The Money Demand

For our readers - really good resources

2011-02-02T15:11:00.036+02:00

SNAFU

2011-02-01T15:04:00.003+02:00

The blog is offline due to serious technical issues.

Really good links - Deficit - Ireland - China - Schuldenbegrenzungsregelung - Netherlands - A cross of rubber - Germany - Carry trade

2011-01-31T15:42:00.002+02:00

Karl Smith - Federal deficit - "If the government takes out a loan and then gives that proceeds of that loan to taxpayers, the balance sheet of the US as a whole has not deteriorated. The government owes more, the people owe less.
   So increasing the supply of US debt in and of itself doesn’t hurt the US’s asset position. It does, however, arbitrage the difference between private borrowing costs and public borrowing costs.
   Performing this type of credit arbitrage is one the main functions of a financial system, however, ours is still working its kinks out and building back up its capital base. Thus, its helpful for the Feds to step in and do the arbitrage for us."

Ralph Atkins - ECB tells Ireland to avoid bank run - "The European Central Bank still faces a stand-off with Dublin. The FT reports today the warning by Lorenzo Bini Smaghi, an ECB executive board member, that Ireland cannot expect to renegotiate the terms of its bail-out. The matter has become an issue in the country’s election campaign.<..>
   Diplomatically but firmly, Mr Bini Smaghi warns Ireland’s politicians that if they imposed losses (a “haircut”) on Irish senior bank bondholders, “immediately you would have a run on the banks”. Irish account holders themselves would worry about the security of their savings. The end result could be a collapse of the banking system – and the Irish taxpayers would face an even larger bill."

Scott Sumner - China and us - "For China to blame the US for its inflation, when they refused to cut back on the number of Treasury bonds they bought as a way of tightening monetary policy and boosting the yuan, would be like the US blaming China for high unemployment, when we refused to buy more Treasury bonds to weaken the dollar and boost the prices of commodities, stocks, TIPS and foreign currencies. Bernanke and company showed in November that they are quite capable of taking affirmative steps to solve our own problems (although I’d like to see even bigger steps.) Now China needs to show the same can-do spirit, and stop blaming foreigners for its problems."

EurActiv - Schuldenbegrenzungsregelung - "Interestingly, the Brussels lawyers are reportedly working on a draft policy to replicate the 2009 German debt brake across the EU, something sources say is also being touted by the Swedish government.
   If member states want to increase the size or scope of the fund, then the German government will expect them to imitate the German brake, the 'Schuldenbegrenzungsregelung', which writes deficit limits into the country's constitution, according to an EU diplomat.
   French President Nicolas Sarkozy came out in favour of an EU-wide adoption of constitutionally-bound debt brakes in June last year."

Robert Shiller - Are Dutch thrifty? - "I bet it’s not true. Because if the Dutch had been conspicuous savers for centuries, they would be vastly richer than any of us. It would accumulate over centuries. I like to use another example from Holland, which is that home prices in Amsterdam, according to Piet Eichholtz at Maastricht University, haven’t gone up – they’re no higher in real terms today than they were 300 years ago. So, I’m sorry, but you can’t be right.
   The amazing thing about saving is that if you really save a lot and you do it for a hundred years, reinvesting interest, you will get awfully rich, and that’s a fact. The best example of that is not Holland, it’s Singapore, which has had a government imposed saving plan. In Singapore, they have a mandatory saving plan that has propelled that nation up rapidly. It’s just arithmetic. If you save and invest, it adds up, because of the power of compound interest."

Kantoos - What do Germans hate more, inflation or bailouts?

Paul Krugman - A cross of rubber - "What about commodity prices? The Fed normally focuses on “core” inflation, which excludes food and energy, rather than “headline” inflation, because experience shows that while some prices fluctuate widely from month to month, others have a lot of inertia — and it’s the ones with inertia you want to worry about, because once either inflation or deflation gets built into these prices, it’s hard to get rid of.
   And this focus has served the Fed well in the past. In particular, the Fed was right not to raise rates in 2007-8, when commodity prices soared — briefly pushing headline inflation above 5 percent — only to plunge right back to earth. It’s hard to see why the Fed should behave differently this time, with inflation nowhere near as high as it was during the last commodity boom.
   So why the demand for higher rates? Well, bankers have a long history of getting fixated on commodity prices. Traditionally, that meant insisting that any rise in the price of gold would mean the end of Western civilization. These days it means demanding that interest rates be raised because the prices of copper, rubber, cotton and tin have gone up, even though underlying inflation is on the decline.
   Ben Bernanke clearly understands that raising rates now would be a huge mistake. But Jean-Claude Trichet, his European counterpart, is making hawkish noises — and both the Fed and the European Central Bank are under a lot of external pressure to do the wrong thing.
   They need to resist this pressure. Yes, commodity prices are up — but that’s no reason to perpetuate mass unemployment. To paraphrase William Jennings Bryan, we must not crucify our economies upon a cross of rubber."

Pasquale Della Corte, Lucio Sarno, Ilias Tsiakas - Carry trade and forward volatility trade - "The standard “carry trade” is a popular currency speculation strategy that invests in high-interest currencies by borrowing in low-interest currencies. This strategy works well if, for example, spot exchange rates are unpredictable. There is ample empirical evidence pointing in that direction or, in academic jargon, showing that exchange rates follow a random walk (Meese and Rogoff 1983). In this case, investors engaging in carry trading will on average earn the difference in interest rates without having to worry about movements in exchange rates. The return to currency speculation can be substantial over time. It should be no surprise, therefore, that the carry trade has attracted considerable attention from academics and practitioners over the years.
   In recent years, investors have been able to speculate not only on the value of currencies but also on the level of volatility of these currencies."

Really good links - QE2 - ECB and BoE - Mid 2000s boom - Fed Laugh Track - Easier money in October 2008 - Price-level targeting

2011-01-20T12:55:00.001+02:00

Perry Mehrling - QE2 - "Normal expansionary monetary policy provides additional low-cost repo financing to dealers, which they are free to use to expand their security holdings—that is how monetary expansion gets into asset prices. QE2, by contrast, removes high-quality collateral from the system, and with it the low-cost financing that makes use of that collateral.
In times of uncertainty, the Fed is in effect joining everyone one else in the flight to quality, demanding $600 billion of the best securities in the system and supplying in return its own reserve liabilities that can be held only by member banks that are already stuffed full."

Hugh Hendry - Europe risks getting it wrong again on rate rises - "[T]he shadow of policy error lurks once more. The European Central Bank’s president even proclaimed his satisfaction with his bank’s decision to raise rates back in the cauldron month of July 2008. I salute him for his willingness to subject the bank’s decisions to open scrutiny. But tightening monetary policy amid the deepest economic crisis of the past 50 years was perhaps not his institution’s finest hour. And with headline inflation rates being boosted by relative price rises in the commodity sector, as Chinese policymakers continue to plug 10 per cent into their GDP calculators, another poorly-timed rise in European rates cannot be so easily dismissed.
The markets are already pricing in the near certainty of a quarter-point rise from the Bank of England by May with another increase expected before October. But perhaps not wanting to be left out, the zealous guardians of Europe’s monetary system, who measure inflation rates across the 17-country bloc to the second decimal point, have recently raised their rhetoric to such an extent that investors are openly speculating that in spite of the continent’s tight fiscal policy European rates are now likely to rise before the end of summer. As they say in the land of macro investing, the cycle isn’t over until the Europeans lift rates. Just don’t bet on money staying tight for long."

David Beckworth - Interest rates in the early-to-mid 2000s were too low

WSJ - Fed Laugh Track: ‘Can We Borrow from the Greeks?’ - Best jokes from the 2005 FOMC Transcripts

David Beckworth - Nominal spending in Great Depression

Scott Sumner - 90 macroeconomists out of 100 agree with Keynes, Friedman and Krugman - "Why weren’t those 90 macroeconomists out picketing the Fed in October 2008, demanding easier money? Well 89 of the 90, the other is in the Fed. Back in late 2008 and early 2009 a few of us quasi-monetarists were just about the only people insisting on the urgent need for much more monetary stimulus. A tiny handful of others (including Krugman) half-heartedly agreed it was worth a shot, and almost everyone else completely ignored monetary policy. One argument was they assumed we were at the zero bound. Actually, we weren’t at the zero bound in October 2008, but let’s say we were close. The main problem with the zero bound argument is that there was no general understanding that monetary policy was ineffective at the zero bound among the macro elite. Indeed many of them (Bernanke included) argued forcefully that the BOJ needed to do much more in the late 1990s and early 2000s."

Ed Dolan - Price-level targeting - "We can look forward to a renewed debate on price-level targeting in 2011. Support for the policy will be strengthened a bit by the fact that the Chicago Fed has a voting seat on the FOMC in odd-numbered years. If inflation remains stubbornly low, as it did throughout the fall, perhaps Chairman Bernanke will become less confident that "both inflation expectations and actual inflation remain within a range consistent with price stability," one of the reasons he gave for rejecting price-level targeting in his August speech. It is even possible that the FOMC has already committed to de-facto price level targeting without saying so explicitly."

Really good links - Treasury is sterilizing QE2 - Credit spreads and Modigliani-Miller - Household saving - QE2 - Nature vs. environment - Utility vs. Happiness

2011-01-12T16:54:00.000+02:00

Andy Harless - Why is the Treasury hoarding reserves and sterilizing QE2? - "Under the circumstances, sterilization makes sense because it reduces the cost of government financing and (not coincidentally) provides a more effective stimulus. Giving banks more reserves will not give them an incentive to lend, nor will it encourage anyone to convert bank deposits into cash. Banks have far more reserves than they need and are constrained by capital, not by liquidity. On the margin, from a bank's point of view, reserves are just a safe asset like T-bills. The special properties that reserves have -- that they can be used to satisfy reserve requirements and settle transactions -- are, on the margin, irrelevant, given that banks have far more than they could conceivably need for those purposes. From the point of view of the public sector, reserves are just another way to borrow: the Fed can borrow by creating bank reserves, or the Treasury can borrow by issuing T-bills. But 3-month T-bills are paying 13 basis points, while reserves are paying 25, so naturally the government prefers to borrow using the cheaper method. This also means that the interest rates earned by the private sector are lower and there is thus more incentive to move out the yield and credit curves and to undertake real investments (or to move nominal investments into foreign currencies, thus weakening the dollar and stimulating the US economy)."

Michael Woodford - Credit spreads and Modigliani-Miller - "Once one's model has multiple interest rates in it, and the possibility of variable spreads between them, there arises the possibility that different dimensions of financial conditions will be differentially affected by alternative central-bank policies. Under the conditions discussed above that imply a Modigliani-Miller theorem, one can actually show that there is only one relevant dimension of central-bank policy, namely, traditional interest-rate policy; but under almost any assumptions that break the Modigliani-Miller theorem, alternative central-bank policies will be able to influence more than one dimension of financial conditions. Moreover, changes in the structure of relative yields on different kinds of financial claims will generally have consequences for the allocation of resources, so that there is no reason in general to suppose that interest-rate policy alone will suffice to achieve desirable adjustments of financial conditions in response to the disturbances to which the economy may be subject. The possible welfare gains from active use of central-bank credit policy alongside interest-rate policy are illustrated in Curdia and Woodford (2010) in the context of one particular (fairly simple) model with endogenous credit spreads. Yet despite this general observation, it is worth noting that the effectiveness of central-bank credit policy does depend on binding financial constraints of one kind or another, that break the Modigliani-Miller theorem. One can also reasonably expect that the effects of such policies are only substantial when the financial constraints are significant."

Menzie Chinn - Explaining Recent Trends in Household Saving

Stephen Williamson - QE2, Preferred-habitat asset pricing, FRB/US model and Lucas Critique, Fed as a "shadow bank"

Tyler Cowen - New paper on gene-environment interaction

Scott Sumner - Utility vs. Happiness

Really good links - Barro on Bernanke - Rubin's strong dollar legacy - Minsky bailout - Selection and insurance - New orders - Mutual funds vs. ETFs

2011-01-06T12:54:00.003+02:00

Robert Barro interview - Ben Bernanke, Great Depression and Lehman Brothers (H/T Marcus Nunes) - "I think they made a big mistake by not bailing out Lehman Brothers – I think they recognized that two days later. That was Paulson’s individual fault and responsibility from what I can gather. <..>
   Q: So what else should I be reading on the Great Depression? A: There’s Ben Bernanke’s research in the 1980s – that’s probably his most important contribution in terms of macroeconomics and financial economics.
   Yes, I saw the Dow Jones Newswires quote on Bernanke’s book, Essays on the Great Depression, which made me laugh: “With some observers saying that the ongoing financial crisis could be the worst since the Great Depression, the greatest living expert on that period is getting the chance to apply its economic lessons.”
   Well Bernanke was thinking that way in April 2008. I remember talking to him at the time, just after the Bear Stearns initial intervention. I got a chance to ask him a question about why they were so aggressive at that time when things didn’t look so bad. And his response was that basically he was worrying about a Depression-type scenario – and trying to act early to nip that in the bud.
   Q: So what is the thrust of his book and why is it important? A: It’s focusing on the Great Depression as a credit implosion, not so much the money supply, which Friedman and Schwartz had emphasized, but a somewhat related phenomenon, which is credit availability. That had been imploding from 1929 through to the trough, early in 1933. So it’s really focusing on the credit aspects and trying to measure that, particularly by looking at patterns in interest rates.
   Today, for example, if you look at the spread between lower quality bonds – like B-rated corporate bonds, say – and compare those to treasury yields, that’s a good indicator of the extent of stress in the credit markets. And actually the recent period is going back to the kinds of spreads that you saw in the early 1930s. Well, perhaps not quite as much, but certainly reminiscent of that. So he’s focused on that as a measure of the extent of the credit stress, and on the other side he focused on how what turned things around was when the credit problems were being eased."

Tim Duy - Rubin's strong dollar legacy - "[W]hat I believe was a central element of the Rubin agenda, and an element that was in fact the most disastrous in the long run - the strong Dollar policy.
   The strong Dollar policy takes shape in 1995. At that point, Rubin made it clear that the rest of the world was free to manipulate the value of the US Dollar to pursue their own mercantilist interests. This should have been more obvious at the time given that China was last named a currency manipulator in 1994, but the immensity of that decision was lost as the tech boom engulfed America.
   Moreover, Rubin adds insult to injury in the Asian Financial Crisis, by using the IMF as a club to enact far reaching reforms on nations seeking aid. The lesson learned - never, ever run a current account deficit. Accumulating massive reserves is the absolute only way to guarantee you can always tell the nice men from the IMF and the US Treasury to get off your front porch.
   In effect, Rubin encourages the US to unilaterally enact a new Plaza Accord on itself."

Hyman Minsky - Minsky bailout - "The lender of last resort must intervene promptly and assure the availability of refinancing to prevent financial difficulties from turning into an interactive cumulative decline that could lead to a great depression. <..> The need for lender-of-last-resort operations will often occur before income falls steeply and before the well nigh automatic income and financial stabilizing effects of Big Government come into play. If the institutions responsible for the lender-of-last resort function stand aside and allow market forces to operate, then the decline in asset values relative to current output prices will be larger than with intervention; investment and debt financed consumption will fall by larger amounts; and the decline in income, employment and profits will be greater.<..>
   Even though the lender-of-last-resort function of the Federal Reserve was of vital importance in stabilizing the economy in 1966, 1969-70, 1974-75, and 1981-82, this function and operations it entails are poorly understood. A lender of last resort is necessary because our economy has inherent and inescapable flaws that lead to intermittent financial instability.<..>
   The creation of a lender-of-last-resort function was a major objective of the legislation establishing the Federal Reserve System in 1913, but that original objective was subverted by a view that the primary and dominant function of the Federal Reserve System is controlling the money supply. <..> Because the Federal Reserve has the responsibility, so to speak, to pick up the pieces when things go wrong, it must be concerned with and guide the growth and evolution of financial practices in periods of tranquility as well as when circumstance forces it to intervene."

A Fine Theorem - Insurance, adverse selection and advantageous selection - "But what of the case where people with lower risk are the ones demanding more insurance, or “advantageous selection”?
   Consider long-term care insurance. The type of people who buy a lot of such coverage are also likely people who are thoughtful and careful in other areas of their life, and hence people who will have lower long-term care costs otherwise. In such a case of advantageous selection, we avoid the usual informational problems. How true is this empirically? <..> In some markets, these two empirical facts combined can tell us why adverse selection does not destroy the market: in the standard adverse selection story, more life insurance is demanded by those who know they will die sooner, but because of heterogeneity is preferences for risk, those who live longer also turn out to be those who demand more life insurance. "

Annaly Salvos - Manufacturers’ new orders

Sandeep Baliga - Mutual Funds vs. ETFs - "First, ETFs are cheaper than the corresponding mutual fund so the first puzzle is why mutual funds are not driven out by ETFs. This is one answer: there is demand for mutual funds from people with self-control problems and in fact they are willing to pay to commit. There is a value to commitment.
   Second, investors who think they cannot beat the market but believe they have self-control should buy ETFs. If their belief in their self-control is naïve, they will trade anyway and get worse returns than investors who bought mutual funds.<..>
   There is a value to commitment but there is also a value to self-knowledge: recognizing your self-control helps you to know that you should commit and if you commit, you will lose less money."

Really good links - Germany and the solution for the Eurozone crisis - Krugman in 1998 - Money and Metaphysics - Deflation - Equilibrium and institutional process - Consumer confidence - Taxes and government spending

2010-12-30T15:28:00.000+02:00

Crispin Odey - Towards a more balanced Eurozone - "The key feature of the European “now” is not government debt nor under-capitalised banks. It is Germany with an inflationary boom under way. German growth means rapid growth of imports from the eurozone worth significant percentage points on non-German eurozone GDP and a far easier path out of recession for the European periphery than is priced into bonds and equities.
   Those with long memories would argue that the German authorities will spot where all this is heading and will do what is necessary to trample on growth. But Europe and Germany have changed. Sovereign power is not what it was. The German authorities no longer have control of their own policy. <..>
   Of course, Germany will be divided in its attitude to this boom and if it were down to the authorities, interest rates would rise and the currency strengthen. But they are going to be as unable to reach the brake pedal next year, as Ireland et al were unable to reach the accelerator this year."

Tyler Cowen - Paul Krugman's predictions from 1998

Matthew Yglesias - Money and Metaphysics

Dave Altig - Probability of deflation has fallen to the levels observed prior to the economy's summer soft patch

Arnold Kling - Equilibrium vs. institutional process - "As Boettke points out, the profession is split between economists who work out the properties of equilibrium and economists who focus on institutional processes. The latter are marginalized, although they include many Nobel Laureates, including Douglass North and Elinor Ostrom.
   The focus on properties of equilibrium attracts interventionists. You point out an undesirable property of an equilibrium, and then you propose a fix. For example, Stiglitz and Rothschild pointed out that a health insurance market could collapse because of adverse selection, so it follows that government should impose a mandate to purchase health insurance.
   The focus on institutional processes attracts libertarians. You see the benefits of the forces of competition and creative destruction. You see the adverse institutional properties of government."

Tim Duy - Curiously Weak Consumer Confidence - "Consumer confidence figures appear inconsistent with actual spending patterns. That inconsistency will be resolved by either confidence rising or falling spending growth, with more or less obvious policy implications. There will be a tendency to assume the resolution will come from decelerating spending growth. To be sure, the recent trend appears unsustainable. But I also think it is worth paying attention to the more positive household spending data."

David Andolfatto - Robert Shiller's bad idea of a tax-financed increase in government spending - "Its not that I'm against increasing (components of) G. Public works projects of the sort mentioned by Shiller (building highways and improving our schools) were advocated by sensible economists long before Keynes (as evidence of this, note that public works were implemented in the Depression well before publication of the General Theory). What I have a problem with is in using some silly theory to support the notion, for example, that taxes should be raised to finance a large public capital expenditure. Shiller has been rightly celebrated for his work in the theory of finance, and on asset price bubbles in particular. But is this not a rather odd stand to take for a professor of finance?
   Now, I'm no expert in finance myself, so maybe I should be careful in what I'm about to say. But it seems to me that a large capital expenditure should be financed with debt. The debt service could be supported by toll revenue (on bridges and roads) and user fees in general, backed by the Treasury, if needed. The use of tax finance advocated by Shiller in his balanced-budget exercise implicitly assumes (among other things) lump-sum taxes. For some thought experiments, the assumption of lump-sum taxes is innocuous enough. But this is not one of those cases. Taxes are distortionary and to the extent that they are needed to support public spending, they should be spread out over time. This is a standard principle of public finance (I think). "

Really good links - Nominal GDP targeting - Shadow banking - Milton Friedman's thermostat - Origins of the national debt - QE2 and market factors

2010-12-27T15:36:00.000+02:00

David Beckworth - The case for nominal GDP targeting - "Mark Thoma wants to hear the case for nominal GDP targeting. This approach to monetary policy requires the Fed stabilize the growth path for total current dollar spending. As an advocate of nominal GDP level targeting, I am more than happy to respond to Mark's request. I will focus my response on what I see as its three most appealing aspects: (1) it provides a simple and intuitive approach to monetary policy, (2) it focuses monetary policy on that over which it has meaningful influence, and (3) its simplicity makes it easier to implement than other popular alternatives. "

Interview with Gary Gorton - Shadow Banking; The Rise of Repo; Growth of Securitization; Information Sensitivity; The Collapse of Repo; Regulatory Reform; Creating Collateral, not Insurance; Vulnerability to Panic

Nick Rowe - Milton Friedman's Thermostat

Brad DeLong - Alexander Hamilton and the Origins of the National Debt - "Back in the early 1790s, the national debt was close to 40% of annual GDP. It was close to 40% because the first Treasury Secretary, Alexander Hamilton, thought it was a good idea to make it close to 40%. <..>
   The most important reason, however, was that Alexander Hamilton was Secretary of the Treasury in a country where the rich were at best uneasy about the revolution and independence. Of America's upper class as it stood in 1775, full half of them were gone: had fled to Britain or Canada during the Revolutionary War. Those who remained remembered that back before 1775 the British monarch had protected property, that the British army and navy had protected them against deprivations of all kinds, that it was quite clear who the police worked for. Now you have a republic with a much broader electorate. Might politicians run on a platform of soaking the rich and redistributing wealth to the poor? Thus the rich people were nervous--and at least thinking about how maybe it would be good if the British came back and ruled again.
   This was where Alexander Hamilton had his good idea. Suppose, he thought, he could set things up so that the rich owned a lot of U.S. government bonds. Then if the British returned--well, the British were not going to pay off the Revolutionary War debt of the United States of America under any circumstances. Having a national debt was a way to bind the United States rich to the country--giving them a stake in the new republic's survival. And by large it worked: the national debt was a national blessing."

