bargaining processes would give principals and investors a share of the equity value on the table.

This is not the arms-length equal-treatment impersonal-rule-of-law ideal to which a government should aspire. This does, however, seem to get the incentives about right.

Charlie Kindleberger once wrote, in Manias, Panics, and Crashes, that the key to avoiding both depression and moral hazard was for the lender-of-last-resort to always show up in a crisis but for its appearance to always be doubted until the very last moment. These two precedents suggest that the Federal Reserve is evolving a case-law-of-twenty-first-financial-crisis that is somewhat different: in a crisis the lender-of-last-resort will always show up, but investors and principals in individual institutions that need to be specially rescued will discover that the lender of last resort is not their friend.

Asset Price Deflation

George Soros on the financial crisi:

The Financial Crisis: George Soros: I think it was, but it would have required recognition that the system, as it currently operates, is built on false premises. Unfortunately, we have an idea of market fundamentalism, which is now the dominant ideology, holding that markets are self-correcting; and this is false because it's generally the intervention of the authorities that saves the markets when they get into trouble. Since 1980, we have had about five or six crises: the international banking crisis in 1982, the bankruptcy of Continental Illinois in 1984, and the failure of Long-Term Capital Management in 1998, to name only three.

Each time, it's the authorities that bail out the market, or organize companies to do so. So the regulators have precedents they should be aware of. But somehow this idea that markets tend to equilibrium and that deviations are random has gained acceptance and all of these fancy instruments for investment have been built on them.... The large potential risks of such investments are not being acknowledged....

The authorities, the regulators--the Federal Reserve and the Treasury--really failed to see what was happening. One Fed governor, Edward Gramlich, warned of a coming crisis in subprime mortgages in a speech published in 2004 and a book published in 2007, among other statements. So a number of people could see it coming. And somehow, the authorities didn't want to see it coming. So it came as a surprise.... [Y]ou have a whole establishment involved. The economics profession has developed theories of "random walks" and "rational expectations" that are supposed to account for market movements. That's what you learn in college. Now, when you come into the market, you tend to forget it because you realize that that's not how the markets work. But nevertheless, it's in some way the basis of your thinking....

[T]he situation is definitely much worse than is currently recognized. You have had a general disruption of the financial markets, much more pervasive than any we have had so far. And on top of it, you have the housing crisis, which is likely to get a lot worse than currently anticipated because markets do overshoot.... I'm sure that it will be necessary to arrest the decline [in housing] because the decline, I think, will be much faster and much deeper than currently anticipated.... [F]oreclosures are going to add to the supply of housing a very large number of properties.... There are about six million subprime mortgages outstanding, 40 percent of which will likely go into default in the next two years.... Problems with... adjustable-rate mortgages are going to be of about the same magnitude as with subprime mortgages. So you'll have maybe five million more defaults facing you over the next several years....

[Y]ou need to reduce the number of foreclosures. You need to keep as many people as possible in their houses so that they don't come onto the market. You need to arrest the decline in house prices, but you also need to prevent human suffering and social disruption because it's going to be very, very severe....

[Rescue] is their [the Federal Reserve's] job, whether unhealthy or not... to save the system when it is in danger. However, because that is their job, it ought to be their job also to prevent asset bubbles from developing. And that task has not been recognized. Greenspan once spoke about the "irrational exuberance" of the market.... [I]t's generally accepted that the Fed tries to control core inflation, but not asset prices. I think that control of asset prices has to be an objective in order to prevent asset bubbles because they are so frequent.... You have to recognize that just controlling money doesn't control credit.... [Y]ou have to take into account the willingness to lend. And if it's too great—if borrowers can obtain large loans on the basis of inadequate security--you really have to introduce margin requirements for such borrowing and try to discourage it....

[W]e are close to a tipping point [for the dollar] where, in my view, the willingness of banks and countries to hold dollars is definitely impaired. But there is no suitable alternative so central banks are diversifying into other currencies; but there is a general flight from these currencies. So the countries with big surpluses—Abu Dhabi, China, Norway, and Saudi Arabia, for example—have all set up sovereign wealth funds, state-owned investment funds held by central banks that aim to diversify their assets from monetary assets to real assets. That's one of the major developments currently and those sovereign wealth funds are growing. They're already equal in size to all of the hedge funds in the world combined. Of course, they don't use their capital as intensively as hedge funds, but they are going to grow to about five times the size of hedge funds in the next twenty years.

I must say, these days when I read my backlist I feel like a genius--for example, back in 1998 I tried to convince the Brookings Panel that:

Why We Should Fear Deflation: Economies may well have more to fear than declines in broad goods-and-services price indices alone. If securities and real estate holdings have been pledged as collateral for debt contracts, then large-scale asset price declines also trigger the confusion of macroeconomic events with entrepreneurial failure that makes deflation feared.

Is the United States today potentially vulnerable to large-scale asset price declines in this way? In real estate no [this was written in 1999]. In the stock market yes [ditto]. Perhaps fundamental patterns of equity valuation have truly changed, as investors have recognized that the equity premium over the past century was much too large--in which case stock prices have reached a permanent and high plateau. But it seems more likely that there are substantial risks of stock market declines on the order of fifty percent back to Campbell-Shiller fundamentals...

http://www.jstor.org/stable/pdfplus/2534666.pdf

The Current Macroeconomic Situation: April 21, 2008

Audio: http://www.j-bradford-delong.net/2008_mov/20080421_131604.mp3

Slides:

• U.S. Real GDP
• U.S. Civilian Employment to Population Ratio
• U.S. Trade Balance
• Investment in Recessions
• Housing Starts
• Financial Losses
• The Collapse of the Fed Funds Market
• The Dollar Cycles

Washington Post Death Spiral Watch (George F. Will Edition)

Outsourced to Mark Thoma:

Economist's View:: George Will tries to talk about Fed policy, but if you don't understand the Fed's goals - and he doesn't - then the analysis of policy will be based on a faulty premise and reach incorrect conclusions. George Will thinks:

The Fed's mission is to preserve the currency as a store of value by preventing inflation. ... The Fed should not try to produce this or that rate of economic growth or unemployment

But that's wrong. As Mishkin says:

In a democratic society like our own, the ultimate purpose of the central bank is to promote the public good by pursuing a course of monetary policy that fosters economic prosperity and social welfare. In the United States, as in virtually every other country, the central bank has a more specific set of objectives that have been established by the government. This mandate was originally specified by the Federal Reserve Act of 1913 and was most recently clarified by an amendment to the Federal Reserve Act in 1977.