John Hussman - QE2 and market factor analysis - "The key event related to QE2 wasn't its formal announcement, but was instead the Op-Ed piece that Ben Bernanke published a few days later in the Washington Post, which essentially advanced the argument that the Fed was targeting a "wealth effect" in stocks and other risky assets, in hopes of getting people to consume off of that perceived wealth. At that moment, Bernanke unleashed a speculative bubble in risky assets, and a selloff in safe ones. This has rewarded risk-seeking and punished risk-aversion, but it has also unfortunately driven the markets into an overvalued, overbought, overbullish, rising-yields condition that has historically ended in steep and abrupt losses.
   Ned Davis Research tracks a set of "factor attribution" portfolios, which measure the performance between the top 10% of stocks ranked by a given factor, and the bottom 10% of stocks as ranked by that factor. The factors are things like market beta, dividend yield, 26-week momentum, and so forth. Essentially, the these factor portfolios track the return of hypothetical portfolios that are long the top 10% and short the bottom 10% of stocks based on any given variable.
   The performance of these 133 factor portfolios over the past 13 weeks offers tremendous insight into the extent to which the Federal Reserve has encouraged speculative risk. Investors are chasing stocks with the greatest exposure to market fluctuations, commodities, credit risk, small-cap risk and volatility. Conversely, securities demonstrating reasonable valuation, stability, quality, or payout have been virtually abandoned by investors. Here is a sampling:

FACTOR	FACTOR GROUPING	13-WEEK RETURN
Market Beta	Risk	17.80%
Raw Materials Beta	Commodity Sensitivity	17.47%
Credit Spread Beta	Macro Economic Sensitivity	14.66%
Small vs. Large Beta	Style Sensitivity	12.54%
Silver Beta	Commodity Sensitivity	10.87%
Sigma Risk (Volatility)	Risk	10.73%
Operating Cash Flow Yield	Valuation	-4.02%
EPS Stability	Quality	-5.56%
Value vs. Growth Beta	Style Sensitivity	-5.87%
Return on Invested Capital	Profitability	-6.61%
Dividend Yield	Valuation	-9.34%
10-Year T-Note Beta	Macro Economic Sensitivity	-9.55%
High vs. Low Quality Beta	Style Sensitivity	-15.70%

Monetary policy and Minsky cycles

2010-12-18T19:22:00.001+02:00

1. It is impossible to understand the Great Recession without invoking Minsky's cycle theory.

2. Minsky cycle creates the least damage if Minsky recession takes place in the context of stable NGDP growth. Minsky crash creates collateral damage if there is a downward deviation from the NGDP trend.

3. We observe the asymmetry of Minsky booms and Minsky crashes. Traditional monetary policy is a very powerful AD fine-tuning tool during the Minsky boom, on the other hand, monetary policy is prone to crashes and mistakes during the Minsky bust.

4. Monetary authorities usually operate some kind of peg, this peg may crash or lose credibility when the Minsky moment arrives. During the Great Depression, the dollar gold peg lost credibility, and the AD was too low until the Roosevelt devaluation. These days the Fed is operating a crawling fed funds rate peg, this peg has crashed after the bankruptcy of Lehman, and the AD was too low during the crash. During the collapse of the fed funds rate peg, we had the flight to liquidity problem, not the flight to safety problem, so the root cause of low AD was monetary, not Minskyite. The fed funds rate peg was restored in late October 2008.

5. When the monetary peg is restored, it is important that it is restored at the levels where it promotes the speedy recovery. Roosevelt repegged the dollar at the level that generated a fast recovery, on the other hand, the federal funds rate was too high when the fed funds rate peg was restored in late October 2008. Scott Sumner's NGDP expectations peg is useful in this regard. If the NGDP expectations peg crashes, most likely it will be restored at the previous NGDP trend.

6. If the neutral short term risk free interest rate drops below zero during the Minsky bust, the risk of monetary policy mistakes increases. Monetary tools that bring the neutral interest rate back into the positive territory need to be aggressively employed. There are three such tools - higher inflation targets, quantitative easing, credit easing.

7. Higher inflation targets are undesirable, as credibility of monetary policy is diminished during normal times. NGDP path targeting removes the need to change the goals of the monetary policy during the Minsky cycle.

8. Quantitative easing is powerful only until the term risk premium is lowered to zero. After that, it loses the direct effect and only signalling effect remains. The power of quantitative easing is limited, so Bernanke did not use this tool until March 2009.

9. Credit easing is the most powerful non-traditional monetary tool. Bernanke started using it in 2007. However, the extensive use of credit easing increases the risk of Fed's insolvency, it also creates various legal, technical and political problems. Credit easing programs were not expanded to the extent needed to stabilize AD. Bernanke has indicated that additional fiscal stimulus is needed to increase AD.

10. Measures that increase the use of credit easing would be helpful. Larger Fed's capital base could reduce the risk of Fed's insolvency. Development of broad short term credit market indexes could help us design credit easing programs that are not discriminatory and thus more attractive politically.

11. NGDP path pegging is the policy that could prevent the collateral damage caused by the Minsky crash. NGDP path peg gives us a speedy recovery when monetary policy temporarily loses credibility. NGDP path provides a good focal point for the coordination of monetary and fiscal policies when the zero interest rate constraint is binding.

Really good links - Optimism about US recovery - Bailout - What is money? - Mankiw is a New Keynesian

2010-12-16T14:29:00.000+02:00

Nick Rowe - Optimism about US recovery - "What matters is the gap between what the market believes will happen and what the market believes the Fed believes will happen. I think we have just such a gap right now. The market believes the Fed is too pessimistic. That creates an upside cumulative process. That's what makes me optimistic."

Tyler Cowen - Bailout and inequality - "In short, there is an unholy dynamic of short-term trading and investing, backed up by bailouts and risk reduction from the government and the Federal Reserve. This is not good. “Going short on volatility” is a dangerous strategy from a social point of view. For one thing, in so-called normal times, the finance sector attracts a big chunk of the smartest, most hard-working and most talented individuals. That represents a huge human capital opportunity cost to society and the economy at large. But more immediate and more important, it means that banks take far too many risks and go way out on a limb, often in correlated fashion. When their bets turn sour, as they did in 2007–09, everyone else pays the price.
   And it’s not just the taxpayer cost of the bailout that stings. The financial disruption ends up throwing a lot of people out of work down the economic food chain, often for long periods. Furthermore, the Federal Reserve System has recapitalized major U.S. banks by paying interest on bank reserves and by keeping an unusually high interest rate spread, which allows banks to borrow short from Treasury at near-zero rates and invest in other higher-yielding assets and earn back lots of money rather quickly. In essence, we’re allowing banks to earn their way back by arbitraging interest rate spreads against the U.S. government. This is rarely called a bailout and it doesn’t count as a normal budget item, but it is a bailout nonetheless. This type of implicit bailout brings high social costs by slowing down economic recovery (the interest rate spreads require tight monetary policy) and by redistributing income from the Treasury to the major banks. <..>
   The upshot of all this for our purposes is that the “going short on volatility” strategy increases income inequality. In normal years the financial sector is flush with cash and high earnings. In implosion years a lot of the losses are borne by other sectors of society. In other words, financial crisis begets income inequality. Despite being conceptually distinct phenomena, the political economy of income inequality is, in part, the political economy of finance<..>
   Another root cause of growing inequality is that the modern world, by so limiting our downside risk, makes extreme risk-taking all too comfortable and easy. More risk-taking will mean more inequality, sooner or later, because winners always emerge from risk-taking. Yet bankers who take bad risks (provided those risks are legal) simply do not end up with bad outcomes in any absolute sense. They still have millions in the bank, lots of human capital and plenty of social status. We’re not going to bring back torture, trial by ordeal or debtors’ prisons, nor should we. Yet the threat of impoverishment and disgrace no longer looms the way it once did, so we no longer can constrain excess financial risk-taking. It’s too soft and cushy a world."

Paul Krugman - What is money? - "Surely we don’t mean to identify money with pieces of green paper bearing portraits of dead presidents. Even Milton Friedman rejected that, more than half a century ago. For one thing, a lot of those pieces of green paper are pretty much inert — sitting outside the United States, in the hoards of drug dealers and such. For another, checking accounts are clearly a close substitute for cash in hand.
   Friedman and Schwartz dealt with this by proposing broader aggregates –M1, which adds checking accounts, and M2, which adds a broader range of deposits. And circa 1960 you could argue that those aggregates were good enough.
   But now we have a large shadow banking system, in which things like repo serve much the same function as deposits; M3 used to capture some of that, but the Fed discontinued it, in part I think because it wasn’t clear which repo belonged there, and data on repo not involving primary dealers is scattered. Whatever.
   The truth is that these days — with credit cards, electronic money, repo, and more all serving the purpose of medium of exchange — it’s not clear that any single number deserves to be called “the” money supply. Intellectually, this isn’t a problem; nor is there necessarily a problem maintaining monetary policy even if there isn’t any single thing you’re willing to call money."

JTapp - Textbook politics - " I had been using the Mankiw Principles of Macro text for the 2 years I’d been at my current position and decided to adopt his Micro this year in order to bring some symmetry and take advantage of his Aplia sets, etc. But I share Micro with other professors who would also be required to adopt it. One lodged a complaint when a Google search revealed Mankiw is a “New Keynesian,” which immediately raised a flag b/c anything with “Keynes” in it is problematic. Nevermind that the department, including this professor, had been using other New Keynesians, including Mishkin, for years in other classes and I’d been using Mankiw’s macro for years and adopted Ball in the M&B class– Micro was a step to far.
   He had our department chair (a marketing professor) take it home to check for subversive material. One of Mankiw’s 10 Principles of Economics being “government can sometimes improve market outcomes” was a red flag. In the end we adopted it b/c they trusted my judgment. In higher education, EVERYTHING is political, maybe worse than proper academia. (I sent the story to Mankiw who found it amusing, he commented that just working at Harvard made him a socialist to many.)"

Really good links - Global AD - Austrian theory - Germany - A sentence to ponder

2010-12-08T22:44:00.001+02:00

Bill Gross - Global aggregate demand - "The global economy is suffering from a lack of aggregate demand. In simple English that means that consumers are not buying enough things and that companies are not hiring enough people because of it. Growth slows down, especially in developed as opposed to developing countries, and the steel mills of Allentown, USA and Sheffield, England close down.
   This shortfall of global demand is a nearly impossible concept to grasp amongst politicians and their citizenry. Don’t people always want to buy more things and isn’t demand theoretically insatiable? They do, and it is. Yet economic growth is a delicate dance between production and finance and when a nation’s or a family’s credit card gets maxed out, then demand/spending slows measurably. We are witnessing these commonsensical repercussions across the entire continent of Europe today and to a lesser extent in the United States.
   Developing nations and their consumers want to buy things too. And while their economies are growing fast, their overall size is not yet sufficient to pull along the economies of Europe, Japan and the U.S. Their financial systems are still maturing and reminiscent of a spindly-legged baby giraffe, having lots of upward potential, but still striving for balance after a series of missteps, the most recent of which was the trio of the 1997–98 Asian crisis, the 1998 Russian default and the 2001 Argentine default. And so their policies are oriented towards export to debt-laden developed nations instead of internal consumption, leaving a gaping hole in global aggregate demand. China is a locomotive to be sure, but it cannot pull the global economy uphill on the basis of mercantilistic exports alone. It needs to develop many more of its own shopping malls and that will take years, if not decades."

Steve Randy Waldman - Austrian hangover theory - "Austrian-ish “hangover theory” claims, plausibly, that if for some reason the economy has been geared to production that was feasible and highly valued in previous periods, but which now is no longer feasible or highly valued, there will be a slump in production. It wisely asks us to consider not only the prosperity we measure today, but the sustainability of that prosperity going forward. I am not “Austrian”, and have no interest in defending specific claims regarding the roundaboutness of activity or the role of central banks in causing bursts of quasiprosperity. But as Brad DeLong wisely reminds us, it is good to be somewhat catholic in our evaluation of macroeconomic schools, and to take what is useful from each. I consider myself Keynesian at least as much as I am Austrian, but I recognize good and not-so-good offshoots of both schools. (Austrian and Keynesian ideas are more complementary than most people acknowledge. The Austrians focus on unsustainable arrangements of real capital, while the Keynesians focus on unsustainable arrangements with respect to money, debt, savings, and income. I think both approaches are fruitful.)<..>
   At an individual level the correlation between past consumption and recent unemployment is obviously negative. The people who have sinned are not by and large the people being punished. Some people overconsumed relative to their income, and some people invested poorly. Those who overconsumed have mostly faced consequences for their misbehavior — they are either deeply in debt, or they have endured foreclosure or bankruptcy. But the people who invested absurdly, especially “savers” who lent money but permitted themselves ignorance and indifference to how their wealth would be mismanaged, have not suffered the costs of their recklessness. Instead, they have been almost entirely bailed out. It is lenders and investors more than any other group who determine the patterns of our macroeconomy. There are always people willing to overconsume or gamble on foolish enterprises. We do and must rely upon those with resources to steward to ensure those resources are used wisely. They did not, and their recklessness has brought us to catastrophe. But rather than condemn them for negligence and permit their claims to be appropriately devalued, we applaud them for “prudence” and let government action be bound by commitments to sustain their destructive and ridiculous claims. You don’t counter that sort of villainy with technocratic arguments about liquidity traps. You point out that the motherfuckers who are calling themselves prudent, who are blocking both writedowns and government action that might risk inflation, are hypocrites and thieves. You state clearly that their claims are illegitimate and will be written down one way or another, unless we can generate sufficient growth to ratify them ex post, which would require claimants to behave less like indignant creditors and more like constructive equityholders. It is not technocratic economists who will win the day and pull us out of our cul-de-sac, but angry Irishmen and Spaniards who challenge, on moral terms, the right of German bankers to impose vast deadweight costs on current activity because they lent greedily into what might easily have been recognized as a property and credit bubble."

Daniel Pfaendler - German view - "What we should not forget though is that a) just as the peripheral countries were profiting from very low real yields during the past decade amid the German economic malaise, Germany suffered from too high real yields amid the periphery's boom which rendered its economic weakness even worse and most importantly b) if Germany would not have done the corporate restructuring/budget consolidation/structural reforms, the German economy would be in a much worse shape at present."

Michael - A sentence to ponder - "Most people are libertarian with regards to their own lives and people they like, statist with regards to people they don't know, and positively fascist about people they dislike, stereotype, or don't understand."

Payroll tax holiday and the credit channel

2010-12-08T13:28:00.001+02:00

Bryan Caplan says Obama has botched the payroll tax holiday:

"If you cut a tax on employers, this reduces labor costs, increases the quantity of labor demanded, and reduces surplus labor. If you cut a tax on employees, in contrast, this increases worker compensation, increases the quantity of labor supplied, and increases surplus labor.

In both cases, admittedly, a tax cut might directly increase demand and, with nominal wage rigidity, increase employment. But when you cut taxes on employers, the incentive effect and the fiscal effect work in the same direction. When you cut taxes on employees, the incentive effect and the fiscal effect work in opposite directions.

That's why Obama's proposed payroll tax holiday botches an idea of truly Singaporean cleverness. Instead of giving the tax cut to employers, where it would do the maximum good, or splitting it evenly, where it would do intermediate good, he's giving all of it to employees, where it does the minimum good"

I have an alternative interpretation. It is true that if you cut a tax on employees, you do very little to directly correct the labor market imbalances. However, the poor functioning of the labor market was caused by the insufficiently stimulative monetary policy that is constrained by the zero bound on interest rates. The zero interest rate bound creates the most damage to those economic agents who have the weakest balance sheets. And these days the household balance sheets are the weakest. Weak household balance sheets are pushing the optimal fed funds rate down to the negative levels. If you cut a tax on employees, you relax the credit constraints on household balance sheets, and the day when the zero interest rate bound is no longer constraining Bernanke will arrive sooner.

In late 2008 - early 2009 balance sheets of non-financial corporations were very weak, so Bryan Caplan's logic would have worked then very well. But today Obama's payroll tax holiday is the solution that will have the most powerful effect.

Ireland - Greece - Fiscal vs. monetary policy - Eurozone - Overconsumption and recessions

2010-12-05T13:38:00.000+02:00

Barry Eichengreen - Ireland - "The Irish “program” solves exactly nothing – it simply kicks the can down the road. A public debt that will now top out at around 130 per cent of GDP has not been reduced by a single cent. The interest payments that the Irish sovereign will have to make have not been reduced by a single cent, given the rate of 5.8% on the international loan. After a couple of years, not just interest but also principal is supposed to begin to be repaid. Ireland will be transferring nearly 10 per cent of its national income as reparations to the bondholders, year after painful year.
   This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. A populist backlash is inevitable. <..>
   For internal devaluation to work, therefore, the value of debts, expressed in euros, has to be reduced. This would have been particularly easy in the Irish case. A bright red line could have been drawn between the third of the government debt that guarantees the obligations of the banks, on the one hand, and the rest of the government’s debt, on the other. The third representing the debts of the Irish banking system could have been restructured. Bondholders could have been offered 20 cents on the euro, assuming that the Irish banks still have some residual economic value."

John Dizard - Greece - "The Greeks and their advisers are already much further along in their thinking than euro-officialdom. They realise that reaching a “successful” conclusion of the three-year adjustment process agreed with the euro leaders would be a disaster for their balance sheet. As Greek bonds mature over that period, they are paid off in large part with new borrowings from Europe and the IMF, as well as with Greek banks’ discounting bond purchases with the ECB. That means Greece is exchanging outstanding debt that is legally and logistically easy to restructure on favourable terms with debt that is difficult or impossible to restructure. It’s as if they were borrowing from a Mafia loan shark to repay an advance from their grandmother."

Narayana Kocherlakota - Fiscal policy vs. Monetary policy - "I believe that QE is a move in the right direction. However, as I have discussed on earlier occasions, I also think there are good reasons to suspect that the ultimate effects of any amount of QE are likely to be relatively modest. That’s why I would have greatly preferred for the committee to have been able to cut its target rate rather than using QE. The problem is that its target rate is already essentially at zero, and so it was not possible to cut the target rate any further.
   Given this constraint on monetary policy, I believe it is important to ask if it is possible to synthesize the effects of a one-year interest rate cut of, say, 100 basis points using fiscal policy tools. In his current and past work, Minneapolis Fed staff researcher Juan Pablo Nicolini and his co-authors have answered this question in the affirmative. Their key insight is that there is a broad equivalence between monetary and fiscal policy. They argue that the essence of an FOMC interest rate cut is that it makes current consumption cheaper relative to future consumption. With that in mind, the fiscal authorities can use the time path of consumption taxes to accomplish this same change in relative prices.
   In the remainder of my remarks, I’ll illustrate this insight by describing one particular fiscal policy plan that is equivalent to a 100-basis-point cut by the Fed. The proposal has three parts. The first part is a permanent consumption tax of 100 basis points, instituted with a one-year delay. The second part is a permanent decrease in labor income taxes of 100 basis points, also instituted with a one-year delay. The third part is an investment tax credit undertaken in 2011. The Nicolini et al. results demonstrate that, in a wide class of economic models, the effects of this three-part plan would be equivalent to the effects of a 100-basis-point interest rate cut."

Tyler Cowen - Eurozone - "Fiscal union was, is, and will remain a fantasy. The best the eurozone could have done was to abolish national banking systems and have a truly European banking market. It's too late for even that, though."

Karl Smith - Overconsumption theory of recessions

Really good links - Uncertainty and AD - Cash is the king - Interest on reserves - Tea party

2010-11-29T09:34:00.002+02:00

Brad DeLong - Uncertainty and aggregate demand - "The future is always uncertain--and how uncertain it is fluctuates. When the future is more than unusually uncertain, economic players want the security of extra financial asset holdings before they are willing to spend to put people to work. It is, then, the business of the government to make sure that they have the amount and the kinds of financial assets they need to sleep easily. That was one of the insights of John Maynard Keynes. That was one of the insights of Milton Friedman."

Jeremy Grantham - Cash is the king - "We've already started to sell [stocks]. We're not even— averagely weighted. We're modestly underweighted. And you must remember bonds are even worse than stocks on a seven-year forecast. So, you get caught in this paradox. It's very tempting— and this is what the Fed wants by the way.
It wants us to go out there and buy stocks, which are overpriced because bonds they have manipulated into being even less attractive. So, we’re being forced to choose between two overpriced assets. That is not always a terrific choice to make because there is a third choice, and that is don't play the game and hold money in cash.
And cash has a— a virtue that people don't appreciate fully. And that is its— its optionality. In other words, if anything crashes and burns in value— say the U.S. stock market, if you have no resources, it doesn't help you. If the bond market crashes, and you have no resources, it doesn't help you. And what cash is is an available resource. It buys you the right to buy the U.S. market if the S&P drops from 1,220 today to 900, which is what we think is fair value."

Mark Thoma - Interest on reserves - "There’s been a lot of talk lately about the Fed’s policy of paying interest on reserves with many claiming that this has caused banks to retain reserves that might have otherwise been turned into loans, and thus the policy has depressed aggregate activity. However, paying interest on reserves is a safety net for the Fed that allowed them to do QEI and QEII. If the Fed wasn’t paying interest on reserves, QEI would have likely been smaller, and QEII may not have happened at all. <..>
The tool the Fed has for removing reserves from the system is open market operations (QEI and QEII are essentially traditional open market operations, but the Fed buys long-term rather than the more traditional short-term financial assets). So why do they need another tool — interest on reserves — to control reserves? Removing reserves too fast through open market operations could disrupt financial markets. Paying interest on reserves gives the Fed a way to remove reserves in a more leisurely fashion while still maintaining control over inflation."

Steve Landsburg - Cut agencies - "Like I said, cut agencies. And cut them in bunches, to dilute opposition. As I’ve said before on this blog, the department of commerce steals from workers and farmers to subsidize businesses; the department of agriculture steals from workers and businesses to subsidize farmers, and the department of labor steals from businesses and farmers to subsidize workers. Eliminate them all at once and every American will lose one friend and two enemies."

Really good links - Case against the Fed - Fiscal democracy - IOR - Bernanke and Palin - EMU - Boom-bust-bailout

2010-11-27T19:27:00.001+02:00

Tyler Cowen - The case against the Fed is weak - "To whatever extent we can do without a Fed, it's because there are so many Treasury securities, which should be a sobering thought to a market-oriented perspective. If the Fed were shut down, over time the new base money would not be gold, "Hayeks," or a commodity bundle. It would be T-Bills. We would have achieved the full integration of the monetary and fiscal authority but to what useful end? (Better not balance the budget!) The real question is whether the Treasury should be the Fed or whether the Fed should be the Fed, but you won't often see it framed that way."

John McDermott - Democracy as a solution for fiscal crisis - "Imagine that in country X, measure A receives 90 per cent support in parliament but measure B squeezes through with only 51 per cent. The bond issued to pay for measure A is given seniority. Its holders get paid before those with the bond behind measure B. (If measure C then receives 98 per cent support it would trump A, and so on.)
   [Hans Gerbach of the ETH says:] Vote-share government bonds align the strength of the political support for particular government activities with the pledge to repay debt. This is desirable in its own right, as voting for debt-financed government expenditures is connected to the willingness to repay. Accordingly, it may have a favourable effect on deliberation in democracy by linking debt-financing with repayment promises when political debates about new government expenditures take place."

Bill Woolsey - Interest on reserves and inflation - "Murphy does make an odd error when discussing the possible strategy of the Fed paying higher interest on reserves. He says that investors will figure out that an exponential increase in reserves will hardly allow the Fed to control inflation. Now, suppose the expected inflation rate does rise to 10 percent and that a 12 percent interest rate is needed so that the demand for reserves will be high enough so that the demand for base money remains $2.6 trillion. Murphy seems to imagine that since each reserve balance would increase by 12 percent each year, base money would rise at a 12 percent annual rate. No. The Fed would simply have to sell between $200 billion and $300 billion in assets each year to leave base money the same. Rather than having to sell off $1.8 trillion in assets post haste, they could sell much fewer assets and prevent any excess inflation."

Scott Sumner - Ben Bernanke and Sarah Palin - "The reason QE worked was not the operation itself (which I agree does little or nothing) but rather because it tells the market that the Fed is now more serious about boosting long term prices and NGDP. In other words they are now willing to leave that base money out there long enough to get closer to their implicit inflation target. The Fed was afraid to directly call for higher inflation (something Krugman thinks could work) so they spoke in code, hoping the markets would understand them but Sarah Palin would not. Unfortunately for Bernanke, Sarah Palin has advisers who know exactly what the Fed was up to. "

Ambrose Evans-Pritchard - Way out for EMU - "A reader asked me this week whether there is any graceful way to avoid this coming chain of disasters.
Yes, there are two options, neither entirely graceful. The European Central Bank can print money like a drunken sailor, flood the bond markets with €2 trillion, and tank the euro against China’s yuan for good measure.
   If the Germans refuse to accept this, they should abandon EMU at once, leaving France and southern Europe with the residual euro and the institutions of monetary union. Existing euro debt contracts would be upheld. Germany would revalue – alone or with Finns, Dutch, etc - so holders of Bunds would enjoy a windfall gain.
   France could revive the Latin Union of the late 19th Century, a more benign venture than the Máquina Infernal now asphyxiating Portugal, and deflating Spain.
   Any better ideas out there?"

Simon Johnson - Boom-Bust-Bailout - "In “The Quiet Coup,” published in Atlantic magazine in May 2009, I compared the U.S. economic boom-bust-bailout cycle to what has become typical in emerging middle-income countries such as Russia, Argentina or Indonesia. Just don’t think these problems are limited to emerging markets.
   There is a much more general or global phenomenon in which powerful people cooperate to build an economic model that provides growth based on a great deal of debt. When the crisis comes, those who control the state try to save their favorite oligarchs, but there aren’t enough resources to go around."

Really good links - Sovereign default - Brad DeLong and Larry Summers - No Trade Theorem - Austrian zero bound - Billion prices - Interest elasticity

2010-11-25T04:03:00.002+02:00

Simon Johnson and Peter Boone - Sovereign default - "The Germans should recall the last episode of widespread sovereign default – Latin America in the 1970’s. That experience showed that countries default when the costs are lower than the benefits. Recent German statements have pushed key European countries decisively closer to that point. <..>
   Bond-market participants naturally turn now to calculating “recovery values” – what creditors will get if countries default today. For example, Greece’s debt stock, including required bridge financing under the IMF program, should peak at around 150% of GNP in 2014; much of this debt is external. If a country can support debt totaling 80% of GNP (a rough but reasonable rule of thumb), then we need approximately 50% “haircuts” on this existing and forthcoming debt (reducing it to 75% of its nominal value).
   However, of this 150% of GNP, at least half is or will be official in some form. If it is fully protected, as seems likely (the IMF always gets paid in full), then the haircut on private debt rises to an eye-popping 90%. And this leaves out government spending that may be needed for further recapitalization of Greek banks."

Robert Waldman - Brad DeLong and Larry Summers - "You [DeLong] thought the problem was George Bush not Joe Cassano. You thought the fundamental problem with the US economy was the huge federal budget deficit. You thought the crisis would come when the People's Bank of China got tired of throwing good money after bad and let the dollar collapse and US long term interest rates shoot up.
   Why did you think this (aside from evidence and logic) ? Well you are much inclined to think that the Clinton economic team did a very good job. So you are much inclined to think that Bush did a terrible job. Also you can't stand him.
   The idea high deficits cause high real interest rates which are terrible for growth is very dear to you (not to mention overwhelmingly supported by massive evidence).
   I think this is also true of Larry Summers. He put Harvard's money where his mouth was. He bet on high interest rates on US Treasuries. That most definitely was not because he thought that Greenspan could control everything. That was because he was sure that Bush would cause a catastrophe not just by neglecting dangerous Wall Street developments but by undoing the great work of Clinton, Bentson, Rubin and Summers."

Alex Tabarrok - No Trade Theorem

Tweet of the day - Garrett Jones - "In Austrian term-structure-of-capital theory, the zero nominal bound would seem particularly perilous."

James Hamilton - Billion prices project

Jeremy Grantham - Interest elasticity of consumption - "And let me point out that the Fed's actions are taking money away from retirees.
   They're the guys, and near retirees, who want to part their money on something safe as they near retirement. And they're offered minus after-inflation adjustment. There's no return at all. And where does that money go? It goes to relate the banks so that they're well capitalized again. Even though they were the people who exacerbated our problems.
   And, hopefully, the redeeming feature in that infamous trade is that your corporations go out there, borrow money, build factories, hire people, which they're not doing because consumption is weak and because they were also terrified by the crunch. I— I think, therefore, under these conditions, low rates is actually hurting the economy. It's taking more money away from people who would have spent it —retirees — than are being spent by passing it on to financial enterprises and being distributed as bonuses to people who are rich and, therefore, save more."

Really good links - Deleveraging - Bernanke and tax cuts - Pain caucus - Causes of economic downturns - Critics of QE2 - Sustainability - Hugh Hendry video

2010-11-22T08:03:00.001+02:00

Paul Krugman - Deleveraging - "The situation: over the past decade, households ran up what is almost universally regarded as an excessive amount of debt — shown here for the United States, but also in the UK, Spain, and elsewhere. They are now being forced to pay down that debt by cutting spending.
   The question is, what will replace their spending? We’re told that we can’t have fiscal expansion, because that’s Big Government. And now we’re being told that we can’t have monetary expansion, which might induce businesses and low-debt consumers to spend more, because that’s debasing the dollar. Oh, and while we’re on that, we can’t allow the dollar to fall, which might help exports."

Ben Bernanke (2002) - Tax cuts - "A pledge by the Fed to keep the Treasury's borrowing costs low, as would be the case under my preferred alternative of fixing portions of the Treasury yield curve, might increase the willingness of the fiscal authorities to cut taxes."

Scott Sumner - Open letter to fellow conservatives

Brad DeLong - What is wrong with American macroeconomics? - "What is wrong with American macroeconomics? In a nutshell, when 2007-9 came along every single macro textbook (including mine) and every single macro course (save possibly Perry Mehrling's) was of little or no use in helping people who had read or taken them to read publications like the FT as they chronicled the downturn or understand the policy debates hosted by the FT.
   At the very minimum, a macro course should teach people enough about the macroeconomy that they can then read the reporting of the FT. And it should teach people enough about the theoretical approaches that underpin policy advocacy that they can then understand and evaluate the policies proposed in contributions to the FT.
   What would such a macroeconomics course look like?
   It would, I think, teach the five still-live theories of the causes of economic downturns that underpin people's analyses. <..>
   All five of these theories are best taught sympathetically by being taught historically: as long traditions of thought that smart people have used to try to understand a changing and confused world. Thus Minskyism from its nineteenth century roots with Walter Bagehot or perhaps Adam Smith grappling with nineteenth-century financial crises, Keynesianism from its roots in Knut Wicksell's studies of disturbances to the flow-of-funds, monetarism from its roots in John Stuart Mill trying to understand the first industrial downturn in England in 1825, overinvestment theories from their roots in Karl Marx grappling with the crisis of 1848, high-real-wage from its roots in Nassau Senior's examinations of technological unemployment in the pre-1850 Midlands--all tussling with a set of problems first raised by Jean-Baptiste Say and Thomas Robert Malthus.
   That would be a macro course that would turn out graduates who could read the FT--and who would be of great value to all the employers who need people to process information from the FT."

Bill Woolsey - Why are many free market economists so critical of the Fed's proposed quantitative easing?

David D. Friedman - Sustainability - "Generalizing the point, "sustainability" becomes an argument against whatever policies one disapproves of, in favor of whatever policies one approves of, and adds nothing beyond a rhetorical club with which partisans can beat on those who disagree with them."

BBC Video - Fund manager Hugh Hendry vs. politicians and audience

Cartoon - QE2, Hayek and Scott Sumner

Really good links - Too little money chasing too many goods - Credit Easing - Will the Fed Scale Up QE2? - Leverage as a positive good - Currency war - Fed - IOR

2010-11-18T11:05:00.001+02:00

Bill Woolsey - Recession - "Recession is NOT too little money chasing too many goods.
   It is too little money chasing too few goods."

Ben Bernanke, please bring credit easing back! Here is what you said about it in 2002:
   "If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities."

Tim Duy - Will the Fed Scale Up QE2? - "But we shouldn't kid ourselves. Flooding the market with money is dangerous business. It risks distorting prices and capital allocations. We simply don't know where the money will wash up. I know that is in vogue to believe there is a nice, obvious story that links an increase in the money supply to an increase in nominal GDP, but that only works on paper. In the real world, the paths between money and output and prices are complicated. The ultimate composition of aggregate demand matters. It matters a lot - distortions have consequences. Warsh's risks amount to a laundry list of the possible distortions that might occur as the result of ongoing quantitative easing. And he clearly takes those risks seriously.
   It makes me think that I haven't been taking those risks seriously enough. But when monetary policy is the only game in town, what choice do you have? You do what you can up to a point…but then you throw it back to Congress and say "you take responsibility for the mess you created by abdicating your role in crafting long run, stabilizing macroeconomic policies." Warsh has set the stage for doing exactly that.
   Of course, seriously, if we really have to throw this back to Congress, we are absolutely done for. Cooked. Toast. Somebody remember to tell the last guy to turn off the lights on his way out. Better to take our chances with the next bubble.
   Bottom Line: One can tell a seemingly optimistic story - the threat of the double dip is behind us, setting the stage for a nice return to potential growth. But that story holds the dark side of persistent, pernicious low levels of labor utilization. Still, I think now the Federal Reserve would have chosen the optimistic narrative had it not been for the obvious slowdown midyear. Which suggests to me they are not eager to do more, especially if growth settles back in at trend. Reinforcing that belief is the Warsh speech, which makes a strong case that further monetary policy is increasingly ineffectual and very risky. But even more important, he makes clear a belief that only Congress and the Administration have the tools to restore growth. I imagine if that view is, or becomes, a widespread opinion among policymakers, we have seen the last gasp of quantitative easing. They have abated the financial crisis, serving as the lender of last resort, and flooded the economy with cash. They have done what they can. The rest is up to the fiscal authorities. "

Brad DeLong - Leverage as a positive good - "Once we had concluded that the Federal Reserve had the tools and the competence to absorb financial shocks, the jaws of the trap snap shut. Leverage then appears to be a positive good rather than a danger. Why? Because if the past two centuries of financial market history prove anything, it is that the markets are woefully short of patent capital willing to bear risks. The financial rich are overwhelmingly the patient risk-bearers. The financial poor are those who sought safety, or who were unwilling or unable to hold their positions and wait for fundamentals to reassert themselves. Leverage then becomes a way of taking the money of the risk-averse of whom the market has too many--for that is what low long-term returns on "safe" portfolios tell us--and putting it too work in the hands of the too-few who will use it to take the long-term risks that the market, historically, has always handsomely rewarded. And financial sophistication becomes a way of concentrating and amplifying the rewards of risk-bearing to call forth additional risk-bearing capital to bolster the numbers of the too-few."

Menzie Chinn - QE2 and currency war - "I have also been thinking about the anger with which the policymakers and economists in the rest-of-the-world (as well as certain US politicians) have greeted QE2 with. In some ways, the fact that they are angry speaks volumes about the effectiveness or ineffectiveness of QE2. (In other words, to criticize QE2 as having no effect, and then to be angry that it is being undertaken, are internally inconsistent views.)
   My view is that anger at the US position is currently being driven by an understanding that QE2 has been surprisingly effective at depreciating the dollar, and that the rest-of-the-world has limited scope in countering that depreciation."

Statsguy - Fed and the support of financial system - "Finally, the one CONSISTENT principle the Fed has pursued has been to support the financial system. Period. I would challenge you to name a single decision in the last 3 years that hasn’t favored the financial system. Even QEI was not unleashed until the Fed was absolutely sure the threat of rising interest rates had been crushed, and the risk of financial collapse through defaulting loans and asset depreciation had exceeded the risk of financial collapse through loss of bond valuations. AKA, liquidity crunch.
   The current QEII round has directed preferential liquidity through primary dealers, thereby supporting trading activity which has buttressed bank balance sheets (in other words, infused capital) to compensate for the bad loan book.
   You currently view Bernanke et. al.’s endorsement of QEII as an intellectual victory. Consider, for a moment, it simply reflects a closer alignment between the interests of large financial entities, and the broader economy."

Niklas Blanchard - Interest on reserves - "I think that Drum gets two things wrong in his analysis. The first is that interest on reserves is a very desirable policy that smooths out the Fed Funds rate fluctuations, reduces lending spreads, and reduces the opportunity costs of capital. Milton Friedman was the most famous proponent of interest on reserves, and Canada and Australia (if I’m not mistaken, working from memory) also pay interest on reserves.
   When Kevin says that the IOR should be zero, what he should be saying is that the Fed Funds rate should be zero, and should have been in Sept 2008 (currently 0-.25, at the time it was 2). "

Really good links - QE2 as a signal - Gold and monetary policy - QEII - EMH - Clearinhouse panic

2010-11-15T11:55:00.000+02:00

Menzie Chinn - QE2 as a signal - "There is some mystery why the impact on the exchange rate has been so much more marked than that on long term rates. As several observers have observed, QE2 is fairly small in quantitative magnitude, and in terms of implied impact on duration adjusted interest rates. Theory suggests offsetting inflation and liquidity effects from open market operations, so the impact on observed nominal rates could in principle be small (and in either direction).
   I think a large chunk of the impact comes from the fact that QE2 signals additional information about the willingness of the monetary authorities to undertake actions to stimulate the economy, perhaps by future injections. I will also observe that the likelihood of a sensible fiscal policy declined after the mid-term elections (that is the US will more likely undertake contractionary fiscal policy by not offsetting state spending reductions), so that from a simple Mundell-Fleming model, we should expect dollar depreciation."

Gavyn Davies - The gold price is not a very useful signal - "In the graph, which is drawn on a log scale, the gold price has risen in a virtual straight line for the whole of the past decade. There have been some periods when the gold price has fallen, but these have not lasted very long.
   Over the same period, global price inflation has had periods of rising (before 2007) and falling (after 2007). Government debt ratios and budget deficits have similarly had periods of improvement and deterioration. The dollar has seen years in which its trend has been rising, and years where the reverse has been true. Global current account imbalances have widened, and then narrowed. The gold price has risen when measured in “inflationary” currencies like the dollar, and it has also risen (though by less) when measured in “deflationary” currencies like the yen. In other words, it is not at all clear what the rise in the price of gold has been warning us about.<..>
   Consequently, I am genuinely unsure about what the gold market is signalling which could be useful to policy makers, unless it is just a general message that “things are worrying, so get your house in order”. That may be true, but it does not tell us what to do next."

Tyler Cowen - QEII - "I'm not sure it will work, because it won't fix the housing market, may not restore the demands for wealth-elastic goods in a sustainable manner, may not restore the normal flow of credit to small businesses, may not lower subjective estimated risk premia, and may not fix the general disconnect between expectations and reality. The effects on long-term interest rates are murky. "

Brad DeLong - EMH - "He [Summers] (and I) never were believers in the efficient markets hypothesis. How could we be? Look around: there are idiots! The market's prices are the results of a wealth-weighted voting mechanism: the more money you have, the bigger is your weight in the market's average. People who have done well in the recent past thus have more weight than people who have done badly. But those who have done well me be irrational trend-chasers who have been lucky and those who have done badly may be sober-sided fundamentalists whose time has simply not yet come. The questions of the degree to which the limited amount of risk-averse smart money can leverage itself and profit from all this noise in the market by reducing it is a fascinating and subtle one. But nobody thinks that the answer is that the noise simply does not matter, is ironed out into insignificance."

Craig Pirrong - Clearing, voting and panics - "One other historical note that illuminates another important cost of heterogeneity. In Banking Panics of the Gilded Age, Elmus Wicker shows that with one notable exception (the Panic of 1873), the New York Clearinghouse was unsuccessful in dealing with financial panics and contagion. (NYCH was a bank clearinghouse, not a derivatives clearinghouse, but there are important similarities. Most importantly, NYCH had the ability to mutualize some risks.) Wicker argues that conflicts between heterogeneous members were the main impediment in dealing with panics. Although mutualization of risks would have mitigated panic (because the banks collectively were more likely to be solvent than any individual bank), mutualization transferred wealth from the stronger banks to the weaker ones. The inability to overcome this distributive conflict stymied the ability of the NYCH to respond to crises in an effective way. Thus, not only can heterogeneity increase the likelihood of a problem at a CCP (due to its effect on the severity of moral hazard problems), it can reduce the effectiveness of a CCP in dealing with a crisis situation."

Collapse of the Fed Funds Rate Peg and the Great Recession

2010-11-12T16:30:00.002+02:00

The causes of the Great Repression are still a matter of active debate among economists, and Scott Sumner, in a post directed at me, says "the interest on reserve policy was a huge mistake, comparable to the 1936-37 decision to double reserve requirements in the midst of the Great Depression". Here I will attempt to show that the primary cause of the Great Recession was the collapse of fed funds rate peg after the bankruptcy of Lehman Brothers. The second most important cause of the Great Recession is related to the imperfections of interest rate targeting regime that was too closely associated with backward looking Taylor rules. And the interest on reserves program was not a cause of the Great Recession, it was one of the first "green shoots".

The collapse of fed funds rate peg is clearly visible in a chart below. This collapse was seen by markets as a regime change that led to deflationary expectations.

When the standard deviation of effective fed funds rate is so huge, volume weighted average of fed funds rate transactions is no longer a reliable indicator of fed funds rate. As October 2008 FOMC minutes put it, "In the overnight federal funds market, financial institutions became more selective about the counterparties with whom they were willing to trade." Fortunately, overnight LIBOR is an indicator of fed funds market that does not have a participation bias:

Breakdown of fed funds rate market has led to market expectations of elevated future cost of fed funds, and October 2008 FOMC minutes indicated that "the spread of term Libor rates over comparable-maturity overnight index swap (OIS) rates rose sharply from already-high levels". Here is a chart that compares three month Libor to fed funds rate target:

The inadvertent tightening of monetary policy that was caused by the breakdown of fed funds rate market was a matter of great concern for policymakers. On September 18 2008 a $180 billion monetary expansion was announced. The need for softer monetary conditions was communicated to President Bush, who understood the danger and said "If money isn't loosened up, this sucker could go down".

The key instrument that lowered the cost of fed funds was interest on reserves. Start of interest on reserves program led to the announcement of October 13, 2008, on that date the Fed promised to supply unlimited quantity of reserves until the policy objectives have been met. After the announcement overnight Libor and three month Libor rates started falling.

On October 22, overnight Libor finally fell to the rate consistent with the fed funds rate target, and on that date the Fed increased interest paid on reserves to prevent effective fed funds rate from falling further. This was a mistake for two reasons. First, the fed funds rate peg was not completely credible on that date according to three month Libor, and for this reason the expected future cost of reserves was higher than the target. Second, the fed funds rate target as set by the FOMC was too high at that time according to Svenssonian forward looking approach.

Related post: Should Fed stop paying interest on reserves?

Really good links - Kocherlakota: helping the victims of real estate bubble crash - Bad loans - What would Friedman say? - Gold - Bernanke put - McLean & Nocera

2010-11-10T13:59:00.001+02:00

Narayana Kocherlakota, President, Federal Reserve Bank of Minneapolis - Government should recreate the distribution of wealth that existed before the housing bubble crashed - "Amore feasible option might be to allocate government funds so as to re-create the distribution of wealth that existed under the bubble. By doing so, the government can also re-create the higher levels of output that existed under the bubble. This distribution of funds can work in many ways. Consider a person A who has a mortgage from bank B with principal $200,000. A’s property was worth $300,000 at the peak of the bubble and is now worth $150,000. How should the government allocate the proceeds of its new debt issue between A and B? There are many ways to proceed, but my favorite is that the government pays B $150,000 to write down the value of the mortgage to $50,000. I like this approach because A keeps her property and again has $100,000 of equity in her property. In addition, B has a (presumably viable) debt worth $50,000 from A and has received $150,000 from the government."

John Kemp - Bad loans - "But while intervention may have averted the threat of widespread suspensions and failures, the losses from imprudent lending and borrowing to acquire unproductive and permanently impaired assets remain. Someone somewhere has to shoulder them.
   Like central banks around the world, the Federal Reserve has decided they should be borne by depositors, savers, pension funds and bond holders. Not in the form of suspensions, insolvencies and write-downs in the face value of accounts, but through the stealthy and gradual mechanism of negative real interest rates.
   Depositors, savers and bondholders may rail against the unfairness of having their wealth confiscated via inflation, and clamor for a return to more “normal” interest rates. But the reality is that they have put their funds in institutions which have lent and lost them. By making the delinquencies and asset impairments more apparent, normal interest rates would simply accelerate those losses and make them more visible.
   The money has gone. It is not only the banks and their shareholders that have lost money in the crisis. Through deposits and exposure to mortgage products, ordinary savers have lost money too. The only question is what form the losses take.
   Economists remain divided about whether it is better for losses to be recognized and written down, or hidden and gradually worked off over time. But policymakers have shown an overwhelming preference for the hidden, gradual approach."

David Beckworth - Last Word on What Milton Friedman Would Say - "The only reason why Milton Friedman would be critical of QE2 is its ad-hoc nature. While Friedman would be for restoring monetary equilibrium, he would want it to be done in a predictable, rule-like manner. So far that has not happened. It is likely he would have argued the Fed should adopt an explicit nominal target and commit to doing whatever is necessary to maintain it rather than the make-it-up-as-we-go-along approach behind the QEs so far. The economy needs more certainty now and an explicit nominal target would help immensely on this front. "

Martin Wolf - Could the world go back to the gold standard? - "So why choose gold? It is, after all, an impossibly inconvenient means of exchange. But gold has a lengthy history as a widely-accepted store of value. If one is looking to reinstate a pre-modern monetary, gold is the obvious place to start.
   After the experience of the last three decades the monetarism of Milton Friedman is no longer a credible alternative. It was abandoned for two simple reasons: first, it proved impossible for monetarists to agree on what money is; and, second, the relation between any given monetary aggregate and nominal income proved unstable.
   Again, recent experience suggests that we can no longer be so confident that delegation to independent central banks protects against severe monetary instability. That system permitted a gigantic increase in credit, relative to gross domestic product. It is equally clear that governments do not wish to see this edifice collapse, for understandable reasons. This being so, the ultimate solution may be to increase nominal incomes, via inflation. Indeed, several economists recommend this. If that did happen, it would support those who argue for abandonment of the modern experiment with fiat money.
   So would the gold standard be the answer? We would need to start by asking what a return to the “gold standard” might mean.
   The most limited reform would be for the central bank to adjust interest rates in light of the gold price. But that would just be a form of price-level targeting. I can see no reason why one would want to target the gold price, rather than the price of goods and services, in aggregate. <..>
   With these possibilities eliminated, the obvious form of a contemporary gold standard would be a direct link between base money and gold. Base money — the note issue, plus reserves of commercial banks at the central bank (if any such institution survives) — would be 100 per cent gold-backed. The central bank would then become a currency board in gold, with the unit of account (the dollar, say) defined in terms of a given weight of gold.
   In a less rigid version of such a system, the central bank might keep an excess gold reserve, which would allow it to act as lender of last resort to the financial system in times of crisis. That is how the Bank of England behaved during the 19th century, as explained by Walter Bagehot in his classic book, Lombard Street.
   So what would be the objections to such a system? There are three: difficulties with the transition; instability; and lack of credibility."

Izabella Kaminska - Bernanke put - "The Bernanke put — a.ka. that almost magical and metaphysical QE2 effect — appears to be having an impact on equity options skew already.<..>
As UBS comment:

"As we mentioned in our report out earlier this week, These Go to 11, many investors have interpreted a more engaged Fed as providing put protection under the equity market, decreasing the potential for adverse outcomes.