According to this legislation, the Federal Reserve's mandate is "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Because long-term interest rates can remain low only in a stable macroeconomic environment, these goals are often referred to as the dual mandate; that is, the Federal Reserve seeks to promote the two coequal objectives of maximum employment and price stability.

How concerned is George Will about the working class and employment? Should we use monetary policy to try to stimulate employment even if there's a chance of inflation? Not in George Will's world:

A surge of inflation might mean the end of the world as we have known it.

He ends his column by putting his analytical skills to work:

If Congress cannot suppress its itch to "do something" while markets are correcting the prices of housing and money, Congress could pass a law saying: No company benefiting from a substantial federal subvention ... may pay any executive more than the highest pay of a federal civil servant ($124,010). That would dampen Wall Street's enthusiasm for measures that socialize losses while keeping profits private.

First he tells us - incorrectly - that the Fed's sole job is to "to preserve the currency as a store of value." But now he tells us that government should not intervene when markets are "correcting the prices of housing and money." So which is it, do we let markets correct the price of money or not?

He doesn't think the Fed should do anything to help the working class stay employed, but that didn't stop him from trying to make the case in his last column that Democrats, Barrack Obama in particular, follow a "doctrine of condescension toward those people":

What had been under FDR a celebration of America and the values of its working people has become a doctrine of condescension toward those people...

That is, of course, a crock, but what is the condescension here? I think making up Fed goals to support a policy that ignores working class' needs is the condescending act.

Why oh why can't we have a better press corps?

Confusion in Economic Policy

Dean Baker mocks Henry Paulson and Ben Bernanke:

The High Dollar: Wasn't Bernanke Trying to Stimulate the Economy?

Last weekend, Federal Reserve Board Chairman Ben Bernanke and Treasury Secretary Henry Paulson said they would take steps to prevent the dollar from falling further. This is strange, because the dynamic duo had previously indicated that they wanted to stimulate the economy with policies like interest rate cuts and the tax rebate plan.

There is probably no more effective mechanism for stimulating the economy at this point than a decline in the value of the dollar. This will make imports more expensive, causing people to buy more domestically produced goods. It will also make our exports cheaper for people living in other countries which will naturally cause them to buy more American goods. The effect is a reduction in our trade deficit which is an essential part of any recovery plan.

There is a -- slight -- degree of non-insanity in what Paulson and Bernanke are saying. They want a weak dollar to stimulate exports, true. But they also want a dollar that is not expected to fall any further. In our economic models, the two automatically go together. But Paulson and Bernanke fear that in reality they do not.

The Collapse of Construction Investment

Greg Robb reports:

U.S. March housing starts down 11.9% to 947,000: WASHINGTON (MarketWatch) - New construction of U.S. houses plunged to the lowest level in 17 years in March, the Commerce Department estimated Wednesday. Starts fell 11.9% in March to a seasonally adjusted 947,000 annualized units weaker than the 988,000 pace expected by economists surveyed by MarketWatch. This is the lowest level of starts since March 1991. Starts are dpwn 36.5% year-on-year. Starts of new single-family homes fell by 5.7% to 680,000 in March, while starts of large apartment units fell 24.6% to 267,000. Building permits, a leading indicator of housing construction, fell 5.8% to a seasonally adjusted annual rate of 927,000. This is the lowest level of permits since April 1991...

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Note to Self: What the Federal Reserve Has Been Doing...

Steve Cecchetti writes:

Federal Reserve policy responses to the crisis of 2007-08 | vox - Research-based policy analysis and commentary from leading economists: Central bankers are conservative people. They take great care in implementing policy; they speak precisely; they explain changes completely; and they study the environment trying to pinpoint where the next disaster looms. Good monetary policy is marked by its predictability, but when the world changes, policymakers change with it. If a crisis hits and the tools at hand are not up to the job, then central bank officials can and will improvise....

For some time now, there has been a consensus among monetary economists... policymakers' operational instrument should be an interest rate; and officials need to be transparent and clear in communicating what they are doing and why they are doing it. Furthermore, there is agreement that the central bank is the right institution to monitor and protect the stability of the financial system as a whole.

An important part of the consensus has been that central banks should provide short-term liquidity to solvent financial institutions that are in need. But, as events in 2007 and 2008 have shown, not all liquidity is created equal. And critically, the consensus model used by monetary economists to understand central bank policy offers no immediate way to organise thinking about this sort of problem....

On 9 August 2007, the crisis hit and central banks swung into action, supplying large quantities of reserves in response to stresses in the interbank lending market. The spread on 3-month versus overnight interbank loans exploded. And, as problems worsened into the winter, the spread between U.S. government agency securities -- those issued by Fannie Mae, Freddie Mac and the like -- and U.S. Treasury securities of equivalent maturity rose as well. Investors shunned anything but U.S. Treasury securities themselves.... Reductions in the target federal funds rate, the objective of Federal Reserve policy in normal times, had little impact on interbank lending markets... the purchase of securities through open market operations enabled policymakers to inject liquidity... [but] could not insure that it went to the institutions that needed it most.