This dynamic can be observed most directly by looking at the option market’s implied volatility skew, which measures the difference between the cost of puts and calls. As illustrated below, this declined significantly following the Fed’s hint at additional QE on September 21. Why buy downside protection when the Fed has done it for you?"<..>

But there is another point that Curnutt makes, which is that the Fed may be unwittingly displacing all that volatility elsewhere:

"…it looks like there’s a divergence between currency and equity volatility. The Fed may be compressing equity volatility but it’s incentivising currency volatility in its place.""

Eric Falkenstein - Book review - All the Devil's are Here, by Bethany McLean and Joe Nocera

Really good links - Kocherlakota and bubbles - Capping the climate change - Bernanke and stock market - Basel 3

2010-11-07T01:57:00.003+02:00

Narayana Kocherlakota, President, Federal Reserve Bank of Minneapolis - Housing bubbles, credit bubbles and government bond bubbles - "Insufficiently stringent bank regulation may have relatively little impact on bank profits, but nonetheless lead scarce factors (finance talent, land) to be overvalued. <..>
   There has been a great deal of discussion about how monetary policy should respond to bubbles. I will have nothing to say on this issue. In the United States, monetary policy generally takes the form of open market operations. In an open market operation, the Federal Reserve exchanges some govenment liabilities (reserves) for other government liabilities (Treasuries or securities issued by govenment-sponsored enteprises) of equal market value. In this way, the Federal Reserve can influence the composition of outstanding government liabilities, but not the total value of outstanding government liabilities. (The latter is shaped by Congress.)
   As we will see, in the rational bubble framework, the time path of the total value of government liabilities matters a great deal for economic outcomes. However, the composition of those liabilities is, at a minimum, less essential. Hence, I abstract from the latter consideration entirely–and, in doing so, I abstract from monetary policy. <..>
   Because of the government’s ability to tax, public sector bubbles may be more stable than private sector bubbles."

Andrew Restuccia - Thomas Crocker - Newly released paper details origins of cap-and-trade - Inventor now believes it's the wrong approach to climate change - "Cap-and-trade, which Crocker said is not “inappropriate by any means” to reduce greenhouse gas emissions, works better for traditional pollutants like sulfur dioxide, because “incremental emissions of SO2 do a great deal of damage.”
   “Whereas with respect to greenhouse gases,” he continued, “the marginal damages of an additional bit of greenhouse gas is not going to do much harm.”
   Because each additional increment of SO2 that is emitted into the atmosphere is so detrimental to the environment, a proper policy must give certainty with respect to quantity, Crocker said. Cap-and-trade puts a hard cap on emissions and therefore controls emissions quantity. A carbon tax, on the other hand, provides certainty with respect to pricing — it imposes a certain cost on carbon — but does not set a limit on how much carbon can be emitted across the economy.
   Greenhouse gases, Crocker argued, are not as incrementally dangerous as SO2 and other pollutants. Therefore, price certainty, delivered through a carbon tax, is more important."

Scott Sumner - Dating game (Bernanke and stock market) - "If I had some literary talent, I’d try a dating analogy for the game that Bernanke and the stock market are playing. Bernanke sends out some sweet talk, the stock market responds with enthusiasm. That emboldens Bernanke (a rather shy guy) to send out a bit more sweet talk, with the confidence his ‘policy tools’ are not viewed as being impotent. I think you can see why I’ll stay away from literature, I couldn’t even write trashy romances. <..>
   The way the stock market responded to rather vague and unimpressive rumors of monetary ease, suggests to me that credibility is the last thing Bernanke needs to worry about. The stock market seems like a lonely girl who laps up anything she hears from a sweet-talking guy with a very big wallet in his back pocket. A cheap date.
   What do you guys think? Is Krugman right, or is it easy for the Fed to impress the markets? No need to even mention marriage (i.e. higher inflation targets), just give her a wink and a nod, and promise you’ll spend $600b on the date."

Pablo Triana - Basel III - "By keeping total capital requirements almost intact, demanding that the core equity component of those requirements be substantially raised, and insufficiently modifying the mechanisms through which asset risks are measured, the new Basel III regulatory regime still allows for the possibility of a banking blow-up while making it harder for banks to produce juicy returns.
   While banks can still sink abruptly, the journey enjoyed before that happens might be less glamorous than was the case previously (due to the lower return on earnings implied by the harsher equity demands). In fact, Basel III could well result in a perverse combination of higher risks and lower returns."

Nick Rowe - Monetary policy and Daylight Savings Time

Really good links - QE2 - Scott Sumner - Milton Friedman - Voter turnout - Plain English FOMC

2010-11-04T00:58:00.001+02:00

Brad DeLong - QE2 - "The five-year note carries an interest rate of 1.17% per year. The Federal Reserve is thus changing the supply of assets by taking onto its own balance sheet... wait for it... wait for it... duration risk that the market is currently willing to pay $7 billion a year to avoid.
   To take $7 billion a year of duration risk off of the private sector's books in a global economy that still has more than $60 trillion of financial assets is a change in "credit conditions" equivalent to what would be achieved in normal times by a coordinated one basis point reduction in short-term interest rates by the world's central bankers."

Scott Sumner - QE2 - Will it work? - "In the end, the market movements over the last few weeks seem to be telling us that QE2 is likely to provide a modest boost to the economy, and that a double dip recession is less likely than in August. But overall the future still looks bleak. The Fed’s action fell pitifully short of what was needed. At a minimum, I would have liked to have seen enough stimulus to raise 5 year TIPS spreads to 2.0%, instead they merely rose from 1.61% to 1.65%. We didn’t need more QE, but rather the three-pronged attack I suggested earlier (including lower IOR and level targeting.)
   Of course markets are often wrong, and the economy may do better than expected or worse than expected. But for those of us who favor a Svenssonian policy of targeting the forecast, the verdict is already in; the policy is better than nothing, but not nearly enough. My hunch is that unemployment will remain high for quite some time, and the Fed will be forced to do even more in 2011."

David Beckworth - A Reply to Those Who Claim We Misreprensented Milton Friedman - "The growth rates of the monetary aggregates have been anything but stable. In fact, M3 and MZM--arguably better measures of money during this crisis than M2--have had a recent run of negative growth. While M2 has had positive growth, it too appears below trend. All of them have seen plunges in their growth rates. Would Milton Friedman really look at this graph and conclude there has been monetary stability?
   With that said, one should note that in this 2003 WSJ article Milton Friedman appears to have moved beyond aiming to just stabilize the growth of the money supply. For in this piece he praises the Fed for adjusting M2 in response to a M2 "velocity bubble" in the 1990s. Friedman is endorsing the Fed's actions at this time to offset money demand shocks. Thus, in this article he is implicitly calling for the Fed to stabilize the MV part of the equation of exchange (i.e. MV=PY). "

David Myatt (via jeff) - Rational voter turnout - "If each voter is willing to participate in exchange for a 1-in-2,500 chance of influencing the outcome of the election, then turnout will exceed 50%. "

Update: FOMC statement in plain English

Really good links - Successful QE - What would Milton Friedman say? - QE for bankers - University macroeconomics

2010-11-01T15:58:00.001+02:00

David Beckworth - Successful QE in 1934 - "QE has been done before in the United States and it worked incredibly well. It was initiated in early 1934 when FDR and his treasury officials decided to (1) devalue the value of the dollar relative to gold and (2) quit sterilizing gold inflows. <..>
   But that is exactly what was needed, a big permanent shock to inflation expectations that served to stop the deflationary spiral, end the liquidity trap, and allow a recovery in aggregate demand. Now this policy move was backed up with significant and permanent increases in the monetary base over time: it went from about $8 billion right before the policy change to about $24 billion by the end of the 1930s."

Bill Woolsey - What would Milton Friedman say? - "Friedman believed correctly that money expenditures (nominal income) depends entirely on monetary factors. In the long run, unemployment and ouput depend on suppply side factors. And so, monetary factors only determine money prices and wages in the long run. However, short run fluctuations in money expenditures lead to undesirable fluctuations in real output in the short run.
   He found that the conglomerations of assets that make up M2 was more or less proportional to money expeditures. In other M2 velocity is was pretty much constant. The implication was that if the Fed could vary the monetary base in such a way that the M2 combination of assets stated on a 3% growth path, then money expenditures would stay on that same growth path. The price level would be stable, wages and other incomes would grow about 3%, and fluctuations in supply side factors would result in fluctuations in output and also the price level and inflation as the price level moves.
   But it turned out that the M2 measure of the money supply stopped tracking money expenditures. M2 velocity changed.
   Before he died, Friedman noticed that like everyone else. There was never any reason why that combination of assets should necessarily track money expenditures. When they stopped, Friedman began to change his mind.
   However, he always maintained that money expenditures depend on monetary factors, that interest rates don't tell us much about those factors, and that stable growth in money expenditures are important in both the short run and long run."

Karl Smith - QE explained for bankers - "However, the Fed’s strategy can be summed up succinctly for bankers: get out of long dated nominal Treasuries. In the short run we are pushing down yields, so we are lowering the return you can lock in. In the long run yields are going to pop up so you are going to take capital losses.
   Ergo: find some other place to put your money."

Nick Rowe - University macroeconomics and Barro-Grossman supply-side multiplier - "The supply of seats is determined by the individual department. But the demand for seats is determined centrally, by Admissions. Admissions is ordered to bring in as many students as are needed to pay the profs' salaries. But each individual prof and department wants to reduce the number of bums on seats in his course and his department.
   The result is a classic case of chronic excess demand for seats. Just like in the old Soviet Union. Capitalist economies have chronic excess supply. Communist economies have chronic excess demand. My job as associate dean (because I made it my job) was to persuade, cajole, bribe, threaten, or bully departments into putting on enough seats for the bums that needed or wanted to sit in them. I was what the Russians used to call "the pusher". <..>
   You get hoarding. Students grab a seat in any course that's open, even if they think they will probably not want it, just in case they do want it and can't find a seat.
   What's worse is that you get Clowerian spillovers. Walras' Law is totally false. The sum of the excess demand for seats can add up to anything whatsoever, because the student who can't get a seat in course A, will try to get a seat in course B instead, and if he can't will try for course C,...then maybe try course A again, and so on. So the central planner (that was me) trying to find out how many extra seats in which courses are really needed, hasn't got any idea. A notional excess demand for one seat in one course can create an effective excess demand for hundreds of seats all over the university. I am one of the very few economists who has actually seen the Barro Grossman supply-side multiplier at work, in real time. Create a couple more seats in one course, and seats suddenly start appearing in other courses all over the university."

Really good links - Fiscal multipliers - Bond bubble - Soprano Fed - Poker face Fed - Amateur bubbles

2010-10-29T15:52:00.000+03:00

Ethan Ilzetzki, Enrique Mendoza, and Carlos Vegh (via Tyler Cowen) - Fiscal multipliers - "Based on a novel quarterly dataset of government expenditure in 44 countries, we find that (i) the output effect of an increase in government consumption is larger in industrial than in developing countries, (ii) the fiscal multiplier is relatively large in economies operating under predetermined exchange rate but zero in economies operating under flexible exchange rates; (iii) fiscal multipliers in open economies are lower than in closed economies and (iv) fiscal multipliers in high-debt countries are also zero."

John Hussman - Bond bubble - "One might argue that while short-term interest rates are essentially zero, long-term interest rates are not, which might leave some room for a "Hicksian" effect from QE - that is, a boost to investment and economic activity in response to a further decline in long-term interest rates. The problem here is that longer-term interest rates, in an expectations sense, are already essentially at zero. The remaining yield on longer-term bonds is a risk premium that is commensurate with U.S. interest rate volatility (Japanese risk premiums are lower, but they also have nearly zero interest rate variability). So QE at this point represents little but an effort to drive risk premiums to levels that are inadequate to compensate investors for risk. This is unlikely to go well."

Patrick - Soprano Fed - "The Fed needs to take a lesson from Tony Soprano on credibility and managing expectations. Sometimes you need to back-up your threats with real muscle. Most of the time you don't have to resort to muscle if you have a reputation, but every once in a while somebody tries to call your bluff. That's when you need to remind everyone that you really are the baddest dude in town.
The specific machinery doesn't matter all that much so long you have the ability to force people to do what you want them to do. I was only 6 years old at the time, but didn't Volcker teach us that? The Volcker Fed said "we're going to stamp out inflation". Everyone said: "That's nice. I'll believe it when wages and prices stop rising". Then the CB applied muscle; they raised interest rates to 18% (or whatever it was) and everyone started believing them. To this day, does anyone doubt a competent CB's ability to stamp out inflation at will?
At ZIRP with high unemployment and idle capacity the CB can't call our bluff with interest rates, and all the wishy-washy talk of bending the yield curve and keeping rates low for a long time is not going to convince anyone of anything (at least not in any reasonable time frame). The Fed really needs to call our bluff and apply some muscle."

Chevelle - What do the Fed's policy and poker have in common? - "This makes monetary policy akin to bluffing in poker: If the market buys the bluff, inflation expectations rise, real rates fall, cash gets spend, aggregate demand recovers. But why would the market buy the bluff, if, for example, it suspects that the central bank will renege on its “promise” of higher inflation in the future, and that it will “cheat” by raising interest rates once aggregate demand picks up?"

Adam Ozimek - Amateur investors and bubbles

Really good links - Monetary policy and asset bubbles - Yuan and IMF - Behavioural politics

2010-10-27T20:58:00.004+03:00

Adam Posen - Monetary policy and global rebalancing - "Japan’s extended economic stagnation since its stock market peaked on December 29, 1989, has prompted a series of investigations, recommendations, and self-examinations, both in Japan and abroad. As I have argued in several places, it takes more than a bubble to become Japan. While asset price booms and even busts are not uncommon, the persistence of Japan’s Great Recession is, and it was not the bubble and its bursting that produced this outcome. Some noted European commentators, however, have asserted that the Bundesbank’s resistance to international pressures for domestic stimulus in the mid-to late-1980s was what saved Germany from Japan’s fate. More recently, some Chinese and other East Asian commentators have picked up this claim as a reason for China not to accede to analogous requests today. All these participants in the discussion would claim that American pressure on Japan produced the bubble, and the bubble produced the subsequent disaster.

   This view is mistaken, despite its apparent political and intuitive appeal. It was not ‘excessive laxity’ of Japanese monetary policy in 1986–89 which caused the bubble in Japanese equity and real estate prices, nor was it yen appreciation against the dollar which caused the bubble’s impact, except as an induced echo of the asset price boom. As I set out last December, there is no evidence across countries over time that excessive monetary ease was a sufficient condition for the Japanese bubble (“if there is a sustained monetary ease, then a bubble occurs”), a necessary condition for the Japanese bubble (“if a bubble occurs, then there must have been prior monetary ease”), or both. <..>

   For monetary policy to be the source of a bubble, the relative price of one part of the economy (here financial and real estate assets) has to be pumped up by a blunt instrument that usually affects all prices in the economy. And it has to do so in such a way that the relative price shift either does not raise expectations of a countervailing shift in monetary policy in the near future (which relies on strange notions of what the imputed future income from increasing land and stock prices will generate), or is expected to only be affected by monetary policy on the upside but not on the down (which there is no reason to believe, if liquidity is the source of the relative price shift in the first place). Either way, this has to take place when we know both analytically and empirically that the relationship between a policy of low interest rates or high money growth and equity or real estate prices is actually indeterminate over time. <..>

   Another way to see this inconsistency is that supposedly loose Federal Reserve monetary policy in the early 2000s built the US real estate bubble, and now supposedly loose Fed policy is fuelling capital outflows from the US to emerging markets. <..>

   Surely, if it were clear that the BOJ were violating its normal policy priorities due to obvious international pressure, the idea that such low rates would be sustainable without any effect on inflation or medium-term growth would have been discounted. The fault for the asset price increases seems to lie in the unrealistic expectations of participants in a bubble, not in Japanese monetary ease itself. <..>

   This is consistent with my view (Posen (2009)) that regulatory rather than monetary factors are the source of most real estate bubbles."

John Cochrane - Yuan and IMF - "He [Geithner] argues for a brave new system, coordinated by the IMF, of international discretionary currency interventions: "G-20 advanced countries will work to ensure against excessive volatility and disorderly movements in exchange rates." <..>

   This is all as fuzzy as it seems. Markets and exchange rates are not always right. But it is a pipe dream that busybodies at the IMF can find "imbalances," properly diagnose "overvalued" exchange rates, then "coordinate" structural, fiscal and exchange rate policies to "facilitate an orderly rebalancing of global demand," especially using "medium-term targets" rather than concrete actions. The German economics minister, Rainer Brüderle, called this "planned economy thinking." He was being generous. Planners have a clearer idea of what they are doing."

Matt Ridley - Behavioral politics - "But while there is a lot of interest in the psychology and neuroscience of markets, there is much less in the psychology and neuroscience of government.<..>

   The issue of action bias is better known in England as the "dangerous dogs act," after a previous government, confronted with a couple of cases in which dogs injured or killed people, felt the need to bring in a major piece of clumsy and bureaucratic legislation that worked poorly. Undoubtedly the rash of legislation following the current financial crisis will include some equivalents of dangerous dogs acts. It takes unusual courage for a regulator to stand up and say "something must not be done," lest "something" makes the problem worse.<..>

   "Affect heuristic" is a fancy name for a pretty obvious concept, namely that we discount the drawbacks of things we are emotionally in favor of. For example, the Deepwater Horizon oil spill certainly killed about 1,300 birds, maybe a few more. Wind turbines in America kill between 75,000 and 275,000 birds every year, generally of rarer species, such as eagles. Yet wind companies receive neither the enforcement, nor the opprobrium, that oil companies do."

Really good links - Milton Friedman - Tax cuts - Backloaded deficit reduction - Wen's put - Higher expected inflation

2010-10-25T13:29:00.003+03:00

David Beckworth and William Ruger - What would Milton Friedman say? - "Had he been alive, Friedman would have been shocked to see the Fed in late 2008 and early 2009 allow nominal income, as measured by nominal GDP, to experience its sharpest downturn since the Great Depression. He would also be amazed to learn that nominal GDP forecasts are once more headed down.
   Given these developments, Friedman would likely be calling on the Fed again to do a better job stabilizing nominal income."

Karl Smith - Please endorse tax cuts as an option - "Tax cuts. I know for many of my liberal readers this is increasingly becoming a bad term. However, the point is not whether we concede to a so called “republican” idea, the point is whether we reduce unemployment for those in need.
   I have argued and will continue to argue if that for some reason, that I don’t completely understand, the markets fail to take the Fed seriously we still have the option of injecting large amounts of liquidity quickly through tax cuts.
   Please, lets not get hung up on whether tax cuts are an excuse to hand out money to the rich. We can cut payroll taxes. We can even provide a payroll tax credit where you get back the first 5000 your family paid in payroll taxes."

Christina Romer - Backloaded deficit reduction - "While immediate fiscal tightening isn’t wise for the United States, we do need to address the deficit. The best thing would be for Congress to pass a plan now that will reduce deficits when the economy is back to normal. France’s recent plan to gradually raise its retirement age to 62 from 60 is a classic example of such “backloaded” reduction.<..>
   Such backloaded deficit reduction would not hurt growth in the short run — and could raise it. If uncertainty about future budget policy is harming confidence, as some business leaders suggest, spelling out future spending and tax changes could be helpful."

Arthur Kroeber (via FT Alphaville) - Wen’s put - "For the last two months we have unkindly compared Chinese premier Wen Jiabao to the later Alan Greenspan, who helped inflate the US housing policy with his ultra-low interest rate policy which financial markets dubbed “the Greenspan put.” Premier Wen’s put option was his government’s implicit guarantee that GDP growth would never be permitted to fall below 8%. This guarantee destroyed the credibility of all government commitments to structural reform (whose cost is likely to be lower growth), and stoked fears that Beijing simply wanted to buy short-term growth through an endless expansion of credit, and was oblivious to the risk of asset bubbles in the short term and a structurally dysfunctional Japan-style economy in the long term.
   We believe that the official and unofficial statements emanating from last weekend’s annual Communist Party plenary meeting ended the Wen Jiabao put option and signaled that structural reformers are in the saddle (although not with unbridled power). Tuesday night’s surprise interest rate hike, coming immediately after the meeting’s close, strongly amplified this signal. While we do not expect dramatic policy shifts, we do anticipate that the pace of reform measures will visibly accelerate over the next 6-12 months, and that the pace of GDP growth will gradually slow from the current 9% clip to a more sustainable rate of 7-8% over the next two years."

Bill Woolsey - Higher expected inflation - "Only from the point of view of central bankers, with their irrational attatchment to targeting short term and safe nominal interest rates, does higher (expected) inflation provide “benefits.” Their approach to policy, combined with their policy of issuing zero nominal interest currency on demand, has left them stuck. Higher expected inflation would pull them out of this trap of their own construction.
   Well, I guess higher inflation makes the real yield on zero nominal interest hand to hand currency more negative, and so provides more income to the central bankers who borrow by issuing it immediately, and their government owners indiredtly."

Really good links - Price level targeting - International Yuan - China - Mankiw - Social discount rate - Bailouts and AD

2010-10-21T16:36:00.000+03:00

Dave Altig, senior vice president and research director at the Atlanta Fed - Benefits of sticking with a simple price level target - "Some potential benefits of simply sticking with a price-level target is that it (a) is clearly consistent with longstanding Federal Open Market Committee (FOMC) behavior (as attested to by the second chart above); (b) avoids a potentially confusing impression that the central bank is jumping from one framework to another to serve whatever is convenient at the moment; and (c) gives the public a clearer way to monitor if and when the long-term price-level objective is being compromised (as can be seen by comparing the implied tolerance bounds in the two charts above)"

Karl Smith - Paul Krugman and Yuan - "It should mean that when the Fed loosens policy, that China responds by loosening the International Yuan which in turn gets shunted towards commodities. Thus rather than boosting the consumer price level as we hope, Fed easing actually winds up boosting commodities.
   This is because China is offsetting the total increase in worldwide consumer demand by tightening the Yuan at home, and boosting the total increase in commodity demand by loosening the Yuan abroad.
   Thus this Yuan policy does all the wrong things."

Paul Krugman - China raises rates - "So, the United States is pursuing an expansionary domestic monetary policy, which increases overall world demand; however, a side consequence of this policy is a weaker dollar. China is pursuing a weak-yuan policy; to counter the inflationary domestic effects of that policy, it’s pursuing a contractionary domestic monetary policy, reducing overall world demand."

Greg Mankiw - Marginal tax rates - "Mike [Kinsley] says, "If Mankiw’s marginal tax rate has actually been 80 percent for all these years, it doesn’t seem to have affected his incentives very much, and 90 percent won’t, either."
   Mike might recall that he has, as an editor, several times tried to recruit me to write something for him. I turned him down every time. If he had offered me a reasonable fee, and somehow could have promised that this income and all the investment returns it subsequently generated would be free of all taxes, I might well have accepted the jobs."

Brad DeLong - Compound interest and social discount rate - "If long-term real interest rates are as Mankiw describes them, then either the future must be so filthy rich and so satiated with wealth that there is no point in saving, or it is profoundly irrational to consume more than bare subsistence today because the opportunity cost in terms of how much you are impoverishing the future is so large."