In response... Fed officials created... the Term Auction Facility (TAF) and the Primary Dealer Credit Facility (PDCF), and... the Term Securities Lending Facility (TSLF). The TAF... seeks to eliminate the stigma attached to normal discount borrowing. The PDCF extends lending rights from commercial banks to investment banks... the TSLF allows investment banks to borrow Treasury bills, notes and bonds using mortgage-backed securities as collateral.... [T]he Fed made adjustments to existing procedures... extended the term of their normally temporary repurchase agreements to 28 days... accepted mortgage-backed securities rather than the normal Treasury securities.... extended swap lines to the European Central Bank and the Swiss National Bank that allowed them to offer dollars to commercial banks in their currency areas... provided a loan that allowed the investment bank Bear Stearns to remain in operation and then be taken over by JP Morgan Chase.

These new programs are very different from the ones that had been in place prior to the crisis.... By changing the level of the monetary base (really commercial bank reserve deposits at the central bank) Fed officials keep the market-determined federal funds rate near their target.... Given the quantity of assets it owns, the Fed can decide whether it wants to hold Treasury securities, foreign exchange reserves, or a variety of other things.... By the end of March 2008, the Fed had committed more than half of their nearly $1 trillion balance sheet to these new programs:

• $100 billion to the Term Auction Facility,
• $100 billion to 28-day repo of mortgage-backed securities,
• $200 billion to the Term Securities Lending Facility,
• $36 billion to foreign exchange swaps,
• $29 billion to a loan to support the sale of Bear Stearns,
• $30 billion so far to the Primary Dealer Credit Facility.

Changes in the composition of central bank assets are intended to influence the relative price a financial assets -- that is, interest rate spreads. So, by changing its lending procedures, Fed officials hoped that they would be able to reduce the cost of 3-month interbank loans and the spread between U.S. agency securities and the equivalent maturity Treasury rate. At this writing, these programs have met with only modest success.

As I have said before, I find it helpful to group all the things the Fed does and might do into three baskets, each corresponding to a different stage of the seriousness of the financial crisis and the soundness of the financial system.

Stage I policies are "Bagehot rule" policies: the central bank acts to keep the economy at the good equilibrium in a panic when multiple equilibria are possible by lending freely to solvent but illiquid institutions at a penalty rate. Emergency discount window operations are of this kind--and the conventions that the discount rate should be higher than the bank-to-bank federal funds market rate and that borrowing from the discount window should create a stigma and a presumption of a higher degree of future regulatory and counterpary scrutiny are part of the "penalty rate" charged for asking for such help from the central bank. The idea is that institutions that have gotten themselves underreserved and need emergency liquidity should feel some pain as a result of the systemic risk they caused.

Stage II policies are conventional consensus monetary policies: the central bank uses open-market operations to buy Treasury securities for cash in order to flood the market with liquidity--so that nobody will be illiquid--and also to push down real borrowing costs (thus encouraging investment) and push up the cash values of all kinds of debt. If there was worry about the liquidity or solvency of the system before, the hope is that these open-market purchases will drive such worry away.

Then comes stage III. It comes after stage I policies aimed at curing a temporary inability to turn assets into cash at any but fire-sale prices have failed to repair matters. It comes after stage II policies of lowering interest rates across the entire spectrum and flooding the system with liquidity have failed to ease worries that one's counterparties are still insolvent or still at risk of becoming illiquid at an awkward moment. The purpose of stage III policies is to boost relative demand for risky assets and thus to opeate on the margin that is the spread in prices and yields between safe assets like Treasury securities and the risky assets whose falling prices are threatening the stability of the financial system and the macroeconomic flow of investment.

Since last fall the Federal Reserve has done eight things:

1. five cuts in the target federal funds rate totaling 225 basis points, or 2¼ percentage points;
2. a drop in the premium on primary (discount) lending from 100 to 50 and then to 25 basis points, above the federal funds rate target;
3. the creation and then enlargement of the "Term Auction Facility" (TAF) ($100 billion);
4. the extension of collateral status for 28-day repos to mortgage-backed securities ($100 billion)
5. the extension of credit to the European Central Bank and the Swiss National Bank ($36 billion);
6. the change in the preexisting securities lending program to initiate the "Term Securities Lending Facility" (TSLF) ($200 billion);
7. extension of credit to primary dealers through the newly created "Primary Dealer Credit Facility" (PDCF) ($30 billion)
8. the authorization of lending to support the JP Morgan Chase purchase of Bear Stearns ($29 billion)

Policy move (1) is conventional stage II open-market operation monetary policy: flood the system with liquidity and tilt the intertemporal price system to the advantage of financial institutions that borrow short and lend long in order to boost investment spending and relieve fears of counterparty illiquidity or insolvency that might lead to financial meltdown. Policy moves (2) and to some degree (3) are attempts to take stage I tools and use them for stage II purposes by removing the stigma and penalty rate attached to discount borrowing. This reflects a decision that the time to punish the underreserved for their fecklessness has passed and is an obstacle to effective monetary policy.

The rest of (3)--and (4) through (8)--strike me as stage III policies of various kinds, aimed at boosting demand for and the prices of risky assets more directly, given that stage II policies have failed to fix the problem. But I have a hard time analyzing exactly how these programs should be expected to have meaningfully different effects, or how effective they could possibly be.

Paul Krugman is very pessimistic: http://krugman.blogs.nytimes.com/2008/03/08/whats-ben-doing-very-wonkish/.

The Fed Funds Market since Last June

It find this graph from Steve Cecchetti very frightening indeed:

Steve comments:

http://www.cepr.org/pubs/PolicyInsights/PolicyInsight21.pdf: These data regularly are remarkable. Historically, the open market trading desk in New York has been very good at keeping the market-determined federal funds rate close to the target, and the range of trading has been a narrow band around that same target. "Normal" behavior is what we see in the left-hand portion of the figure. Suddenly, beginning on 9 August 2007, the effective rate is much more variable around the target and there is a clear tendency to come in below the target. Not only is the market "soft" in mid- to late-August, but the trading range explodes. The daily low is often well below the target, while the daily high is frequently above the primary lending rate. Prior to the cri- sis, the high end of the federal funds trading range exceeded the discount rate roughly one in ten business days. Since the start of the crisis, the rate has gone up to one in three days. If anything, it looks as if the stigma associated with borrowing increased during the crisis...

New York Times Death Spiral Watch: ar, Peter Goodman, Friedman Would Have Welcomed the Fed's Intervention in Bear Stearns

Peter Goodman of the New York Times writes that Milton Friedman "would surely be unhappy with this turn" of events as the Federal Reserve intervenes in financial markets to cushion the impact of things like the collapse of Bear Stearns.

No, Peter Goodman, you are wrong. Friedman would have welcomed the Fed's intervention in Bear Stearns as a way of preventing a downward move in the deposit-currency ratio and thus a fall in the money stock.

On a deeper level, I really think that Peter Goodman of the New York Times gets Milton Friedman wrong. Milton Friedman said that prosperity springs from markets as long as:

• The government is not allowed to establish and maintain islands of monopoly power.
• The government stabilizes the money stock and keeps the economy liquid--keeps the stock of assets people can readily spend growing at a steady pace.

Had Peter Goodman actually read anything Milton Friedman wrote about the Great Depression, Goodman would know that when Milton Friedman "attributed the worst economic unraveling in American history to regulators," he placed special stress on Depression-era regulators' refusal to move aggressively to handle bank failures--in Friedman and Schwartz's The Great Contraction, the moment when a normal recession becomes the Great Depression comes about when the Bank of United States fails and the Federal Reserve refuses to step in to handle the situation. Friedman was very much pro-bailout as far as bank depositors were concerned when a failure to do so would lead to a systemic reduction in the money stock.

And Friedman's line was always not that market are perfect, but rather that while markets can and do fail governments have more common and worse modes of failure--except for a narrow range of core functions: rule of law, systemic financial stability, increasing-returns infrastructure, et cetera.

There are tens of thousands of people--left, right, and center--who know Milton Friedman's work, and who would not have committed the elementary error of writing "Friedman... would surely be unhappy with this turn" of government--chiefly the Federal Reserve--working to contain and stem the current financial crisi.

So why is ink given to Peter Goodman, far out of his depth? Why oh why can't wett have a better press corps?

Reconsidering Milton Friedman's Legacy: A Fresh Look at the Apostle of Free Markets: Joblessness is growing. Millions of homes are sliding into foreclosure. The financial system continues to choke on the toxic leftovers of the mortgage crisis. The downward spiral of the economy is challenging a notion that has underpinned American economic policy for a quarter-century — the idea that prosperity springs from markets left free of government interference. The modern-day godfather of that credo was Milton Friedman, who attributed the worst economic unraveling in American history to regulators, declaring in a 1976 essay that “the Great Depression was produced by government mismanagement.”...

Just as the Depression remade government’s role in economic life, bringing jobs programs and an expanded welfare system, the current downturn has altered the balance. As Wall Street, Main Street and Pennsylvania Avenue seethe with recriminations, a bipartisan chorus has decided that unfettered markets are in need of fettering. Bailouts, stimulus spending and regulations dominate the conversation. In short, the nation steeped in the thinking of a man who blamed government for the Depression now beseeches government to lift it to safety. If Mr. Friedman, who died in 2006, were still among us, he would surely be unhappy with this turn....

Mr. Friedman’s brand of libertarianism rested on the assumption that economic and political freedom were one and the same. It meshed with and fed the cold war thinking of his time, as the United States offered up capitalism as liberty itself in contrast to the authoritarian Soviet Union. Among professional economists, Mr. Friedman’s analytical mastery was near-universally admired.... His greatest contribution came the following decade, when Mr. Friedman dismantled the consensus view that inflation was a tolerable byproduct of high employment. He demonstrated that high inflation would eventually cost jobs, as businesses were discouraged to invest by the higher wages they had to pay.

“This triumph, more than anything else, confirmed Milton Friedman’s status as a great economist’s economist, whatever one may think of his other roles,” Paul Krugman, an economist (and a New York Times columnist) wrote last year in The New York Review of Books.

Mr. Friedman captured the era with a new formulation known as monetarism: that the government should gradually and predictably inject cash into the financial system, and then let the market figure out where it should go. “Any honest Democrat will admit that we are now all Friedmanites,” Lawrence H. Summers, the Harvard economist and former Clinton administration Treasury secretary, wrote in an appreciation published in this newspaper when Mr. Friedman died. “He has had more influence on economic policy as it is practiced around the world today than any other modern figure”...

Paul Krugman has his own complaint about Goodman:

Paul Krugman: [O]n behalf of economists everywhere, I want to protest about [Goodman's] description of [Friedman's] natural rate hypothesis:

He demonstrated that high inflation would eventually cost jobs, as businesses were discouraged to invest by the higher wages they had to pay.

This is deeply unfair to Friedman -- it makes a quite profound insight sound like nothing more than a rant.

Here's how I described the natural rate hypothesis in the NYRB piece:

He argued that after a sustained period of inflation, people would build expectations of future inflation into their decisions, nullifying any positive effects of inflation on employment. For example, one reason inflation may lead to higher employment is that hiring more workers becomes profitable when prices rise faster than wages. But once workers understand that the purchasing power of their wages will be eroded by inflation, they will demand higher wage settlements in advance, so that wages keep up with prices. As a result, after inflation has gone on for a while, it will no longer deliver the original boost to employment. In fact, there will be a rise in unemployment if inflation falls short of expectations.