Karl Smith - Bailouts and Aggregate Demand

Really good links - Price level targeting - Optimal inflation rate - Interest on bank reserves - Unemployment puzzles - Government sector - QE 2

2010-10-18T16:25:00.000+03:00

Charles Evans, President, Chicago FED - Developing a State-Contingent Price-Level Target - " I would like to use this opportunity to expand the discussion about additional communications tools available to central banks in a low-inflation environment. In a nutshell, I think there are special circumstances when price-level targeting would be a helpful complement to our current and prospective strategies in the U.S. Clearly communicating an expected path for prices would help guide the public’s understanding of the Fed’s intentions while we carry a large balance sheet and promise continued low interest rates for an extended period.
There are quite a number of academic studies of liquidity trap crises that find either price-level targeting or temporary above-average inflation to be nearly optimal policies; and yet, central bankers and the public generally loathe the idea that even a temporarily higher inflation rate could be beneficial or be consistent with price stability over the longer term.
Nevertheless, with potentially beneficial policies so well grounded in rigorous economic analysis, I cannot stare at our current projections for high unemployment and low inflation and think that these projections are consistent with the best monetary policies to address the Fed’s dual mandate responsibilities." - The implied inflation rates for a 2 percent P* path where the current price gap is closed by the end of 2012 (pdf). - A more aggressive P* policy that is assumed to close by the end of 2013 (pdf)

Joe Gagnon - Friedman rule and optimal inflation rate - "Another argument for a positive inflation rate has to do with a fundamental asymmetry built into the Friedman rule that, to my knowledge, has not been explored in the academic literature. Friedman was concerned about the “shoe-leather” cost of minimizing cash holdings when inflation is positive. What gets almost no attention, however, are the much larger costs to society in lower capital and output arising from deflation. Why would anyone hold risky capital with an expected real return of 5 percent during a steady deflation of 6 percent? In that case, the riskless returns to holding cash exceed the risky returns on productive capital. As the rate of deflation increases, the entire economy shrinks as the capital-output ratio contracts. This cost is many orders of magnitude greater than the “shoe-leather” cost associated with positive inflation of 6 percent. The Friedman-optimal rate of inflation may be -1 or -2 percent, but the costs of deviating below that are sky-high whereas the costs of deviating above it are small."

Stephen Williamson - Liquidity, Financial Intermediation, and Monetary Policy in a New Monetarist Model (pdf) - "One source of much confusion concerning current monetary policy in the United States concerns how policy works when the central bank pays interest on bank reserves, in circumstances where the quantity of excess reserves held overnight is greater than zero. The Fed has now been paying interest, at 0.25%, on overnight reserves since October 2008. In our model, it is a straightforward exercise to include interest bearing reserves. What the model shows is that, if excess reserves are held in equilibrium, then open market operations are irrelevant at the margin, much like in the liquidity trap equilibrium, but with a positive nominal interest rate. Monetary policy works in this regime through changes in the interest rate on reserves, which essentially determines all short-term market interest rates. <..>
An increase in risk can make liquidity more scarce in general, and this acts to reduce the real interest rate, and to increase the marginal social cost of inflation. An optimal policy response is for the central bank to sell interest-bearing assets and reduce the inflation rate. The real interest rate rises due to the policy action. This is quite different from typical Keynesian financial crisis analysis, where a problem arises because of the zero lower bound on the nominal interest rate, and the real interest rate is viewed as being too high. Here, the real rate is too low in the absence of intervention, due to the shortage of liquid assets. The optimal policy
response in our model is consistent, in a sense, with what the Fed actually did during the financial crisis. After the Lehman Brothers collapse in fall 2008, the Fed sold a large portion of its portfolio of Treasury securities."

Alex Tabarrok - Unemployment puzzles - "The first puzzle about unemployment when thought about from within the search-matching framework is that unemployment rates are highest among the least skilled and most homogeneous skills, i.e. among those worker/jobs with the easiest matches. It's hard to believe that it takes a year to match a construction worker to a job. <..>
The second puzzle is that uncertainty should matter most when hiring and firing costs are high and once again these costs are lowest for those workers with the greatest unemployment rates."

Menzie Chinn - Government sector (USA) - "The following four figures highlight: (1) normalized Federal outlays are not much higher than in 1986; (2) government consumption to GDP is back up to 1991 levels (and not yet back to 1987 levels; (3) the cyclically adjusted budget deficit is only 2 ppts larger than that recorded in 1987; and (4) Federal consumption remains far below the previous peak in 2007."

Scott Sumner - QE II is arriving right on schedule

CNBC Video - Discussing whether QE2 will work, with James Hamilton, professor of economics at University of California at San Diego.

Really good links - Money expenditures - Why is Paul Krugman angry? - Bretton Woods 2 - Correlation bubble

2010-10-14T15:43:00.000+03:00

Bill Woolsey - Money expenditures - "The problem isn’t that inflation changes and this disrupts output. The problem is that money expenditures change and inflation fails to change enough to avoid disruption of output.
   If some prices change and others don’t (say wages), then the problem isn’t that some prices changed or that everything would be fine if those prices didn’t change. The more fundamental problem is money expenditures changing, and the secondary problem is that some prices failed to change enough.
   In other words, the “too little inflation” approach is wrong, wrong, wrong."

Angry Bear (spencer) - Why is Paul Krugman angry? - "Last quarter real domestic consumption rose at a 4.9% annual rate. That was an increase of $162.6 billion( 2005 $). But real imports also increased $142.2 billion (2005 $).
   That mean that the increase in imports was 87.5% of the increase in domestic demand. That mean[s] that the increase in imports was 87.5% of the increase in domestic demand.
To apply a little old fashion Keynesian analysis or terminology, the leakage abroad of the demand growth was 87.5%."

Tim Duy - Bretton Woods 2 - "Bretton Woods 2 simply morphed forms. Rather than a reliance on US financial institutions to intermediate the channel between foreign savers and US households, a modified Bretton Woods 2 - Bretton Woods 2.1 - relied on the US government to step into the void created by the financial mess and become the intermediary, either by propping up mortgage markets via the takeover of Freddie and Fannie, or the fiscal stimulus, or a dozen of other programs initiated during the financial crisis.
   In essence, a nasty surprise awaited US policymakers - after two years of scrambling to find the right mix of policies, including an all out effort to prevent a devastating collapse of financial markets and a what Administration officials believed to be a substantial fiscal stimulus, the US economy remains mired at a suboptimal level as stimulus flows out beyond US borders. The opportunity for a smooth transition out of Bretton Woods 2 was lost. <..>
   Put simply, the Federal Reserve is positioned to declare war on Bretton Woods 2. November 3, 2010. Mark it on your calendars."

Marko Kolanovic (via FT Alphaville) - Correlation bubble - "We conclude that both the realized correlation of stock prices and option implied correlation are in a ‘bubble’ regime and forecast a significant decline of correlation over a one- to two-year time horizon."

Really good links - Nobel in Economics - Money expenditures - Richard Thaler and EMH - Taxes - China

2010-10-11T14:14:00.002+03:00

Economic Sciences Prize Committee of the Royal Swedish Academy of Sciences - Scientific Background on the Economics Nobel 2010 - "Along similar lines, Diamond argued that a search and matching environment can lead to macroeconomic unemployment problems as a result of the difficulties in coordinating trade. This argument was introduced in a highly influential paper, Diamond (1982b), where a model featuring multiple steady-state equilibria is developed. The analysis provides a rationale for “aggregate demand management” so as to steer the economy towards the best equilibrium. The key underlying this result is a search externality, whereby a searching worker does not internalize all the benefits and costs to other searchers. The model Diamond developed in this context has also become a starting point for strands of literature in applied areas such as monetary economics and housing, which feature specific kinds of exchange that are usefully studied with Diamond’s search and matching model." - See also Tyler Cowen's take

Bill Woolsey - Money expenditures - "If there were a commitment to get the quantity of money high enough and market rates low enough to get money expenditures back to the growth path of the great moderation, then the demand to hold money would fall and the natural interest rate would rise. It is entirely possible, if not likely, that the actual quantity of money would need to fall and market interest rates would need to rise."

Richard Thaler - EMH (via FT Alphaville) - "The bad news for EMH lovers is that the price is right component is in more trouble than ever. Fischer Black (of Black-Scholes fame) once defined a market as efficient if its prices were “within a factor of two of value” and he opined that by this (rather loose) definition “almost all markets are efficient almost all the time”. Sadly Black died in 1996 but had he lived to see the technology bubble and the bubbles in housing and mortgages he might have amended his standard to a factor of three. Of course, no one can prove that any of these markets were bubbles. But the price of real estate in places such as Phoenix and Las Vegas seemed like bubbles at the time. This does not mean it was possible to make money from this insight. Lunches are still not free. Shorting internet stocks or Las Vegas real estate two years before the peak was a good recipe for bankruptcy, and no one has yet found a way to predict the end of a bubble."

Greg Mankiw - Bush tax cuts - "Suppose that some editor offered me $1,000 to write an article. <..> Without any taxes, accepting that editor’s assignment would have yielded my children an extra $10,000 [30yrs from now]. With taxes, it yields only $1,000. In effect, once the entire tax system is taken into account, my family’s marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?
By contrast, without the tax increases advocated by the Obama administration, the numbers would look quite different. I would face a lower income tax rate, a lower Medicare tax rate, and no deduction phaseout or estate tax. Taking that writing assignment would yield my kids about $2,000. I would have twice the incentive to keep working."

Brad DeLong - China (written in 2006) - "At some point China's State Council will tell the People's Bank of China to stop buying dollar-denominated securities. What happens then? Bad things. And if I listen to my inner Friedrich Hayek about how the cost of unwinding a fundamental resource-allocation and investment disequilibrium rises more than one-for-one with the magnitude times the duration of the disequilibrium, I can get very worried indeed. Dollar crashes, financial crises, large-scale housing defaults, deep recessions, panics, revulsions, discredits--and at the very least the movement of 8 million workers in the U.S. out of construction, consumer services, and supporting occupations and into export and import-competing manufacturing, and the movement of 40 million workers in Asia out of export manufacturing and supporting occupations and into... what?"

Really good links - Monetary imbalances vs. financial stability - Stock market returns (Bill Hester) - Old monetarism - Brad DeLong

2010-10-07T16:05:00.000+03:00

Jürgen Stark, Member of the Executive Board of the ECB - Monetary imbalances vs. financial stability - "Not all historical episodes of private sector money and credit balances going off track have been followed by threats to financial stability. But, every major economic crisis in the 20th century was preceded by the emergence of monetary imbalances. <..>
   The Great Depression is another case in point. It is certainly true that the banking crisis brought about by the failure of central banks to understand their role as a lender of last resort under the gold standard was detrimental. But equally detrimental was the sheer unavailability of monetary data that could have signalled the need, given the collapse in money and credit, for monetary policy to be accommodative much earlier on, to a higher degree and for much longer."

Bill Hester - Do Past 10-Year Returns Forecast Future 10-Year Returns? - "Can the process of forecasting long-term stock market returns be simplified to include just one step – calculating the prior decade's return? This is one of the arguments that analysts are currently using to convince investors that the coming decade will offer above-average returns. It's important to take a closer look at the argument because it's become widely discussed and reported. A strategist at a major investment bank argued recently that poor 10-year trailing returns is reason enough to expect lofty returns over the next decade. A similar argument was recently made in Barron's, and by various mutual fund companies. <..>
   The argument that above-average long-term returns typically follow periods of poor past long-term returns is not wrong, it's just incomplete. The more complete argument is above-average long-term returns can be expected to follow long periods of low or negative, provided that they end with low P/E multiples on smoothed earnings and precede a period where the economy can be expected to enjoy robust growth. Today, valuations are at levels that have normally been followed by 10-year returns that are well below average. At the same time, based on a template from more than a dozen prior credit crises, the argument that the economy will grow strongly over the coming decade finds little support."

Nick Rowe - Was Milton Friedman right after all??? - "Suppose you were a monetary economist in the US in the 1930's. And suppose you knew that currency was a medium of exchange, but you didn't know that demand deposits at fractional reserve banks were also media of exchange. You would have noticed the runs on banks, and bank closures, but you wouldn't think that these had anything to do with the supply of money. As far as you knew, the money supply, which you thought of as currency, would have seemed OK. You would completely miss the fall in the money supply.
   Maybe we are like that now. Maybe a large part of the money supply is dark matter. We didn't see it fall. We saw the runs on the shadow banking system, but didn't see how it affected the money supply.
   I have no idea if this is right. It probably isn't. But I'm not as confident as I used to be..."

Brad DeLong - Standard open market operations - "And it is the exact shape of the financial excess demand--which will always be, empirically, a mixed matter--that determines which strategic governmental interventions will be most effective. Printing up more government bonds will fail when the root problem is excess demand for money and money demand is not very interest-elastic. Standard open market operations in short Treasuries will fail when the root problem is excess demand for bonds-as-savings-vehicles or for high-quality assets and money demand is very interest-elastic."

Really good links - Zero bound - Bad news and stocks - Labor market - Countercyclical protectionism - Currency wars

2010-10-05T13:00:00.000+03:00

William Dudley - Zero bound and inflation expectations - "Clear communication on the part of a central bank is important at all times, but it is even more critical when the federal funds rate is at or near its effective lower bound. In this environment, a decline in inflation expectations that drives up the real interest rate and thereby increases the real cost of credit cannot be offset by simply lowering the federal funds rate. Thus, in a very direct sense, a fall in inflation expectations when the target interest rate is at the zero bound represents a de facto tightening of monetary policy and of financial conditions. Such a tightening would clearly be highly undesirable at a moment when unemployment is too high, inflation is too low and the economy has only moderate forward momentum. <..>
   If we judged it desirable, we could go still further and provide more guidance on how monetary policy would react to deviations from any stated inflation objective. One possibility would be to keep track of inflation shortfalls when the federal funds rate is constrained by the zero bound, as is the case today. For example, if inflation in 2011 were a 0.5 percentage point below the Fed’s inflation objective, the Fed might aim to offset this miss by an additional 0.5 percentage point rise in the price level in future years."

Nick Rowe - Bad news and stocks - "With a consistent inflation targeting central bank, it used to make sense that weak data causes stock prices to rise. Weak data is news that the natural rate of interest is lower than we thought it was. The central bank will adjust monetary policy to keep AD and earnings on target, but the lower natural rate means a higher PV of those earnings."

Eric S. Rosengren - Dislocations in the Labor Market? - "In fact, in each of the three previous recessions there was a decline of 5 percent or more in no more than two industry categories – as the figure shows – with many industries experiencing little or no net job loss over the course of the recession. Structural shifts across industries are not uncommon in recessions – and also, some structural dislocation seems inevitable as it will always take some time for capital and labor to flow to those industries with the greatest opportunities.
   In rather stark contrast, the most recent recession is far less a reflection of dislocation in a few industries but rather reflects a general decline in almost all industries. As the chart on the far right shows, in this recession there has been a peak to trough loss of employment of 5 percent or greater in construction, manufacturing, retail trade, wholesale trade, transportation, information technology, financial activities, and professional and business services. To me, this does not suggest that the driver is structural change in the economy increasing job mismatches – although no doubt some of that exists – but instead I see here a widespread decline in demand across most industries."

Stephen Gordon - Some implications of thinking of trade as a form of technology - "One issue where I wish I had remembered this story was when it was suggested that protectionism could be used as a counter-cyclical policy instrument. Yes, I would have replied, in much the same way that forbidding the use of excavators and backhoes would be a counter-cyclical policy instrument: construction firms would have been forced to hire any number of extra workers to dig by hand. Both measures would have put people to work doing tasks that had not been hitherto performed by Canadian workers. And in both cases, it's not at all clear what the exit strategy would have been."

Paul Krugman - Currency wars - " ...rates are pretty much at zero. And in that case, it’s hard to see what mutual intervention accomplishes. Suppose the Fed buys a bunch of euros, and the ECB a bunch of dollars. Suppose also that they do the usual thing and hold the newly acquired reserves in short-term debt — Treasury bills. Then the net effect is just as if each central bank had done a conventional open-market operation in its own T-bills.
   And the whole point of the liquidity trap literature is that such conventional open-market operations have no effect — they just swap one zero-rate asset, monetary base, for another, short-term government debt. So the currency interventions accomplish nothing.
   It would be different if the central banks acquired long-term assets instead; then we’re talking about quantitative easing through the back door."

Brad DeLong and flight to safety

2010-10-02T16:46:00.008+03:00

Brad DeLong ponders the issue of the root cause of the crisis. Is it that the full-employment planned demand for safe assets is greater than the supply, or is it that the full-employment planned demand for medium of exchange is greater than the supply? In other words, is it the flight to safety, or is it the flight to liquidity? Brad DeLong argues that we have the flight to safety:

"Thus we would expect a downturn caused by a shortage of liquid cash money to be accompanied by very high interest rates on, say, government bonds--which share the safety characteristics of money and serve also as savings vehicles to carry purchasing power forward into the future, but which are not liquid cash media of exchange."

The problem is that government bonds serve both as savings vehicles and as medium of exchange. As Gary Gorton said, "it seems that U.S. Treasuries are extensively rehypothecated and should be viewed as money". You purchase groceries with cash, and you purchase other financial assets with U.S. Treasuries, but in both cases we are dealing with media of exchange.

It is very hard to disentangle these two facets of U.S Treasuries, but we have a great natural experiment. After the collapse of Lehman, TIPS were a perfectly safe savings vehicle, but they were much less liquid than cash or other Treasuries. Lehman has mainly used TIPS as repo collateral, and after liquidation the pattern has shifted, the marginal holder of TIPS was more likely to use it as savings vehicle rather than for transactional purposes. The result was what FT Alphaville has called "The largest arbitrage ever documented", as the price of TIPS fell by as much as 20 cents on the dollar as compared to much more liquid Treasuries. This gives us a clear indication that post-Lehman panic was a flight to liquidity, and not a flight to safety. This means the best policy response was the expansion of the quantity of liquid, rather than safe assets. After March 2009 QE announcement, the Fed has greatly enhanced liquidity properties of TIPS.

While the root cause of the crisis might have changed since the Lehman panic, the low prices of Treasury securities give us no indication what it is. We might have the lack of safe assets, or we might have the lack of liquid assets. Policy responses that expand both are to be preferred at this point. One good option is credit easing - expansion of central bank lending collateralized by a diversified mix of medium quality private sector assets. Replacing 3-month T-Bills with reserves achieves nothing, as 3-month T-Bills have greater utility as medium of exchange than reserves, we know this because 3-month bills often yield less than the effective fund rate.

When the Minsky moment arrived in September 2008, we had a flight to liquidity that was not fully accommodated by the Fed. Investors who thought that we had a flight to safety underperformed after Lehman as they purchased safe but less liquid assets such as TIPS, off-the-run Treasuries and gold mining stocks.

Really good links - Risks and policy errors - Basel liquidity standard - Inflation expectations

2010-09-30T19:27:00.000+03:00

Adam Posen - Risks and policy errors - "There are… some very serious risks if we make policy errors by tightening prematurely, or even if we loosen insufficiently. Those risks are not primarily the potential for a double-dip recession or even of temporary measured deflation. While bad, those situations would still be within the range of short-term cyclical developments, and could be weighed against simple inflationary pressures from monetary policy trying to stimulate too much. The risks that I believe we face now are the far more serious ones of sustained low growth turning into a self-fulfilling prophecy, and/or inducing a political reaction that could undermine our long-run stability and prosperity. Inaction by central banks could ratify decisions both by businesses to lastingly shrink the economy’s productive capacity, and by investors to avoid risk and prefer cash. Those tendencies are already present, and insufficient monetary response is likely to worsen them."

Lorenzo Bini Smaghi, Member of the Executive Board of the ECB - The proposed Basel liquidity regulation - "The implementation of the new liquidity standard is intended (and expected) to favour those assets that are counted as liquid, and at the same time reduce incentives to hold assets that are considered less liquid. This will affect the functioning of the underlying markets. In particular the yields of liquid securities are expected to decline relative to those of illiquid ones, so that yield spreads between liquid and illiquid assets would become wider.
   At the moment, it is difficult to quantify the impact on the different market segments, or to judge whether the adjustment will take time or be abrupt. But it can be expected that the categorisation of assets into certain classes of liquidity will lead to a ‘cliff effect’, by which the regulatory categorisation of assets as either liquid or illiquid plays a crucial role for the future of their market. Moreover, it implies that changes in market conditions, such as a downgrade, can move assets from one category into the other, leading to sudden changes in banks’ fulfilment of the liquidity coverage ratio. This could make their fulfilment somewhat unpredictable. The cliff effect could also imply sudden changes in the market conditions for the asset in question, which could suffer from a sudden drying-up of market activity or liquidity."

Justin Wolfers - Inflation expectations - "Q: What explains the differences, if any, between consumers and professional economists regarding inflation expectations?
   A: I wrote a paper on this with Greg Mankiw and Ricardo Reis. What we did was analyze inflation expectations data for both consumers and professional forecasters over the past 50 or 60 years. The motivation for this was that Greg and Ricardo had written down a model that they called "sticky information." The idea is that people revisit their expectations on average only once a year. That's a different microfoundation for the Phillips Curve than those based on sticky prices, one that is more resonant with behavioral economics and can help resolve problems like insufficient inflation persistence in New Keynesian models. An interesting implication of this model is that if something changes dramatically in the economy, then inflation expectations become more spread out. There will be more disagreement because you might have had a chance to update your expectations, but I'm not going to update mine for another six months. So when inflation either increases or decreases, we should see more disagreement. We found that was true for both consumers and professional forecasters. That's a bit surprising. You might expect that professional forecasters would update their expectations more often than consumers but it seems that they don't. In fact, by the way, we were able to do the same exercise for members of the Federal Open Market Committee and they, too, exhibit similar behavior.
   What's also interesting is that not only do consumers and professional forecasters update their expectations with roughly the same frequency, but when you do formal tests of rationality both groups also exhibit the same sorts of problems. Forecast errors are highly autocorrelated. So whatever type of error you made last year, you are likely to make the same mistake this year. The thing that is different between the two groups is that when you ask forecasters about their inflation expectations for the upcoming year, they tend to be grouped between 1 percent and 3 percent. But when you ask consumers, there's a lot of variance. Some will say zero, some will say 12. The central estimate will be quite similar to that of the forecasters but there will be quite a lot of outliers. That suggests that many consumers are not particularly well informed about the likely path of inflation."

Really good links - Housing bubble - Interest on reserves - Currency blocks - Mistake-based discrimination

2010-09-28T15:16:00.003+03:00

Adam Ozimek - House price volatility makes people want to buy a home even more? - "This is an under-explored causal mechanism for the bubble: house price risk went up, people bought homes to insure against that risk, which drove prices up, which increased perceived house price risk, etc. The cascading nature of this is clear, and it’s not hard to see how this could create a bubble. So housing risk makes people want housing even more."

Stephen Williamson - Charlie Plosser does not understand interest on reserves - "I think this is goofy. First, we know that paying interest on reserves in general increases economic efficiency. The ECB and the central banks of Canada, Australia, and New Zealand, have been paying interest on reserves for some time. Second, the fact that paying interest on reserves has implications for the revenue that the Fed returns to the Treasury makes this element of policy no different from another other dimension of monetary policy. Actions by the Fed consist of changing administered interest rates (the discount rate and the interest rate on reserves) and buying or selling assets. All of these actions will make a difference to the Fed's income statement, and will matter in some way for fiscal policy. Monetary policy and fiscal policy are intertwined, and paying interest on reserves does not make the monetary and fiscal arms of policy any less or more interdependent."

Gavyn Davies - Two currency blocs — same problem, different solutions - "The eurozone is beset by problems which are typical of fixed rate blocs in the past, with the main surplus country (Germany) refusing to increase aggregate demand, thus forcing the deficit countries to reduce demand in order to stay within the currency arrangement. This, they appear willing to do, or at least to try.
Meanwhile, the China/US bloc also has a (nearly) fixed exchange rate, and once again the surplus country (China) is refusing, or is unable, to expand domestic demand enough to eliminate the trade imbalance. But, in this case, the deficit country (the US) is increasingly unwilling to accept the consequences, and is adopting policies which are designed to break up the bloc altogether. Two blocs with somewhat similar problems, but very different responses and outcomes for the deficit countries."