What would Friedman be thinking now, if he were still alive? He would be worried about regulatory overreach. He would be conflicted because he would also be well-aware that organizations capable of generating systemic risk need to be regulated in some way in order to diminish the scope for moral hazard (hence Friedman's calls, at times, for extremely strict banking regulation: 100% reserve banking, in fact).

He would mostly, however, be focused on two graphs of the behavior of the money stock:

And he would have been approving of Federal Reserve policy as long as it kept both these lines from either (a) falling or (b) exploding upward.

z

Alice Rivlin Defends the Bernanke Fed

She writes:

The Fed’s Money Well Spent - New York Times: [T[he supposed conflict between Wall Street and Main Street is a false one — Main Street runs on credit and cannot prosper if the financial system is in shambles and credit dries up.... [T]he supposed Fat Cat “bailout” was a disaster for Bear Stearns stockholders, and that the idea of a “moral hazard” risk — that other investment banks will be tempted to emulate Bear Stearns — is preposterous. Never mind that if markets head back up and the collateral can be sold at a profit, taxpayers may lose nothing. In the end, the Fed’s action was not aimed at rescuing those who made bad decisions out of greed or stupidity, but at protecting the rest of the country — and indeed the world — from the possibly devastating consequences of a financial meltdown.

Nevertheless, the outrage is both understandable and useful. Public money has been put at risk to calm a storm on Wall Street while ordinary people are losing their homes. The public is crying, “What about us?” and politicians are listening, as they should.... To be sure, many homeowners were shortsighted and greedy.. borrowed too much and got caught when the music stopped. Like the Bear Stearns shareholders, they should take losses. But putting them out of their homes does not merely harm them and their children, it endangers whole neighborhoods and drags down the assets of their more prudent neighbors.

Congress and the Bush administration should move quickly... to ease the renegotiation of mortgages and keep homeowners who are able to pay the new charges in their homes. Public money will have to be put at risk, but it is worth it. The deals should be structured so that the taxpayer shares in the gains if markets recover and the properties or mortgages are later sold at a profit.

When the immediate crisis is past, however, we must turn to the difficult task of reducing the chances of a replay. It will not be easy to design regulations that do more good than harm, but at the very least all financial institutions that stand to benefit from Federal Reserve help in a crisis must be subject to regulatory scrutiny to make sure they are managing their risk prudently. There must be higher capital requirements and limits on excessive leverage. If the rules are reasonable, we should not weep if a few high fliers choose to move their operations to other countries.... [W]e must take on the even harder job of sorting through the explosion of financial instruments that have proliferated in the boom and deciding which belong in our kit of tools and which should be relegated to the waste heap. If they genuinely spread risk and help move capital into more productive uses, they should stay. But some exotic derivatives seem mainly to reflect the efforts of traders to outsmart each other. Their opaqueness may entail more systemic risk than social value.

The folks who devise these exotica are talented enough to create something useful. We would all be better off if they were productively employed in the “real” economy...

Some Bursting Bubble References...

Reading about bursting bubbles:

• Michael Mussa: "Global Economic Prospects: Bright for 2004 but with Questions Thereafter" http://www.iie.com/publications/papers/paper.cfm?ResearchID=205
• Charles Bean: "Asset prices, financial imbalances, and monetary policy: are inflation targets enough?" http://www.bis.org/publ/work140.pdf?noframes=1
• IMF: "When Bubbles Burst" http://www.imf.org/external/pubs/ft/weo/2003/01/pdf/chapter2.pdf
• IMF: "Financial Asset Price Vulnerability: A Source of Instability?" http://www.imf.org/external/pubs/ft/gfsr/2003/02/pdf/chp3.pdf

Michael Mussa's Take on Global Imbalances as of Early 2004

He wrote:

Paper: Global Economic Prospects: Bright for 2004 but with Questions Thereafter: More generally, while global economic prospects look quite bright through 2004, there are important imbalances in the global economy that raise concerns for the longer term. It is useful to reflect briefly on these concerns before turning to a region-by-region assessment of near-term prospects.

Policy interest rates are exceptionally low in most industrial countries: zero in Japan and Switzerland, 1 percent in the United States, 2 percent in the euro area, and at or near historic lows in the United Kingdom and Canada. Inflation rates also are generally very low in the industrial countries, but, even taking this into account, short-term real interest rates are very low. (Realized short-term real rates went negative during some periods of rapidly rising inflation in the 1970s, but this was an anomaly that is not comparable to the present situation of low anticipated real interest rates.)

The very low level of policy interest rates is an imbalance (relative to normal conditions) that reflects exceptionally easy monetary policies to combat economic weakness. This policy imbalance poses an important challenge for the future conduct of monetary policy. Situations of low policy interest rates and low inflation tend to be associated with unusual inertia in the processes of general price inflation, which makes traditional indicators of rising inflationary pressures less reliable as measures of the need to begin to tighten monetary conditions. Also, these situations tend to be associated with high valuations of equities, real estate, and long-term bonds, which can become fertile ground for large, unsustainable increases in asset prices. In this situation, if monetary policy is tightened too much too soon (perhaps because of worries about unsustainable increases in asset prices), the result can be an unnecessary asset market crunch and economic slowdown, and monetary policy may have relatively little room to ease in order to counteract this outcome.

On the other hand, if monetary policy remains too easy for too long (perhaps because subdued general price inflation gives no clear signal of the need for monetary tightening), then large asset price anomalies may develop before corrective action is taken. The monetary authority would then confront the grim choice of trying to keep an unsustainable asset price bubble alive or trying to combat the collapse of such a bubble without a great deal of room for monetary easing.