Justin Wolfers - Mistake-based discrimination - "The standard neoclassical approach doesn't fully allow for what I think most people really believe discrimination to be: a mistake. With mistake-based discrimination, imagine that you go to evaluate the future profitability of a firm. One of the things that you are going to look at is the quality of the CEO. You probably have a mental picture of a tall white guy in a pinstripe suit, and if the CEO doesn't fit that image you may have a less positive opinion of that firm. If that is true, firms headed by women should systematically outperform the market's expectations. The first paper was somewhat inconclusive; it wasn't clear whether the firm overall outperformed expectations. Alok Kumar and I are working on a follow-up paper that uses quarterly earnings announcements, which gives us a lot of observations. It turns out that female-headed firms beat analysts' expectations each quarter much more frequently than similar male-headed firms. If you look at which analysts are getting things wrong, it's disproportionately male analysts who have inaccurately low expectations of female-headed firms. That's not true of female analysts; female-headed firms actually do not beat the expectations of female analysts. This, then, suggests what we see are mistakes, not tastes. These analysts do not want to get a reputation for poor forecasts; they are not trying to lose money. In fact, one of the ways you can test whether what we observe are mistakes is to ask people if they would be willing to change their behavior when presented with the data. And whenever I teach this paper to my MBA students, many of whom are former analysts, they say that they are going to change their behavior when they get back to the real world."

Really good link - Ben Bernanke and failure of economic engineering and management

2010-09-25T04:28:00.002+03:00

Ben Bernanke - Failure of economic engineering and economic management - "I would argue that the recent financial crisis was more a failure of economic engineering and economic management than of what I have called economic science. The economic engineering problems were reflected in a number of structural weaknesses in our financial system. In the private sector, these weaknesses included inadequate risk-measurement and risk-management systems at many financial firms as well as shortcomings in some firms' business models, such as overreliance on unstable short-term funding and excessive leverage. In the public sector, gaps and blind spots in the financial regulatory structures of the United States and most other countries proved particularly damaging. These regulatory structures were designed for earlier eras and did not adequately adapt to rapid change and innovation in the financial sector, such as the increasing financial intermediation taking place outside of regulated depository institutions through the so-called shadow banking system. In the realm of economic management, the leaders of financial firms, market participants, and government policymakers either did not recognize important structural problems and emerging risks or, when they identified them, did not respond sufficiently quickly or forcefully to address them. Shortcomings of what I have called economic science, in contrast, were for the most part less central to the crisis; indeed, although the great majority of economists did not foresee the near-collapse of the financial system, economic analysis has proven and will continue to prove critical in understanding the crisis, in developing policies to contain it, and in designing longer-term solutions to prevent its recurrence. <..>

   The fact that dependence on unstable short-term funding could lead to runs is hardly news to economists; it has been a central issue in monetary economics since Henry Thornton and Walter Bagehot wrote about the question in the 19th century. Indeed, the recent crisis bore a striking resemblance to the bank runs that figured so prominently in Thornton's and Bagehot's eras; but in this case, the run occurred outside the traditional banking system, in the shadow banking system--consisting of financial institutions other than regulated depository institutions, such as securitization vehicles, money market funds, and investment banks. Prior to the crisis, these institutions had become increasingly dependent on various forms of short-term wholesale funding, as had some globally active commercial banks. Examples of such funding include commercial paper, repurchase agreements (repos), and securities lending. In the years immediately before the crisis, some of these forms of funding grew especially rapidly; for example, repo liabilities of U.S. broker-dealers increased by a factor of 2-1/2 in the four years before the crisis, and a good deal of this expansion reportedly funded holdings of relatively less liquid securities.<..>

   For today's purposes, my point is not to review this history but instead to point out that, in its policy response, the Fed was relying on well-developed economic ideas that have deep historical roots. The problem in this case was not a lack of professional understanding of how runs come about or how central banks and other authorities should respond to them. Rather, the problem was the failure of both private- and public-sector actors to recognize the potential for runs in an institutional context quite different than the circumstances that had given rise to such events in the past. These failures in turn were partly the result of a regulatory structure that had not adapted adequately to the rise of shadow banking and that placed insufficient emphasis on the detection of systemic risks, as opposed to risks to individual institutions and markets. <..>

   Another issue that clearly needs more attention is the formation and propagation of asset price bubbles. Scholars did a great deal of work on bubbles after the collapse of the dot-com bubble a decade ago, much of it quite interesting, but the profession seems still quite far from consensus and from being able to provide useful advice to policymakers. Much of the literature at this point addresses how bubbles persist and expand in circumstances where we would generally think they should not, such as when all agents know of the existence of a bubble or when sophisticated arbitrageurs operate in a market. As it was put by my former colleague, Markus Brunnermeier, a scholar affiliated with the Bendheim center who has done important research on bubbles, "We do not have many convincing models that explain when and why bubbles start." I would add that we also don't know very much about how bubbles stop either, and better understanding this process--and its implications for the household, business, and financial sectors--would be very helpful in the design of monetary and regulatory policies. <..>

   Another issue brought to the fore by the crisis is the need to better understand the determinants of liquidity in financial markets. The notion that financial assets can always be sold at prices close to their fundamental values is built into most economic analysis, and before the crisis, the liquidity of major markets was often taken for granted by financial market participants and regulators alike. The crisis showed, however, that risk aversion, imperfect information, and market dynamics can scare away buyers and badly impair price discovery. Market illiquidity also interacted with financial panic in dangerous ways. Notably, a vicious circle sometimes developed in which investor concerns about the solvency of financial firms led to runs: To obtain critically needed liquidity, firms were forced to sell assets quickly, but these "fire sales" drove down asset prices and reinforced investor concerns about the solvency of the firms. Importantly, this dynamic contributed to the profound blurring of the distinction between illiquidity and insolvency during the crisis. Studying liquidity and illiquidity is difficult because it requires going beyond standard models of market clearing to examine the motivations and interactions of buyers and sellers over time. However, with regulators prepared to impose new liquidity requirements on financial institutions and to require changes in the operations of key markets to ensure normal functioning in times of stress, new policy-relevant research in this area would be most welcome. <..>

   That said, understanding the relationship between financial and economic stability in a macroeconomic context is a critical unfinished task for researchers. Earlier work that attempted to incorporate credit and financial intermediation into the study of economic fluctuations and the transmission of monetary policy represents one possible starting point. To give an example that I know particularly well, much of my own research as an academic (with coauthors such as Mark Gertler and Simon Gilchrist) focused on the role of financial factors in propagating and amplifying business cycles. Gertler and Nobuhiro Kiyotaki have further developed that basic framework to look at the macroeconomic effects of financial crises. More generally, I am encouraged to see the large number of recent studies that have incorporated banking and credit creation in standard macroeconomic models, though most of this work is still some distance from capturing the complex interactions of risk-taking, liquidity, and capital in our financial system and the implications of these factors for economic growth and stability. <..>

   In short, the financial crisis did not discredit the usefulness of economic research and analysis by any means; indeed, both older and more recent ideas drawn from economic research have proved invaluable to policymakers attempting to diagnose and respond to the financial crisis. However, the crisis has raised some important questions that are already occupying researchers and should continue to do so. As I have discussed today, more work is needed on the behavior of economic agents in times of profound uncertainty; on asset price bubbles and the determinants of market liquidity; and on the implications of financial factors, including financial instability, for macroeconomics and monetary policy."

Really good links - Hydraulic macro - Monetary superpower - Eurozone - Summers in 2008

2010-09-24T11:55:00.001+03:00

Karl Smith - Hydraulic macro - "Looking at durables only suggests that inflation might flatten out soon. Looking at durables and new houses suggests that deflation will be upon us for sure. It will be interesting to see what happens.
   Note, however, that this is not saying that a reduction in income spent on durables and housing will cause a decline in inflation. Its saying the Fed has already taken certain actions. The immediate result of those actions is a decline the fraction of income spent on durables and new houses. The future impact of those same actions will be a decline in inflation.
   In other words the inflation decline is already baked in. What we have to ask ourselves now is whether we want to take actions that would raise inflation expectations for the medium future."

Gavyn Davies - Global monetary superpower - "In the 1930s, a shortage of global demand translated itself into protectionist trade policies as individual countries tried to grab a larger share of the available demand for themselves. There were also some competitive devaluations for the same reason. In the current global recession, we have so far seen almost no new trade controls, but exchange rates are becoming increasingly contentious. Hence the complaints from the US last week about the f/x intervention in Japan and (especially) China.
   None of this will deter the Fed, which will probably welcome the fact that foreign central bank action is increasing the impact of their own monetary easing, at a time when they are hamstrung by the zero limit on US interest rates. If foreign central banks ease monetary policy when the Fed eases, then GDP growth overseas, and global asset prices, are likely to rise. If foreign central banks instead allow their exchange rates to rise, then more of the available growth in global demand will come the way of the US."

Ralph Atkins - Eurozone vs. USA - "What makes the study interesting is that Barclays Capital then goes on to calculate what would be the appropriate interest rates for the 11 largest eurozone countries - using the so-called “Taylor rule” by which interest rates are set according to the inflation rate and “output gap” (roughly, the amount of slack in the economy). The report finds a much greater variation than would be the case for the 11 biggest US states. "

Paul Krugman, Robin Wells - The way out of slump - "According to Ryan Lizza of The New Yorker, back in December 2008 Larry Summers prepared a memo for the president-elect that made the case for fiscal stimulus to fight the recession—but then explicitly rejected the idea that the stimulus should be large enough to restore full employment. Summers argued that too much spending might create worries about the US government’s long-run fiscal position, and thus lead to a sharp rise in US borrowing costs."

Really good links - Treasuries as money - FOMC - Monetary policy - The Fed - Inflation swaps

2010-09-21T14:33:00.000+03:00

Gary Gorton and Andrew Metrick via Tyler Cowen - Treasuries as money - "It seems that U.S. Treasuries are extensively rehypothecated and should be viewed as money...This means that open market operations are exchanging one kind of money for another, rather than exchanging money for "bonds." "Quantitative easing" may well be the monetary policy of the future."

Gavyn Davies - FOMC - "At the last FOMC meeting on 10 August, the Fed worried the financial markets by sounding concerned about the economic outlook, while taking only a small step towards additional quantitative easing. Consequently, as the graph shows, all of the main risk assets fell quite sharply for a couple of weeks. This decline was only arrested when Ben Bernanke’s speech at Jackson Hole spelled out the Fed’s thinking on further monetary easing, after which “informed” financial opinion began to suggest that another big round of QE would begin before the end of the year. With US and Chinese economic data showing some improvement as well, risk assets rallied markedly."

Tyler Cowen - Why aren't we using monetary policy to stimulate aggregate demand? - "4. Maybe we are in a new political economy equilibrium where each government agency is given "one shot" at a problem. Treasury had its one shot with the stimulus plan. The Fed had its exotic monetary policy operations and deal-making during the crisis. Maybe in bad times voters aren't happy no matter what, and no one is allowed to try twice. We have not yet thought through the political economy of this scenario.
5. If the Fed can't make the commitment today, when did it go wrong? Perhaps at the peak of the crisis, when it was operating with a high degree of discretion, and various radical actions were viewed as justified, it should have announced that, to complete recovery, the three percent price inflation commitment would commence after the dust had settled. That would have required Magnus Carlsen-like levels of foresight, however. If nothing else, Bernanke may not have realized that some version of #4 was operating."

David Beckworth - The Fed - "The Fed cannot solve all of our problems, but it can stabilize nominal expectations which would add a lot more certainty to our economic environment. Until it starts doing so all I can wonder is "Dude, where's my central bank?""

Nemo - Inflation swaps - "Suppose you and I enter into an inflation swap contract where you offer to pay me $1.10 five years from now, while I offer to pay you CPIthen / CPInow dollars. It is true that one of us is offering a fixed value known today, while the other is offering an unknown value based on future events. But which is which? <..> in my hypothetical inflation swap above, you are offering me 1.10 nominal 2015 dollars. But I am offering you one constant 2010 dollar. What we know today is the real, inflation-adjusted value of my future payment. What we do not know is what your $1.10 will be worth. Therefore I am the one offering the fixed payment; therefore I am the one entitled to the risk premium; and therefore the break-even rate on inflation swaps overstates the market’s true expectations for inflation."

Really good links - Trade wars - Basel III - Sustainable external deficits - Woodhill curve - Peer Steinbrück

2010-09-17T16:42:00.001+03:00

Scott Sumner - Trade wars - "In 1985 Paul Krugman (p. 7) argued that the dollar needed to fall sharply in order to prevent chronic CA deficits, which he said would lead to “infeasible” foreign debt levels. He was right about the dollar, it did fall sharply after 1985. But we’ve had 25 years of almost nonstop CA deficits, and no sign of a light at the end of the tunnel. Why? Because the falling dollar didn’t address the fundamental cause of the CA deficit, a saving/investment imbalance produced by a fiscal regime that is profoundly anti-saving. You can’t fix that with a band-aid. "

Economist.com - Basel III - "The most serious failure in Basel III is that it doesn't address the principal contribution of Basel II to the last financial crisis, namely, the calculation of risk-weights. One of the key components of Basel II was to increase the amount of capital banks had to hold against riskier assets. Extremely low-risk assets, meanwhile, could be held with very little or even no capital. Risk, moreover, was calculated primarily by reference to the rating assigned by one of the recognised ratings agencies. The consequence of this Basel II reform was to discourage banks from lending to risky enterprises, and to encourage the accumulation of apparently risk-free assets. This was a primary contributor to the structured finance craze, as securitisation was a way to "manufacture" apparently risk-free assets out of risky pools. What brought banks like Citigroup and Bank of America to their knees wasn't direct exposure to sub-prime loans, but exposure to triple-A-rated debt backed by pools of such loans, debt which turned out not to be risk-free at all."

Claus Vistesen - Sustainable external deficits - "Economists trained in the art of general equilibrium would immediately point out that it does not matter much since if there is one thing that we can be sure off it is that at all points in time the sum of external deficits will equal the sum of external surpluses. I cannot but agree, but this also means that speaking of surplus nations as the good guys and deficit nations as the bad guys does not make sense. What we really need here is economies with ability to run sustainable external deficits; this basically means economies who need to borrow to maintain trend economic growth and a proper rate of investment given the intrinsic return of the economies investment pool."

Louis Woodhill - Laffer curve - "The Woodhill Curve extends the concept of the Laffer Curve in two ways: 1) It takes into account the element of time-the fact that the future matters; and, 2) It focuses on the impact of tax changes on total Federal revenues rather than on the revenue generated by an individual tax.
The principle behind the Woodhill Curve can be stated as follows: "There are an infinite number of combinations of "tax take" (Federal revenues as a percent of GDP) and average annual real economic growth rate that will yield the same present value (PV) of future Federal revenues." While the shape of the Laffer Curve is a matter for speculation, it is possible to quantify the shape of the Woodhill Curve."

Peer Steinbrück - In a SPIEGEL interview, former German Finance Minister Peer Steinbrück talks about his role in fighting the financial crisis, how he pressured America to stop a second Lehman Brothers and why Greece is not out of the woods yet

Really good links - Global imbalances - Tim Duy - Inflation targeting

2010-09-14T15:08:00.003+03:00

Lorenzo Bini Smaghi - Member of the Executive Board of the ECB - Global imbalances - "The negative correlation recorded during the crisis between the current account and the fiscal balances has been largely in line with expectations. In the long run, however, current account deficits could well increase again globally if the fiscal expansion which has taken place in recent years is not reined in. In fact, the available evidence suggests that the adjustment of current account imbalances has so far been largely cyclical. The reduction in trade imbalances following the crisis has slowed and, in several cases, has started to reverse. In both the United States and China we are already close to pre-Lehman levels in absolute terms.
   The sheer asymmetry in size and composition of the fiscal stimulus in advanced countries compared with any measures taken in emerging economies is likely to magnify the expected resurgence of current account imbalances. Similarly to the pre-crisis situation, advanced economies’ indebtedness would be financed with capital flows from emerging economies. This implies not only a massive misallocation of global capital, but also undermines the credibility of any initiative to rebalance savings and investments both within and across the main regions of the global economy. As a result, it risks creating - once again I should say - delusional expectations in financial markets about the sustainability of imbalanced financial and trade flows. <..>
   It seems to me that we need better economic analysis in order to address this issue. First, we need to understand whether a given level of world growth, if achieved through unsustainable imbalances, is in itself sustainable. In 2003-07 the world economy grew at an unprecedented pace, also owing to the large imbalances financed through the recycling of large capital flows. If these imbalances were not sustainable, the underlying rate of growth of the world economy, and of some of its components - in particular the deficit countries -was probably in itself not sustainable. Accordingly, asking who will provide the demand of last resort if the deficit countries save more might not be the right question to ask, because it is based on the presumption that the unsustainable pre-crisis growth rate represents the post-crisis objective.
   We certainly need a better understanding about the potential growth of the various economies and its structure, taking due account of how comparative advantages have changed, also as a result of the crisis. My intuition is that such an analysis would suggest that potential growth in the United States is substantially lower than the average growth it experienced over the past decade and requires a shift of resources from the non-tradable to the tradable sector. Given that such a shift in resources cannot occur instantaneously, it should not be surprising if the US economy experienced a period of temporary higher unemployment. In that case, trying to stimulate growth and reduce unemployment to achieve the pre-crisis equilibrium through macroeconomic policies, as some are suggesting, might only delay the adjustment and lead again to an unbalanced path. On the other hand, some surplus countries, such as Germany, might be able to achieve higher growth than in the past decade, because of the increased potential resulting from their better positioning in international trade specialisation achieved over the years and if they are able to employ resources more efficiently in the non-tradable sector."

Tim Duy - Fed Watch - "Bottom Line: Although the Federal Reserve is poised for another round of quantitative easing, it is important to recognize their ultimate objective. It is not to pursue an a rapid return to potential output in order to rapidly alleviate unemployment. It is simply to maintain policy expectations in the context of a return to potential growth. Thus, one should expect the actual easing to be commensurate with such a policy. In other words, pay attention to what Bullard is saying - "measured" policy action. This, in my opinion, will be too little too late, as I am more concerned with an aggressive assault on unemployment and believe that using potential growth as a policy reference effectively locks the US into a suboptimal equilibrium."

Nick Rowe - Inflation targeting - "Inflation targeting wasn't something dreamed up in academic seminars. It came out of the central banks themselves, and their interactions with governments. But it turned out to fit right in with the rules vs discretion debate. Twenty years ago the new Prime Minister of New Zealand was going around all the government departments insisting they announce some sort of target they would be held accountable for meeting. When asked for his target, the Governor of the Reserve Bank of New Zealand said "Ummm, inflation?". The Bank of Canada had been quietly working on implementing an inflation target at the same time. It announced its target with the government's backing."

Really good links - Krugman on global savings glut - New Keynesian macro - Seeing like a state

2010-09-13T21:43:00.000+03:00

Paul Krugman, Robin Wells - Global savings glut - "In China, whose trade surplus accounts for most of the US trade deficit, the desire to protect against a possible financial crisis has morphed into a policy in which the currency is kept undervalued, which benefits politically connected export industries, often at the expense of the general working population. <..>
   Europe managed to inflate giant housing bubbles without turning to American-style complex financial schemes. Spanish banks, in particular, hugely expanded credit; they did so by selling claims on their loans to foreign investors, but these claims were straightforward, “plain vanilla” contracts that left ultimate liability with the original lenders, the Spanish banks themselves. The relative simplicity of their financial techniques didn’t prevent a huge bubble and bust. <..>
   Our guess is that the bubble got started largely thanks to the global savings glut, but that it developed a momentum of its own—which is what bubbles do. "

Nick Rowe - Currently planned future desired expenditure is not equal to currently expected future income - "Now, if every individual knew what every other individual were planning to spend next year, and knew what every other individual were expecting to earn in income next year, and understood National Income Accounting, and could add up all the numbers, they would learn that Et[AE(t+1] and Et[Y(t+1)] weren't equal. So they would know that someone is being overly optimistic, or pessimistic, but they wouldn't know if it was them. Maybe all the other people are wrong; I'm not going to change my plans or expectations. The amount of knowledge an individual would need to figure out that he was wrong would be enough to make that individual smart enough to be appointed central planner, so we wouldn't need New Keynesian macroeconomics anyway.
   There's sensible rational expectations, then there's silly rational expectations, and then there's the rational expectations that would be needed to make New Keynesian macroeconomics work."

James Scott - The trouble with the view from above - "The example of scientific forestry is meant here as a signal and cautionary example of the dangers of the forms of simplification typical of states and large bureaucratic organizations. In Seeing Like a State, I developed several examples in considerable detail: the imposition of uniform land tenure and cadastral surveys on vernacular forms of land tenure; the imposition of uniform legal codes on vernacular customs, the replacement of dialects with a national language, the design (or redesign) of abstractly planned cities (e.g. Brasilia) compared to “vernacular” unplanned towns, the forced resettlement of peasants and pastoralists in poor countries compared to “vernacular” movement and settlement, agricultural collectivization compared with small-holder mixed farming, and, finally, the difference between praxis or vernacular knowledge on the one hand and epistemic knowledge on the other. The emphasis, throughout, is on the processes whereby hierarchical organizations, of which the most striking example is the state, create legible social and natural landscapes in the interest of revenue, control, and management."

Really good links - Momentum and EMH - Greece - Bequests - Financial analysts and company guidance - Germany

2010-09-09T13:03:00.001+03:00

Gavyn Davies - Efficient market hypothesis and the puzzling success of momentum strategies - "Andrew Haldane is an economist at the Bank of England who writes some of the most interesting stuff available on the (mis)behaviour of the financial sector, and I recommend his recent speech on Patience and Finance. This argues that patience (or long-sightedness) is an economic virtue, the exercise of which should lead to faster GDP growth, higher returns to fund managers, and a sounder financial system. However, the part of his speech which I found most fascinating seemed to contradict this conclusion. This is an assessment of investment strategies which are based on momentum in asset prices, rather than long term economic fundamentals. Momentum wins the race hands down."

Michael Lewis - Beware of Greeks Bearing Bonds - "Greece--a nation of about 11 million people, or two million fewer than Greater Los Angeles...Add it all up and you got about $1.2 trillion, or more than a quarter-million dollars [in government debt] for every working Greek."

Adam Ozimek - How to fund existence - "The implication that Becker and Murphy draw from this is that parents who do not leave bequests have no mechanism to compensate themselves for having more children, and thus they are under-producing children. They therefore conclude that poor people have too few children, and rich people have just the right amount. Go ahead, read that last sentence again."

Tony Jackson - Financial analysts - "Companies emit a torrent of public information, and are formally constrained from saying anything else. The analyst is thus reduced to going cap in hand to the company for a few crumbs of enlightenment. Those crumbs are dispensed on agreed terms. If the analyst persists in deviating from the official line, he/she may be cut off. For why should the company waste time on the recalcitrant?
   This situation is not merely tolerated by regulators, but is in large part their creation. Anecdote has it that one London analyst recently had a call from the UK’s Financial Services Authority.
   Why, the FSA allegedly asked, was the analyst’s forecast so far from the consensus? Did that not imply inside information? What was going on? If true – and I cannot vouch for it – this strikes a note of real pathos for my old profession. Forecasts from the company are only as good as the company’s powers of clairvoyance. Attempting to do better – to think independently – ought to be the analyst’s job."