A further concern related to the general monetary policy imbalance in the industrial countries is its effect on emerging market economies. Interest rate spreads for emerging market borrowers have contracted substantially and flows of new credit have increased. The boom in emerging market credit has not yet reached the frenzy of the first half of 1997, but it is headed in that direction. Another major series of emerging market financial crises (such as 1997-99) does not seem likely in the near term in view of the very low level of industrial country interest rates and the favorable global economic environment for emerging market countries. By 2005 or 2006, however, either upward movements in industrial country interest rates or deterioration of market perceptions of the economic and financial stability of some emerging market countries could trigger another round of crises.

Another important policy imbalance of global significance is the medium- and long-term fiscal imbalance of most industrial countries. Ratios of government debt to GDP are high in several countries, most notably Japan and Italy. Fiscal deficits are large in Japan and the United States and above the desired ceiling of 3 percent of GDP in Germany and France. Most important, industrial countries generally face enormous fiscal challenges from financing social benefits for aging populations that will materialize during the next two to three decades. These problems imply that, even in the near term, expansionary fiscal policy cannot prudently be used as a significant means for stimulating more rapid growth of aggregate demand in the industrial countries. To the extent that such stimulus may be needed, monetary policy is the prudent tool. But, as just noted, monetary policy does not at present have much remaining capacity to play this role and may not regain this capacity any time soon.

The other key global imbalance is the massive US current account (and net export) deficit and the corresponding surplus of the rest of the world. While it is plausible to suppose that the United States can continue to attract voluntary net capital inflows sufficient to finance a current account deficit of 2 to 2½ percent of its GDP, continuing deficits of 5 percent of US GDP are not plausible. The global adjustment necessary to reduce the US current account deficit by roughly half involves three essential elements.

First, in order to shift world demand toward US goods and services and away from those of the rest of the world by $250 billion to $300 billion, the real effective foreign exchange value of the US dollar needs to decline from its peak in 2000/01 by roughly 30 percent. Substantial downward corrections of the US dollar against the euro, sterling, and the Canadian and Australian dollars, and lesser correction against the Japanese yen, have now delivered somewhat less than half of the total required correction. Some further depreciation of the US dollar against these (aforementioned) currencies, particularly the Japanese yen, is needed over the next couple of years. However, the key remaining challenge for exchange rate adjustments is securing appreciations in the exchange rates of key emerging market currencies, especially in Asia. The exchange rate of the Chinese yuan has rightly received much recent attention in this regard (and Nicholas Lardy will comment further on this issue). But the issue is much broader. For most of emerging Asia, there has been little or no currency appreciation against the US dollar since 2000/01 (implying effective depreciation of the trade weighted exchange rate), and most of these countries have recently been intervening massively to resist market pressures for appreciation. These policies need to change to allow a broader downward correction of the value of the US dollar.

Second, for the US current account deficit to decline, domestic demand in the United States must grow more slowly, by a corresponding amount, than US output (real GDP). (This is the reverse of the pattern of recent years, when the excess of domestic demand growth over real GDP growth has accounted for the large deterioration in the US current account.) Getting this to happen in the United States, while also keeping US output close to potential, poses some difficulties. If domestic demand growth falls below potential output growth, the improvement in US net exports must step in to keep total demand for US output growing in line with potential. Otherwise, margins of slack will increase in the US economy. On the other hand, if output (and, hence, income) growth matches potential (with the level of output near potential), then there must be something to depress the growth of US domestic demand below the growth of US income. Otherwise, if US net exports are improving (due to the effects of a weaker US dollar and stronger demand growth abroad), then there would be undesirable overheating of the US economy. The necessary depressing force on US demand growth could come from a progressive tightening of US monetary policy. But this would depress domestic demand growth primarily by slowing private investment, thereby slowing the longer-term growth rate of the US economy. The preferable policy solution would be for the reversal of the fiscal expansion of 2001/04 to provide the desired negative impetus to domestic demand.

Third, for the rest of the world, the counterpart of US adjustment must be that domestic demand grows more rapidly than output. The amount of this difference corresponds to the deterioration of the current account in the rest of the world, which must match the improvement in the US current account. (Since the US economy accounts for about one-quarter of world output at market exchange rates, an improvement in US net exports equal to 3 percent of US GDP requires a worsening of net exports in the rest of the world of about 1 percent of GDP.) In recent years, however, the rest of the world has had difficulty generating sufficient demand growth to keep output growing at potential—and has relied on a net contribution of demand from the growing US net export deficit. Thus, securing a boost to demand growth in the rest of the world over the next couple of years poses a challenge, particularly so because, as previously noted, fiscal policy is generally not available to provide much demand stimulus, and monetary policies (at least in industrial countries) are already quite easy. At a minimum, it would appear desirable to keep monetary policies easy to support demand growth, but not so easy as to frustrate the exchange rate adjustments that are also a necessary factor in correcting global payments imbalances...

April 9 Lecture: Econ 101b: Arguments Against Lender-of-Last Resort Operations

Lecture Audio

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Arguments Against Standard Central Bank Lender-of-Last Resort Operations:

• Since at least 1844, central banks have been trying to avoid great depressions by acting as lenders-of-last-resort in times of financial crisis
  • Stage I: provide liquidity (at a penalty rate)
  • Stage II: lower interest rates on safe assets (via open market operations)
  • Stage III: direct market support of some kind

The critics say...

• This is immoral

  • We have a system in which the Princes of Wall Street earn great fortunes by virtue of their analytical skills, entrepreneurial vision, and willingness to take and bear risks
  • The lender-of-last-resort function provides them with a safety net, and so turns them from economic heroes into villains
  • Response I: There are no Randites in a panic...
  • Response II: Exactly: if it's good to have a safety net for rich financiers, it's better to have a safety net for the middle class and the poor as well--and a progressive income tax to fund it...