Lawrence White - Ludwig Erhard - "Germany's new Social Democratic Party wanted to continue the controls and rationing, and some American advisers agreed, particularly John Kenneth Galbraith. Galbraith, an official of the U.S. State Department overseeing economic policy for occupied Germany and Japan, had been the U.S. price-control czar from 1941-1943; he completely dismissed the idea of reviving the German economy through decontrol.
   Fortunately for ordinary Germans, Erhard—who became director of the economic administration for the U.K.-U.S. occupation Bizone in April 1948—thought otherwise."

Scott Sumner and long term interest rates

2010-09-07T20:09:00.002+03:00

Scott Sumner writes:

"I predicted that aggressive QE would raise long term interest rates, a view which seemed to be refuted by the response on T-bond yields to the March 2009 Fed QE announcement. <..>

Any effective monetary stimulus would be expected to raise long term rates. We have plenty of examples of that occurring. My favorite is the surprise stimulus announcement of January 3, 2001, which caused long term (nominal) rates to soar. Thus I was shocked to see long term rates fall sharply on the day of the March 2009 QE announcement.

I don’t have a good theory for why that happened. One could point to the fact that they quickly reversed, and soon rose far above the pre-announcement level. So maybe markets made a mistake and I was right all along. But that means the EMH is wrong, a theory I hold even more dearly. So either way I’m screwed.

If I had to guess I’d say it might have something to do with the type of stimulus. It didn’t so much raise the monetary base (indeed the Fed was correct in denying that it really was QE) rather it changed the composition of their balance sheet. Even so, other markets (stocks, foreign exchange) reacted as if it was bona fide monetary stimulus. So I am not really satisfied with that explanation either.

I am reluctant to form a firm opinion based on a single observation, so I will watch market reactions to other QE-type actions, to see if a pattern develops. If I was forced to critique my own blog, the market response to the Fed’s March 2009 “QE” would be my number one weapon."

As Krugman reminds us, EMH is false. Arbitrage capital was very expensive in March 2009, and treasury market, one of the most liquid and important markets in the world, was more inefficient than normally. Here is a must-see video that shows the term structure of interest rates over the recent past, degradation of market efficiency is clearly visible with the naked eye.

March 2009 QE announcement was an effective monetary stimulus, as real risk assets rallied. The Fed said it will perform Treasury-Agency bond arbitrage, expectation of such arbitrage has made Treasuries more attractive for some investors who were previously holding Agencies. These investors (with inflexible investment mandates) created buying pressure that overwhelmed the actions of those speculators who are sensitive to macro developments, and markets made a mistake.

Related posts: Krugman and the bond bubble

Really good links - Too much debt - Ricardian stimulus - Too big to liquidate is too big to live - Who gets the money first?

2010-09-06T10:38:00.000+03:00

Brad DeLong - Too much debt - "If our big problem were too much debt we would not be here, in depression. Too much debt generates inflation. The things that generate depression are shortages of financial assets, and excess demand for some class of financial assets then produces, by Walras's Law, excess supply of currently-produced goods and services. We had a "shortage of liquid cash money" recession in 1982; we had a "shortage of long-duration bonds" recession in 2002, and now we are having a "shortage of safe assets" recession."

Stephen Williamson - Credit market frictions and Ricardian stimulus - "Is there some case for a fiscal policy initiative that we could construct based on the particulars of the financial crisis? If we think that a key source of our recent problems is a temporary increase in credit market frictions, one approach might be a pure Ricardian one. When there are credit-constrained economic agents, a temporary tax cut for everyone, with a promise to pay off the resulting debt with higher future taxes, is effectively a large government credit program. It does not require any new government bureaucracy, and just works through the existing income tax mechanism. Those who are credit constrained spend the tax cut as if they were getting a loan, and work harder or consume less in the future so as to pay the higher future taxes, as if they were paying off the loan. Those who are not credit-constrained save the tax cut so as to pay their future taxes. There are no long-run implications for the government budget. Why didn't we just do that?"

John Kemp - Too big to liquidate is too big to live - "Poor use of language reflects muddled thinking and compounds mistakes. No phrase in the debate about financial reform is more wrong-headed and pernicious than the description of certain institutions as “too big to fail”. It should be expunged from the lexicon.
No institution is too big to fail. But some institutions are too big to liquidate. Such institutions pose an existential threat to the stability of the financial system and cannot be allowed to live."

Scott Sumner - Who really deserves to get the new money first, so that they can spend it before prices adjust? - "The group that initially receives the new money is bond holders. But they are not lucky, as old money is just as useful as new money in stores. So if you don’t sell your bonds to the Fed, you can sell them to another person, and use that money to buy things. Thus those receiving the “new money” do not have any special advantages.
The second misunderstanding is the idea of buying things before prices adjust. Those things where profits are easiest to earn (commodities, etc) see their prices adjust immediately, as the Fed announces the new policy. There are sticky prices that adjust slowly, but all 300 million Americans have an equal shot at those. They can use new money or old money to buy things. Those lacking money can sell assets to get old money, and then buy the sticky price goods."

Sweden tightens monetary policy, fear of asset bubbles prevents speedy closure of resource utilization and inflation gaps

2010-09-02T18:46:00.003+03:00

Riksbank raised policy rate by 0.25 percentage points to 0.75 percent today. Interestingly, Swedish monetary policy decisions include central bank's three year forecast of future policy rates, according to which repo rate will be gradually increased to 3.8 percent by Q3 2013. Lars Svensson dissented, he preferred unchanged repo rate that gradually raises to 1.75 percent during next three years. In an earlier speech Svensson argued lower repo rate path would achieve a better outcome for both inflation and resource utilization. He also said that any risks linked to excess lending and rapid increases housing prices should addressed by supervisory authorities and monetary policy should not be affected. Recent appointee Karolina Ekholm also dissented. She agreed with a decision to raise repo rate by 0.25 percentage points, but preferred a flatter path of repo rates in the future.

Really good links - Japan - German jobs miracle - Bernanke - Mr. Bean

2010-09-01T13:25:00.002+03:00

Jonathan Allum - The lessons to be learnt from Japanese bonds - "The Japanese experience – over both the long and the short term – suggests something different and rather darker. Despite all the alarmist rhetoric, the bond vigilantes have been perfectly happy with the JGB market, presumably because Japan offered something much rarer than mere fiscal rectitude, namely deflation. If those charged with stewardship of a major economy really see their main task as keeping the bond markets onside, they should be wary. The price of this favour may not lie in slashing the deficit, which may be difficult to achieve, albeit a laudable long-term goal, but in fostering a period of substandard growth and persistent deflation.
   That is not a desirable goal in either the short or long term. The good news is that it may, despite the Japanese example, be difficult for other economies to achieve. The bad news for bond investors is that their markets are already trading at levels that suggest that 1990s Japan is, as they now say, the “new normal”. And this may not even be true of contemporary Japan."

Gavyn Davies - German jobs miracle - "In the past two years, the Merkel government has worked hard to boost part time (or short time) work during the recession, through a programme of subsidies, exhortation to employers, influence on wage bargains, and other measures. As a result, Germany has become the world leader in part time employment, and in many industries, part timers now account for over a quarter of the total workforce.
   This is a two-edged sword. It has certainly spread the cost of the recession much more widely across the population, rather than allowing it to be concentrated on the relatively few who become unemployed. This contrasts sharply with the US, where firms have been particularly eager to cut total jobs during this recession. But is has also greatly depressed the growth of labour productivity. In 2009 alone, GDP per employed person fell by a remarkable 4.9 per cent in Germany, while it rose by 1.8 per cent in the US. And it may have damaged the long term performance of the economy, by locking people into jobs which have become obsolete. One day soon, the German government will have to reduce its subsidies, and the degree of under-employment in the economy will become more visible."

Matthew Yglesias - Bernanke's speech - "Taken literally, I don’t think Ben Bernanke’s speech last week made any sense at all. He described a hypothetical future situation in which the inflation rate gets lower and employment growth continues to be unsatisfactory. He said that in such a situation the Federal Reserve would attempt to increase aggregate demand and that he believed it would be successful in doing so. So far so good. He also said that currently the inflation rate is below what he regards as optimal and that currently real output is below what it could be. Given Bernanke’s stated belief in the possibility and desirability of monetary action to raise aggregate demand in the hypothetical scenario and his description of the current scenario, it’s clear that the Fed should act now to raise aggregate demand. But it’s not going to happen.
   I think the most reasonable way to read the speech is non-literally. Several FOMC members and Regional Fed Presidents who aren’t currently voting FOMC members are clearly agitating for tighter policy or, at a minimum, the status quo. The speech is incoherent because the Chairman is trying to put together a consensus that papers over existing divides"

Charles Bean, Matthias Paustian, Adrian Penalver, and Tim Taylor (Bank of England) - Price level targeting - "Whatever the explanation for the trend‐stationarity of the price level, these results suggest that existing policy frameworks have delivered something quite close to price‐level targeting in practice. That suggests the welfare gains from making the extra step may be limited, particularly when there are costs to changing the framework. The issue is, nevertheless, worthy of further investigation.
<..>
   It is, though, worth pointing out that there may be times when having a price‐level target is likely to be unhelpful. For instance, consider the present case of the United Kingdom, where upward shocks to oil prices and indirect taxes and a substantial depreciation of sterling have led to inflation running consistently above the 2 per cent target, but at a time when the economy has also been subject to an adverse demand shock which has opened up a substantial margin of spare capacity. Price‐level targeting would dictate that this excess inflation must subsequently be unwound. Consequently, inflation expectations would be lower and real interest rates higher. That in turn would exacerbate the downward pressure on demand, worsening the constraint of the ZLB (zero lower bound - ed.).
<..>
   The theoretical superiority of price‐level targets over inflation targets hinges on the forward‐looking nature of expectations. If expectations are not forward‐looking, then their automatic stabilising feature is lost. And the presence of inertia in the inflation process also reduces the relative superiority of price‐level targets. In particular, if a significant fraction of firms set their prices on the basis of past inflation, then it becomes optimal to permit some drift in the price‐level path in response to shocks. That is because those firms that are able to will raise their price in response to a shock that raises the overall price level relative to target. If the central bank subsequently seeks to bring the overall price level back on to the originally prescribed path, then the relative price of those firms will be too high. It is better instead to allow some base drift in order to reduce the average (squared) distortion in relative prices across the economy as a whole. That suggests that some hybrid of price‐level and inflation targeting may be a good idea; targeting average inflation over a run of years is one way to approximate such a hybrid regime (King, 1999).
   A final issue with price‐level targeting lies in communications. While the public can probably relate to the idea of inflation as the average rate at which prices in the economy are changing, it less clear that they will understand what a consumer price level index means. Such a target for the price‐level would therefore probably need to be portrayed as stabilising average inflation over a very long period."

Really good links - QE - Kocherlakota - Mother of all bank runs - Flight to safety - Basel - Bond bubble

2010-08-30T12:43:00.000+03:00

Alan Blinder - QE - "If the FOMC is serious about re-entry into quantitative easing, it should buy private assets, not Treasurys. Which assets? The reflexive answer is: more MBS. But with mortgage rates already so low, how much further can they fall? And would slightly lower rates revive the lifeless housing market?
To give quantitative easing more punch, the Fed may have to devise imaginative ways to purchase diversified bundles of assets like corporate bonds, syndicated loans, small business loans and credit-card receivables. Serious technical difficulties beset any efforts to do so without favoring some private interests over others. And the political difficulties may be even more severe. So the Fed will go there only with great reluctance."

Adam P - Kocherlakota - "the very worst part of what Kocherlakota said is that he was advocating for a policy and that policy was to tighten monetary policy *TODAY*.
If the Fed stands ready to raise rates before inflation has increased (based on other indications of a normalization) then that is a change in the reaction function that constitutes a tightening. (Look at it this way, in Sumner's phrasing it is a statement that the Fed stands ready to reduce the money supply even earler than we though, the monetary injection has gotten *less permanent*)."

Brad DeLong - Mother of all bank runs - "However, at some future time the dollar will cease to be the linchpin of the world financial system, in which case the Federal Reserve's financing its balance sheet via overnight borrowing will leave it vulnerable to the mother of all bank runs. It would be very good to fix this now: to give the Federal Reserve now the option to borrow not in what are essentially demand but rather in time deposits--to grant the Federal Reserve the power to issue its own bonds. This diminishes the chance of a great financial crisis in 2050 or so, with no downside that I can see"

David Pearson - Flight to safety? - "To further confuse the picture, the "flight to safety" or "safe haven" explanations for zero 5yr real yields simply do not fit with other asset prices. Investment grade corporate bond spreads, for instance, are at very tight levels -- indicative of little credit fear. High yield bonds are also enjoying a boom. So the bond market is sending mixed signals: corporate default risk is very low, but required real returns on a risk-less asset are zero. Further, record-high gold prices are indicative of some level of long term inflationary fear, and while TIPS inflation has declined, it is still positive. How could these prices all be reconciled?"

Craig Pirrong - Basel - "Risk-based capital requirements are like a regime of price controls, in this instance, risk price controls. If some risks are mispriced, and particular, priced too low, all affected institutions face the same incentives to take on those particular risks. The more institutions that fall under the capital regime, the more institutions that will take on these underpriced risks. That’s why I am very leery of global capital regimes, a la Basel. If they screw up the prices–and screw them up they will, with metaphysical certainty–the effect of the perverse incentives will be global."

Nick Rowe - Bond bubble - "I approach the question of "fundamental value" as a macroeconomist, not a microeconomist -- from a general equilibrium, not partial equilibrium perspective. If we define the "fundamental" value of an asset as the price that asset would have if all markets, not just the market for that asset, were in long-run equilibrium (and with inflation at target), then bond prices are above their fundamental values. And if we define "bubble" as a price above that fundamental value, then bond prices are a bubble."

Really good links - Fed&TIPS - Monetary policy - Bailout risks - Krugman, Christ and the resurrection of Milton Friedman - Kocherlakota and Zimbabwe - Scott Sumner - 3% inflation

2010-08-27T16:34:00.003+03:00

Steve - Fed and TIPS spreads - "If the Fed makes a policy announcement that the market deems deflationary, TIPS spreads will *immediately* shrink. Directionally, the market renders an immediate verdict on the Fed decision as you said.
   However, the *magnitude* of the reaction depends on circularity: does the Fed trust the market (they will correct their decision next time) and does the market trust the Fed.
   If the Fed renders a “bad” decision, but their is mutual trust between the market and the Fed, TIPS spreads will fall a little and stocks will fall a little, even if the decision is terrible. What is the cost of six weeks?
   However, if the Fed renders a “bad” decision and says it is smarter than the market, the TIPS spreads and the stocks will both crash. If the Fed thinks it knows better than the market, the market will price in the full extent of any perceived bad decision immediately. See September/October 2008."

Scott Sumner - The empathetic, the amoral, and the sadistic monetary policy - "Instead, I’d like to argue that central bankers are a bunch of well-meaning (or at worst amoral) people who act like sadists because they have the wrong model in their heads. They think that it is “natural” for inflation to fall during periods of high unemployment. And we know that ‘natural’ means good. After all, natural foods are good for you, aren’t they? Why do they think low inflation is natural in a weak economy? Because it almost always happens. When it doesn’t happen, e.g. 1974, the event is viewed as bizarre. "

Andy Harless - The Real Activity Suspension Program - "Think of this as a guest post by the Cynic in me. <..> Now this bailout program is not without its risks. The biggest risk is that the economy will recover, which would be a disaster for the program. Suddenly, not only would banks be holding losses on their Treasury notes, but their cost of funds would go up, as depositors realized that there were more attractive investments available than zero-interest bank deposits."

Paul Krugman - Christ and the resurrection of Milton Friedman

Karl Smith - Kocherlakota on Deflation - Apparently Kocherlakota was right - zero interest rates will cause deflation. But he forgot to tell us that we are going to see hyperinflation before that. Case study - hyperinflation and deflation in Zimbabwe.

Tweet of the day - Garett Jones - Scott Sumner - "If the U.S. Congress were functional, then Scott Sumner would be testifying monthly."

Update:
Ben Bernanke (Jackson Hole) - 3% inflation - Price level targeting is a bad idea because we didn't screw things up that much - "A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC. Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.
   However, such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability. In this context, raising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed's hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets--including inflation risk premiums--would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy."

Krugman and the bond bubble

2010-08-25T17:10:00.007+03:00

Ten assorted thoughts about the government bond bubble (please also see these excellent posts by Krugman and DeLong):

1. You could have earned a lot of money in bonds by following Krugman's analysis during last four years. Bond market is clearly not incorporating and reflecting the very public information from Krugman's blog in a timely manner, this means that the Efficient Market Hypothesis (EMH) is false for government bonds.

2. Rober Shiller has shown that volatility of stocks is much larger than can be explained by the news about economic fundamentals. The same applies to bonds; they are too volatile, with bubbles and anti-bubbles forming.

3. In early 2010, bonds were in the anti-bubble territory. Investors were overestimating the probability that the recovery will remain on the V shaped track. You should be allowed to talk about bond bubble only if you said bonds were cheap in early 2010, otherwise you should be using EMH.

4. Krugman has a model that says 10-year bond is trading at the right price now. The problem is that Krugman is assuming that the only tool Fed will use is zero interest rates. There is approximately 20% probability that Fed will do the right thing by restarting aggressive quantitative easing and credit easing as suggested by Bernanke in 2003. Bond market is ignoring this possibility and 10-year bond is already overpriced.

5. Many economists think that bubbles are harmful and that the Fed should actively lean against the bubbles. Well, the bond bubble is also very harmful, as bonds are pricing in extended unemployment and below-trend inflation. Bernanke should print more money ASAP in order to burst the bond bubble.

6. Fiscal stimulus can also successfully deflate the bond bubble. Tax cuts that can be reversed in the future cause no significant long term fiscal damage while stimulating the economy, healing the private sector balance sheets and containing the growth of the bond bubble.

7. Noise traders are a key source of stock market inefficiency. They are a big problem for bond market too. As asset maturities get shorter, the noise trader risk is diminished, and the short end of the bond market is pretty efficient. This means that we can rely more on the prices of short term treasuries when formulating public policy. Temporary tax cuts are a no-brainer, while it is much harder to reliably measure the NPV of infrastructure investments with long payback periods.
There are a lot of trend-following momentum players in bonds, and a fall in Treasury bond prices would certainly induce further selling.

8. The most important noise trader in the interest rate markets is China. Authorities are pushing for a much higher level of the savings than can be justified by the preferences of the Chinese people.

9. Every bubble has faulty valuation models. There is no exception now, as we have Gluskin Sheff's David Rosenberg:

"Well, the Fed just told us that it has no intention of hiking rates for a long, long time. So, Fed tightening risks are off the table and at a time when the policy rate is almost zero. And we have a long bond yield of 3.6%. That is a 360 basis point curve from overnight to 30 years, and historically, that spread averages out to be 200bps.
As we invoke Bob Farrell’s Rule 1, which is about reversion to the mean, we should see the long bond yield approach or even possibly test the 2% threshold before its final resting stop is reached. If we are right on -1% to -2% deflation in coming years as the post-bubble excesses continue to unwind, nominal yield will actually be quite juicy in “real” terms."

10. Every bubble has excessive trader sentiment, here is David Rosenberg again:

"We have also been hearing that bullish sentiment towards Treasuries is now 98%, according to some surveys, approaching the incredible 99% on December 16, 2008, right as yields were plunging to their trough (the 10-year note approaching 2%). <..>
At the Grant’s Conference in April, Jim labeled the event we closed down together on stage as “Bonds are for losers.” Even in June, the Barron’s poll showed the vast majority of forecasters calling for higher yield activity. Now every bond bear, from the 5.5% yield projectors at Morgan Stanley, to my old shop who are now broadly filled with perma-bulls (now are calling for a 2.5% yield on the 10-year note) outside of Mary Ann Bartels, have thrown in the towel."

Really good links - Interest on reserves - China - S&P correlation - Recalculation

2010-08-24T19:39:00.000+03:00

Roger Farmer - Interest on reserves - "May 18, 2006 was an important day. It was the day when the Bank of England began to pay interest on reserves. In October 2008 the Fed followed suit. This monumental change in policy gave the Bank an important new tool in its arsenal. It allowed the Bank to influence the economy not just through expansion or contraction of the stock of money, but also through the composition of its balance sheet."

Ambrose Evans-Pritchard - China - "Diana Choyleva from Lombard Street Research said China has a delicate task ahead. Rampant overheating has given way to a "sharp cyclical downswing", yet China cannot easily unleash another stimulus blitz without risking inflation. They are in the "nasty quadrant " of the economic cycle where all choices are hard, though China is not as far gone as over-cooked India."

James Mackintosh - S&P correlation - "In fact, the tendency of the top 1,000 US stocks to move in the same direction as the overall market – their correlation – hit its highest point since at least 1950 in July, according to Barclays Capital. Correlations between the blue-chip S&P 500 index and the mid-sized S&P 400 reached 98 per cent while the blue-chip and small company indices were 99 per cent correlated over three months; contrast this with Citigroup’s figures showing just 68 and 72 per cent correlation, respectively, over 10 years. The options market is pricing in high levels of future correlation, too.
This matters. The whole point of paying a fund manager to select stocks is that he or she is supposed to beat the market. But if the shares of both “good” and “bad” companies perform similarly, that manager has little chance of success. It is bad enough that so few mutual fund managers are able to beat the market even in normal times. Additional headwinds for active managers will persuade more investors to give up on highly-paid humans and switch to cheap computer-run index trackers."

Tweet of the day - Garett Jones - Recalculation and ZMP (Zero marginal product) workers - "Kocherlakota and Williamson find a Recalculation, with some ZMP workers loitering nearby. http://ow.ly/2t3HH"

Scott Sumner is back.

Really good links - Deficit economics - Econometrics - Unemployment - Deflationary expectations

2010-08-19T14:41:00.000+03:00

Brad DeLong - Deficit economics - "It deals with the case in which the macroeconomic market failure is one of promise-keeping on the part of the government. As the late economist Milton Friedman put it, for the government to spend is for the government to tax. Whenever the government spends money to purchase something, it is also promising explicitly or implicitly to tax somebody, either in the present or the future, either directly or indirectly, to pay for that purchase.
The government can tax now to pay for spending later—and so run a budget surplus. The government can spend now and promise to tax later—and so run a budget deficit and increase the national debt. But what happens when the government runs up too great a debt and the political system tries to get the government to break its promise to tax, or even when investors and savers and managers and workers and spenders fear that the government will explicitly or implicitly try to break its promises? How to guard against such attempted promise-breaking by the government and what happens when attempted promise-breaking occurs is deficit economics. And once again it is not pretty: capital flight, disinvestment, stagflation, currency collapse, and hyperinflation."

Arnold Kling - Econometrics - "There simply is not enough information in the data to make a convincing case for any particular theory of macroeconomics."

Narayana Kocherlakota (President, Federal Reserve Bank of Minneapolis) - Unemployment - "Of course, the key question is: How much of the current unemployment rate is really due to mismatch, as opposed to conditions that the Fed can readily ameliorate? The answer seems to be a lot. I mentioned that the relationship between unemployment and job openings was stable from December 2000 through June 2008. Were that stable relationship still in place today, and given the current job opening rate of 2.2 percent, we would have an unemployment rate of closer to 6.5 percent, not 9.5 percent. Most of the existing unemployment represents mismatch that is not readily amenable to monetary policy."

Narayana Kocherlakota (President, Federal Reserve Bank of Minneapolis) - Deflationary expectations - "To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation. The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. Again, using our simple arithmetic, this negative real return combined with the near-zero fed funds rate means that inflation must be positive. Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.
That sounds easy—but it’s not. When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation."