• This is unfair

  • Rich, feckless financiers who ought to be punished escape with their wealth to their yachts
  • Thriftless, feckless, imprudent borrowers who ought to have known better escape loss--and live more lavishly than the thrifty and prudent who played by the rules
  • Response: Markets aren't fair--the lucky prosper, and this is a form of luck. Markets are about productivity and efficiency, politics is about justice--see above re progressive income tax, etc.

• This won't work in the long run

  • I: Moral Hazard:
    • Financiers in the future, knowing that the central bank has always shown up in the past, will be even more imprudent and feckless
    • Thus the rescue doesn't cure the current financial crisis so much as create future ones
    • Response I: Yes, this is a danger to guard against--but the risks we want to guard against are those of running the real economy into an iceberg, not an unfair rearranging of the chairs on the pool deck
    • Response II: The principals of Bear Stearns lost the bulk of their wealth; the principals of LTCM lost their fortunes as well; how much additional moral hazard is created by LoLR?
  • II: Adverse Selection
    • You need big depressions and their losses to clean the the ranks of the entrepreneurs...
  • III. Overinvestment
    • The financial crisis is a reflection of a real disequilibrium--of an overinvestment. Boosting the prices of financial assets simply generates more overinvestment--and a bigger problem, because the bigger amount of overinvestment then has to be worked off...

This is a very old argument indeed: Karl Marx and Friedrich Engels made it.

It is, I think, a matter of time and scale: we want investment spending to decline as rapidly as workers can be redeployed to other potential leading sectors--but no faster. The bubble needs to "deflate," not "pop"...

Paul Krugman has, I think, the best answer:

THE HANGOVER THEORY: Are Recessions the inevitable payback for good times?: A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the "Austrian theory" of the business cycle--a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire. Oh well. But the incident set me thinking--not so much about that particular theory as about the general worldview behind it. Call it the overinvestment theory of recessions, or "liquidationism," or just call it the "hangover theory." It is the idea that slumps are the price we pay for booms, that the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion.

The hangover theory is perversely seductive--not because it offers an easy way out, but because it doesn't. It turns the wiggles on our charts into a morality play, a tale of hubris and downfall. And it offers adherents the special pleasure of dispensing painful advice with a clear conscience, secure in the belief that they are not heartless but merely practicing tough love.... The many variants of the hangover theory all go something like this: In the beginning, an investment boom gets out of hand... all that investment leads to the creation of too much capacity--of factories that cannot find markets, of office buildings that cannot find tenants... reality strikes--investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off, prices and wages fall from their excessive boom levels, and only then is the economy ready to recover.

Except for that last bit about the virtues of recessions, this is not a bad story about investment cycles.... But let's ask a seemingly silly question: Why should the ups and downs of investment demand lead to ups and downs in the economy as a whole?... Here's the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods--implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?

Most modern hangover theorists probably don't even realize this is a problem for their story. Nor did those supposedly deep Austrian theorists answer the riddle. The best that von Hayek or Schumpeter could come up with was the vague suggestion that unemployment was a frictional problem created as the economy transferred workers from a bloated investment goods sector back to the production of consumer goods. (Hence their opposition to any attempt to increase demand: This would leave "part of the work of depression undone," since mass unemployment was part of the process of "adapting the structure of production.") But in that case, why doesn't the investment boom--which presumably requires a transfer of workers in the opposite direction--also generate mass unemployment? And anyway, this story bears little resemblance to what actually happens in a recession, when every industry--not just the investment sector--normally contracts.... The hangover theory, then, turns out to be intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present. Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives.... But moderates and liberals are not immune to the theory's seductive charms--especially when it gives them a chance to lecture others on their failings...

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Karl Marx and Friedrich Engels, 1848:

The bourgeoisie, during its rule of scarce one hundred years, has created more massive and more colossal productive forces than have all preceding generations together. Subjection of Nature's forces to man, machinery, application of chemistry to industry and agriculture, steam-navigation, railways, electric telegraphs, clearing of whole continents for cultivation, canalisation of rivers, whole populations conjured out of the ground - what earlier century had even a presentiment that such productive forces slumbered in the lap of social labour?...

Modern bourgeois society with its relations of production, of exchange and of property, a society that has conjured up such gigantic means of production and of exchange, is like the sorcerer, who is no longer able to control the powers of the nether world whom he has called up by his spells.... It is enough to mention the commercial crises that by their periodical return put on its trial, each time more threateningly, the existence of the entire bourgeois society. In these crises a great part not only of the existing products, but also of the previously created productive forces, are periodically destroyed. In these crises there breaks out an epidemic 10 that, in all earlier epochs, would have seemed an absurdity - the epidemic of over-production. Society suddenly finds itself put back into a state of momentary barbarism; it appears as if a famine, a universal war of devastation had cut off the supply of every means of subsistence; industry and commerce seem to be destroyed; and why? Because there is too much civilization, too much means of subsistence, too much industry, too much commerce.... The conditions of bourgeois society are too narrow to comprise the wealth created by them. And how does the bourgeoisie get over these crises? On the one hand by enforced destruction of a mass of productive forces; on the other, by the conquest of new markets, and by the more thorough exploitation of the old ones. That is to say, by paving the way for more extensive and more destructive crises, and by diminishing the means whereby crises are prevented...

Karl Marx and Friedrich Engels, 1851:

The years 1843-5 were years of industrial and commercial prosperity, a necessary sequel to the almost uninterrupted industrial depression of 1837-42. As is always the case, prosperity very rapidly encouraged speculation. Speculation regularly occurs in periods when overproduction is already in full swing. It provides overproduction with temporary market outlets, while for this very reason precipitating the outbreak of the crisis and increasing its force. The crisis itself first breaks out in the area of speculation; only later does it hit production. What appears to the superficial observer to be the cause of the crisis is not overproduction but excess speculation, but this is itself only a symptom of overproduction. The subsequent disruption of production does not appear as a consequence of its own previous exuberance but merely as a setback caused by the collapse of speculation....

In the years of prosperity from 1843 to 1845, speculation was concentrated principally in railways, where it was based upon a real demand.... The extension of the English railway system... 1845... the number of bills presented for the formation of railway companies [i.e., IPOs] amounted to 1,035.... The heyday of this speculation was the summer and autumn of 1845. Stock prices rose continuously, and the speculators' profits soon sucked all social classes into the whirlpool. Dukes and earls competed with merchants and manufacturers for the lucrative honour of sitting on the boards of directors of the various companies; members of the House of Commons, the legal profession and the clergy were also represented in large numbers. Anyone who had saved a penny, anyone who had the least credit at his disposal, speculated in railway stocks. The number of railway journals rose from three to twenty. The large daily papers often each earned £14,000 per week from railway advertisements and prospectuses. Not enough engineers could be found, and they were paid enormous salaries. Printers, lithographers, bookbinders, paper-merchants and others, who were mobilized to produce prospectuses, plans, maps, etc; furnishing manufacturers who fitted out the mushrooming offices of the countless railway boards and provisional committees — all were paid splendid sums. On the basis of the actual extension of the English and continental railway system and the speculation which accompanied it, there gradually arose in this period a superstructure of fraud.... Hundreds of companies were promoted without the least chance of success, companies whose promoters themselves never intended any real execution of the schemes, companies whose sole reason for existence was the directors' consumption of the funds deposited and the fraudulent profits obtained from the sale of stocks.

In October 1848 a reaction ensued, soon becoming a total panic.... The railway crisis lasted into the autumn of 1848, prolonged by the successive bankruptcies of less unsound schemes as they were gradually affected by the general pressure and as demands for payment were made. This crisis was also aggravated by developments in other areas of speculation, and in commerce and industry; the prices of the older, better-established stocks were gradually forced down, until in October 1848 they reached their lowest level....

If the new cycle of industrial development which began in 1848 takes the same course as that of 1843-7, the crisis will break out in 1852. As a symptom that the excess speculation which is caused by overproduction, and which precedes each crisis, will not be long in coming, we can quote the fact that the discount rate of the Bank of England has not risen above 3 per cent for two years. But when the Bank of England keeps its interest rates down in times of prosperity, the other money dealers have to reduce their rates even more, just as in times of crisis when the Bank raises the rate considerably, they have to raise their rates above the Bank's. The additional capital which, as we have seen above, is always unloaded onto the bond market in times of prosperity, is enough by itself to force down the interest rate, as a result of the laws of competition; but the interest rate is reduced to a much larger extent by the enormous expansion of credit produced by general prosperity, which lowers the demand for capital. In these periods a government is in a position to reduce the interest rate on its funded debts, and the landowner is able to renew his mortgage on more favourable terms. The capitalists with investments in loan capital thus see their income reduced by a third or more, at a time when the income of all other classes is rising. The longer this situation lasts, the more they will be under pressure to look for more profitable capital investments. Overproduction gives rise to numerous new projects, and the success of a few of them is sufficient to attract a whole mass of capital in the same direction, until gradually the bubble becomes general. But, as we have seen, speculation has at this point of time only two outlets; cotton growing and the new world market routes created by the development of California and Australia. It is evident that this time the scope for speculation will assume far greater dimensions than in any earlier period of prosperity....

Sir Robert Peel... has been apotheosized in the most exaggerated fashion by almost all parties as England's greatest statesman. One thing at least distinguished him from the European 'statesmen' — he was no mere careerist. Beyond this, the statesmanship of this son of the bourgeoisie who rose to be leader of the aristocracy consisted in the view that there is today only one real aristocracy: the bourgeoisie.... Catholic emancipation and the reform of the police, by means of which he increased the bourgeoisie's political power... the Bank Acts of 1818 and 1844, which strengthened the financial aristocracy... the tariff reform of 1842 and the free trade legislation of 1846, with which the aristocracy was nothing short of sacrificed to the industrial bourgeoisie.... His power over the House of Commons was based upon the extraordinary plausibility of his eloquence. If one reads his most famous speeches, one finds that they consist of a massive accumulation of commonplaces, skillfully interspersed with s large amount of statistical data. Almost all the towns in England want to erect a monument to the man who repealed the Corn Laws. A Chartist journal has remarked, referring to the police trained by Peel in 1829: 'What do we want with these monuments to Peel? Every police officer in England and Ireland is a living monument to Peel...

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From BobbyK's Paul Krugman Archive:

: THE HANGOVER THEORY: Are Recessions the inevitable payback for good times?

SYNOPSIS: The constantly occuring idea of helpful Recessions is incoherent and faulty

A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the "Austrian theory" of the business cycle--a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire. Oh well. But the incident set me thinking--not so much about that particular theory as about the general worldview behind it. Call it the overinvestment theory of recessions, or "liquidationism," or just call it the "hangover theory." It is the idea that slumps are the price we pay for booms, that the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion.

The hangover theory is perversely seductive--not because it offers an easy way out, but because it doesn't. It turns the wiggles on our charts into a morality play, a tale of hubris and downfall. And it offers adherents the special pleasure of dispensing painful advice with a clear conscience, secure in the belief that they are not heartless but merely practicing tough love.

Powerful as these seductions may be, they must be resisted--for the hangover theory is disastrously wrongheaded. Recessions are not necessary consequences of booms. They can and should be fought, not with austerity but with liberality--with policies that encourage people to spend more, not less. Nor is this merely an academic argument: The hangover theory can do real harm. Liquidati