Really good links - Liquidity trap - Zero bound - Fed

2010-08-16T17:54:00.002+03:00

Brad DeLong - Liquidity trap - "I have always understood "liquidity trap" to mean a situation in which cash is effectively a perfect substitute for Treasury bills and in which as a result open-market operations in their standard form have no effect on anything.
   However, that does not mean that central banks are powerless in a liquidity trap:
   By taking duration, default, and systemic tail risk onto their balance sheets, they can diminish default and risk premia on debt instruments other than short-term Treasury bills.
   By changing expectations of future inflation rates, they can alter business decisions without taking any action to change the current levels of nominal interest rates."

Bill Hester - The Paradox of the Zero Bound - "Promising low rates for long periods of time is particularly pernicious following periods of credit crises, points out Arun Motianey, now with Roubini Global Economics, in his book SuperCycles. In a discussion of Japan's low policy rates over the last 15 years, Motianey points out that deflation became worse the longer Japan's equivalent Fed Funds rate stayed at zero.
   Motianey argues a slightly different transition mechanism that pushes the economy into deflation, mainly through lending markets. He argues that after a credit crisis, government-supported banks are borrowing at close to government rates and at the same time being coerced to lend at rates lower than they would otherwise demand for the risk of default. The result is that they demand higher credit standards (typically higher operating cash flow) of their borrowers. Borrowers, mostly companies, oblige by halting the growth in or cutting the nominal wages of workers. Generalized price deflation typically follows wage deflation."

Tim Duy - A Bleak View - "Deferring to the faltering economy, the Federal Reserve stepped up its policy efforts last week. Barely. Almost imperceptibly. Indeed, it is almost as if the Fed could muster nothing better than throwing a bone to its critics. Will they throw more bones in the coming months? In this environment, I suspect the Fed will continue to do more than I expect, but less than is necessary."

Really good links - FOMC - Limits of arbitrage - Director's law - Public sector employees

2010-08-11T13:30:00.000+03:00

Paul Krugman - The FOMC has spoken - "What the FOMC announced was a slight change in policy: rather than allowing its balance sheet to shrink as the mortgage-backed securities it owns mature, it will maintain the balance sheet’s size by reinvesting the proceeds in long-term government bonds. Roughly speaking, it has gone from a completely crazy policy of monetary tightening in the face of massive unemployment and incipient deflation, to a policy of standing pat in the face of same."

Kenneth R. French - To what extent do the limits of arbitrage discredit the idea of market efficiency? - "I think there are many papers that show the limits of arbitrage framework can help us understand the behavior of financial prices. <..> Although the limits of arbitrage argument is based on the premise that prices do not fully reflect all publicly available information, it also says that mistakes in prices do not imply easy profits. In fact, I think the argument implies that almost all investors should act as if prices are right."

Eric Falkenstein - Director's law - "Friedman states that it is a common myth to think the government takes from the rich and gives to the poor. He mention Director's law--really an empirical tendency in the US circa 1960--that the rich and poor pays for programs to the middle class.
As depressing as Friedman's argument may be, there are worse things than tyranny of the middle class: a coalition of the elites with the lowest classes. We have legislators bestowing all sorts of sinecures, pensions, and welfare on the masses, creating a coalition of the unproductive, and they grow in popularity and power by granting more entitlements. The end game is bankruptcy. " - but where is the data, Eric?

Steve Landsburg - Are public-sector employees overcompensated? - "Quit rates in the public sector are about one third what they are elsewhere. In other words, government employees sure do seem to like holding on to their jobs."

Good news from the Fed

2010-08-10T22:29:00.001+03:00

While the Fed did not implement any of our favourite proposals, the Fed eased monetary policy by stopping the exit strategy and reinvesting principal payments from agencies in longer-term Treasuries. The direct benefits of such QE-lite are minor. However, the good news is that this action by the Fed should be interpreted as a signal that further easing will be forthcoming if adverse economic developments continue.

Really good links - Fed - QE

2010-08-10T15:55:00.000+03:00

Tim Duy - Fed - "That said, despite Fedspeak that appears resistant to further easing, the press has been fueling speculation that more easing - albeit largely symbolic - is imminent. From where does this chatter emanate, other that unnamed sources? Perhaps from high ranking staff. Word on the street is that Fed staff are increasingly frustrated with the lack of action from leadership."

Tyler Cowen - Will QE work? - "I hold the default belief that such policies could prove effective today. There's also the broader point that QE can work by stimulating AD, without having to push around long rates very much."

Really good links - QE2 - Bernanke - Eurozone breakup - Housing boom - China bubble

2010-08-09T12:16:00.000+03:00

Ambrose Evans-Pritchard - QE2 - "After digesting Friday's jobs report, Goldman Sachs' chief economist, Jan Hatzius, thinks the Fed will abandon its exit strategy and relaunch QE this week, taking the first "baby step" of rolling over mortgage securities. Future asset purchases may be "at least $1 trillion". He is not alone. Every bank seems to be gearing up for QE2, even the inflation bulls at Barclays. The unthinkable is becoming consensus.
<..>
   Unfortunately, such obscurantism is taking hold in the US as well. Alabama Senator Richard Shelby has blocked the appointment of MIT professor Peter Diamond to the Fed Board, ostensibly because he is a labour expert rather than a monetary economist but in reality because he is a dove in the ever-more bitter and polarised dispute over QE.
   The Senate has delayed confirmation of all three appointees for the board, who all happen to be doves and allies of Fed chairman Ben Bernanke. The Fed is in limbo until mid-September. So the regional hawks who so much misjudged matters in 2008 have unusual voting weight, and now they have a commodity spike as well to rationalise their Calvinist preferences.
   Whatever Dr Bernanke wants to do this week - and I suspect he is eyeing the $5 trillion button lovingly - he cannot risk dissent from three Fed chiefs: one yes, two maybe, but not three. He faces a populist revolt from the Tea Party movement, with its adherents in Congress and the commentariat."

Tim Duy - Bernanke does not appear overly concerned with the incipient second half slowdown - "Bottom Line: The Fed shows no sense of urgency with respect to the current economic situation, and appears prepared to endure a weaker second half with no policy shift. Moreover, even if the economy does worsen more than they expect, the likely candidates for policy action are more smoke than fire. The Fed knows this, and doesn't want to lose credibility on actions with little likelihood of success. A more aggressive policy stance Gagnon-style appears off the table as long as the Fed fears the possibility that such policy might actually work and push up long term rates. That means more significant action only after outright deflation expectations are evident. Appears extreme, but central bankers tend to be a conservative lot. Lacking a financial crisis, the need for more action is not apparent to them. They fundamentally believe they have done pretty much all that can be reasonably expected. Moreover, we need to reassess the Fed's inflation comfort level; they may think they are hitting one mandate just fine."

Tyler Cowen - Collapse of the Eurozone - "You might think that the collapse of the current Eurozone, and the devaluations, are good in the longer run (I do), but in the short run the entire process would be a nasty, volatility-laden, solvency-revaluing shock to the entire global economy."

Scott Sumner - Housing boom - "So here is my suggestion. Never reason from a price change. Don’t ever say “oil prices will be high next year; hence I expect oil consumption to decline.” That’s bad reasoning. And don’t ever talk about high or low interest rates causing some sort of change in the economy. Instead say something like ”I believe the high tech bust helped boost the housing industry.” That sort of reasoning is consistent with the central idea of economics—scarcity. If less resources are devoted to making one type of capital good, then you’d expect more resources to be devoted to making other types of capital goods. Interest rates are merely the transmission mechanism that facilitates the “recalculation.”
   Of course I am not suggesting that the tech bubble bursting caused the housing boom. GGG find only about 20% of the boom is explainable via interest rates, and the tech bubble bursting is just one of many variables that can affect real interest rates. High Asian savings rates are another factor, and Fed policy is a third. However, the liquidity effect is less significant than usually assumed, as interest rate changes far more often reflect economic conditions than exogenous changes in Fed policy. So even if low interest rates had caused the housing boom, you would still not be able to claim that a Fed easy money policy contributed to the housing boom. "

Edward Chancellor - How states nurture bubbles and strife - "The part played by governments in fostering financial crises is not just a matter of historical interest. Beijing is engaged in another risky experiment in bubble economics.
   Last year the Chinese authorities instructed state-controlled banks to boost their loan books by a third. The result has been a rapid pick-up in real estate prices and construction.
   A recent National Bureau of Economic Research paper, Evaluating Conditions in Major Chinese Housing Markets, notes that Beijing land prices have nearly tripled since early 2008. Land sales have become the main source of income for local governments.
   These sales also support some Rmb10,000bn (£946bn, €1,129bn, $1,475bn) of bank loans to local government infrastructure projects. Meanwhile, Chinese banks are repackaging their loans and selling them on to investors, says Fitch."

Should Fed stop paying interest on reserves?

2010-08-04T22:21:00.003+03:00

FT Alphaville asks:

Is the policy of continuing to pay interest on the bank reserves held at the Federal Reserve a good idea, a bad idea, or completely irrelevant?

The quick answer is that Fed should stop paying interest on reserves in the process of driving fed funds rate down closer to zero. But with many serious misconceptions about interest on reserves floating around a longer discussion is needed.

Paying interest on reserves is expansionary

Milton Friedman in 1959 advocated the policy of paying interest on reserves held at central bank. He was worried that if reserves earn no interest, this is equivalent to a distortionary tax on reserves. This distortionary tax harms the activities of banking sector and the whole economy.

Recent research by Vasco Curdia and Michael Woodford supports Milton Friedman's conclusion that paying interest on reserves is a good idea. Curdia and Woodford explain that there are three independent dimensions of monetary policy: target for the federal funds rate, credit policy (funds lent to the private sector by central bank) and interest rate paid on reserves. Curdia and Woodford show that if federal funds rate is held constant, higher levels of interest on reserves are associated with lower lending spreads and higher levels of economic activity. When central bank removes artificial scarcity of reserves that was caused by zero interest rates on reserves, the quantity of reserves increases and commercial banks can expand lending even though fed funds rate stays the same. This is why some countries like Canada and New Zealand have long ago started paying interest on reserves.

Credit crisis and the start of interest on reserves program in September/October 2008

If we return to the above-mentioned three independent dimensions of monetary policy, it is important to note that the only dimension of policy that Fed got right during the crisis was interest on reserves policy (IOR policy). Starting in October 2008, Fed began moving interest rate paid on reserves closer to fed funds rate. As recommended by Curdia and Woodford, eventually these two interest rates became equal. Alas, Fed has misjudged the severity of credit crisis and federal funds rate was not cut fast enough, and despite multitude of acronyms such as TALF, Bernanke's credit policy was too weak to save the economy.

Critics of the IOR policy

Fed's IOR policy was immediately criticized by James Hamilton and David Beckworth. But their criticism suffers from two shortcomings. First, they picked the wrong target by saying that interest rate paid on reserves is too high. Because the primary tool used by the Fed is fed funds rate, Hamilton and Beckworth should have argued instead that fed funds rate is too high. Second, it is not true that hoarding by banks of massive quantity of excess reserves under IOR regime is somehow more harmful than hoarding of a small quantity of required reserves under previous zero interest rate regime.

Scott Sumner, another famous critic of IOR, deserves a separate mention. He focuses on opportunity cost of reserves. He argues that interest paid on reserves discourages lending by providing alternative source of income to banks. This is not true. Under IOR policy the opportunity cost of reserves is IOR rate. However, under previous zero IOR policy regime opportunity cost of reserves was not zero, because quantity of reserves was artificially scarce, and banks were willing to hold reserves that pay zero interest, because they were earning liquidity related convenience yield. The size of such convenience yield is equal or greater than fed funds rate, so IOR policy does not reduce the willingness of banks to lend.

What the Fed can do?

Back in February we warned that "extended period of exceptionally low levels of the federal funds rate will last longer than many think." Developments since then have vindicated this forecast, as markets have postponed the date they think the Fed will start raising interest rates; in addition to that, TIPS market is indicating that inflation will be lower than Fed's implicit target of 2% during next five years, this means that aggregate demand is too low and monetary policy is too tight.

Current target of federal funds rate is the range of 0.00 - 0.25. The Fed should cut federal funds rate target to zero; and the Fed should stop paying interest on reserves while fed funds rate is zero. The primary benefit of such move is that a signal would be sent to markets that a majority of FOMC members believe they should combat deflationary shocks, thus providing at least a short term support to stock market. Direct benefits of 25bps reduction are not so large, as Stephen Williamson says:

"Now, what would be the effects of a decrease in IROR to zero? As Bernanke says, not much. Reserves would become slightly less attractive to banks, and in the course of trying to shed them, the price level would rise by a small amount, reserves would fall, and the quantity of currency (in nominal terms) would rise."

The most important steps that the Fed should take are different. First, the Fed should be more explicit about policy goals and should switch to explicit target of price level path, or even better, nominal income path. Second, the Fed should restart the support of private credit markets by purchasing commercial investment grade-bonds with maturities of up to three years.

Really great links - What is the Fed thinking? - Time-varying capital requirements - Stress testing central banks

2010-08-03T11:57:00.000+03:00

Arnold Kling - Cynical explanation for the Fed's actions - "If the Fed were to make a dramatic change, it would have to explain what it is doing. This is always a problem for the Fed, where part of the mystique comes from its vague communication about policy. Even worse, it probably would have to be specific about the target that it is aiming for, such as future nominal GDP (Scott Sumner's favorite) or inflation (DeLong's choice). Any time you announce a target ahead of time, you do two things:
   a) you reduce the significance of the open market committee. With the target in place, policy is set. What the Fed does in the money market to try to hit the target becomes an operational/technical question, not a policy question. So a lot of people lose the prestige that they enjoy when policy is subject to frequent reviews and can be changed ad hoc.
   b) you run the risk of missing the target (what if that nutcase Kling turns out to be correct about monetary impotence?), and that would damage the Fed's prestige, perhaps irreparably.
   So, from a status-preservation point of view, I can understand why the Fed would not do what seems to make the most economic sense from a textbook macro perspective."

Samuel Hanson, Anil Kashyap, Jeremy Stein - A Macroprudential Approach to Financial Regulation (pdf) - Time-Varying Capital Requirements - "One intuitively appealing response to the problem of balance-sheet shrinkage is to move to a regime of time-varying capital requirements, with banks being asked to hold higher ratios of capital to assets in good times than in bad times. This way, when an adverse shock hits, banks can draw down their buffers, and continue operating with less pressure to shrink. Kashyap and Stein (2004) argue that time-varying capital requirements emerge as an optimal scheme in a model where the social planner maximizes a welfare function that weights both: i) the microprudential objective of protecting the deposit insurance fund; and ii) the macroprudential objective of maintaining credit creation during recessions. The idea is that in bad times, when bank capital is scarce and credit supply is tight, it is optimal for a planner concerned with both objectives to tolerate a higher probability of bank failure than in good times.
   A challenge in designing such a regime is that in bad times, the regulatory capital requirement is often not the binding constraint on banks. Rather, as the risk of their assets rises, the market may impose a tougher test on banks than do regulators, refusing to fund institutions that are not strongly capitalized.5 Table 1 shows that, as of 2010Q1, the four largest U.S. banks had an average ratio of total Tier 1 capital to risk-weighted assets (RWA) of 10.7%, and an average ratio of Tier 1 common equity to RWA of 8.2%.6 These are both well above the regulatory standard, which requires a ratio of total Tier 1 capital to RWA of 6% for a bank to be deemed “well capitalized”. Thus even as we emerge from a deep financial crisis, the regulatory constraint is manifestly non-binding.
   This implies that in order to achieve meaningful time-variation in capital ratios, the regulatory minimum in good times must substantially exceed the market-imposed standard in bad times. Thus if the market-imposed standard for equity-to-assets in bad times is 8%, and we want banks to be able to absorb losses of, say, 4% of assets without pressure to shrink, then the regulatory minimum for equity-to-assets in good times would have to be at least 12%.
   Moreover, a loss on the order of 4% of assets is actually less severe than the experience of the major banks during the recent crisis; the IMF (2010) estimates that cumulative credit losses at U.S. banks from 2007 to 2010 will be on the order of 7% of assets. Using this figure, one could argue for a good-times regulatory minimum ratio of equity-to-assets of 15%. Either way, these are high values, significantly higher than obtained from a microprudential calculation that asks only how much capital is needed to avert failure."

Terrence Keeley - Now let us stress-test the central banks - "The European Central Bank, Federal Reserve and Bank of England have the advantage of denominating the bulk of their assets and liabilities in the same currencies. With combined balance sheets of 20 per cent of their collective GDP, however, their credit and interest rate exposures are no less worrisome than the foreign currency translation risks faced by their Swiss and Asian counterparts.
   It is now estimated that the European System of Central Banks (ESCB) owns as much as 40 per cent of Greek and 20 per cent of Spanish government bonds outstanding. Depending on their severity, federal debt restructurings for Greece and Spain could generate billions in losses for the ESCB. In the case of the Fed, with more than a trillion dollars’ worth of US mortgages now in hand, a 1 per cent increase in US interest rates could generate marked-to-market losses of as much as $50bn. This is more than the entire profit the Fed paid to the US Treasury last year."

Administrivia - Subheading of the blog was changed from "Delicious Journeys Through Macroeconomics for the Purpose of Making Central Bankers Visibly Uncomfortable in the Presence of Really Great Links about Their Errors" to ""If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008".

Really great links - Recession warning - Ice Age - Black Friday - TARP

2010-07-30T16:21:00.000+03:00

John Hussman - Recession warning - "Based on evidence that has always and only been observed during or immediately prior to U.S. recessions, the U.S. economy appears headed into a second leg of an unusually challenging downturn."

Albert Edwards - Ice Age - "We are at the most dangerous stage in the Ice Age – the ‘post-bubble cycle’. For although it is clear that leading indicators have turned downwards, the choir of sell-side sirens is singing its song of reassurance. The lesson from Japan was that once the cyclical rally is over, any downturn in the leading indicators should find you stuffing beeswax in your ears to block out that lilting melody so as to avoid the jagged rocks of recession.
   My views on the outlook could not be clearer. They may be wrong, but at least they are clear. We still call for sub-2% 10y bond yields and equities below March 2009 lows.
   I have for a very long time likened events now unfolding with what we saw in Japan a decade ago. Of course there are some major differences, but one can still draw clear parallels to see how extreme equity overvaluations unwind in a post-credit bubble world.
   I have long maintained that even within a structural bear market, there are huge returns to be made in equities from participating in short-lived cyclical rallies like the one we have just seen. The Nikkei regularly used to enjoy 40-50% rallies as policy stimulus drove pronounced cyclical upturns in both GDP and profits. You had to remember however that you were still in a structural bear market and you had to get out when the cycle began to top out. A downturn in the leading indicators proved to be a very useful sell signal for equity investors."

Craig Pirrong - Black Friday, 24 September, 1869 - "I have long been fascinated by Black Friday, 24 September, 1869. On that day, a massive corner in gold collapsed, throwing the American financial system into chaos.
   My initial interest in the subject stemmed from my interest in corners <..>. The episode shows how corners work; how they can fail; and interestingly, illustrates some of the game theoretic aspects of corners. Specifically, Fisk and Gould were in a prisoners’ dilemma, and in the event, Gould ratted out on Fisk, selling when prices were driven up at the end by a surge of Fisk buying. When Fisk stopped buying, the price collapsed, leaving Fisk with a boatload of losses, and Gould with a nice gain. (Gould was actually selling to his erstwhile partner Fisk in some of his trades.)
   But Black Friday also relates to one of my other obsessions–clearing. Since about 1997, I’ve used the story of Black Friday to show that (a) clearinghouses can fail, and (b) that the consequences of said failure are catastrophic."

Tweet of the day - Garett Jones - TARP - "U.S. Stock Mkt Cap: $15T. Fall in stocks when House rejected TARP: 7%=$1T. P(PermReject|Vote)=1/3. So value of TARP=$3T."

Really great links - Next credit crisis - Choc-finger - Monetary aggregates -

2010-07-27T16:05:00.000+03:00

Craig Pirrong - Capital standards and the next crisis - "Enhanced capital requirements are again being touted as a way of preventing the next crisis. But the Basel Rules were a response to a crisis–the Latin American debt crisis–that paved the way for the next one.
   If the incentive system encourages financial institutions to take on tail risks (due, for instance, for implicit government guarantees), those institutions will find the vulnerabilities in the capital requirements through which they can smuggle such risks onto their balance sheets, like hackers identifying and exploiting each new vulnerability in Windows.
   The existence of vulnerabilities is inevitable–no centrally created set of risk prices will be even close to right. Which means that enhanced capital requirements provide a false sense of security.
   The problem is that the ability of the institution that can price risks more accurately–the capital markets–is fatally undermined by the very real prospect of bailouts of institutions that fail. That is the Original Sin, and as long as we remain in that fallen state, a future crisis is almost inevitable, capital requirements or no. Indeed, the main effect of capital requirements as implemented will be to determine exactly what causes the crisis, not the likelihood of its occurrence."

Craig Pirrong - Chocolate Kisses, or the Financial Times in the Tank - "In this case, it appears that Armajaro already had customers for the cocoa delivered to it. See!, the commentor says, there is real demand, real customers. Well, if you know anything about manipulation, you know that the biggest danger is related to burying the corpse of the manipulation: that is, selling the massive deliveries that you take to squeeze the market. A clever fellow bent on manipulating the market pre-arranges the funeral. If the reports about forward sales of old crop cocoa to processors are correct, that was done in this case. So, rather than being exculpatory, such sales are actually evidence of manipulative intent.
<..>
   The other common excuse, again seen in my SA comments, is that the stuff that is delivered will be consumed. Well, duh. It’s not like the guy is going to eat it all himself, or burn it, or build houses out of cocoa beans. It is going to be consumed. But manipulation distorts consumption pattens–the timing and location of consumption. The stuff is consumed, but in the wrong place at the wrong time, and too much of it is shipped around to the wrong places. The fact that the delivered cocoa will eventually be consumed does not imply that the deliveries are efficient.
   All in all, none of the arguments raised in Armajaro’s defense are even remotely exculpatory, and some are actually adverse. A final judgment would require a full forensic and econometric evaluation of prices, pricing relationships, price-quantity relationships, and movements of cocoa. Time permitting I hope to do some of that. But at this juncture, there is sufficient evidence to conclude that there is a colorable case against Armajaro, and that the arguments raised in its defense are risible.
   Taking huge deliveries in a large backwardation is consistent with manipulation. This is especially true when one party takes all the deliveries. Delivery economics are pretty straightforward, and if they work for one party they tend to work for several. One firm taking all of the deliveries is suspect."

Jürgen Stark - Member of the Executive Board of the ECB - Analysis of M3 and other monetary aggregates - "Money has been ignored. In the canonical New Keynesian macro-model on which the intellectual foundations of inflation targeting rests, money has been considered a redundant element in the monetary transmission mechanism. At best, money is seen as a useless appendix to the model, serving only to confuse and distract any policy-maker misguided enough to consider it. Now that the financial crisis has exposed the fault lines underlying this model...
<...>
   The timing of this work in 2007 to enhance monetary analysis was most opportune. Having faced excessive money growth for years, we were indeed perceiving severe challenges. The calls we received at the time were to simply ignore them. We did not find reassurance in these calls. We remained uneasy, but we had no idea ex ante how the excesses in money and credit would eventually unwind.
   At the time, we issued warnings about upside risks to inflation. Eventually the imbalances manifested themselves in successive asset price collapses, a systemic banking crisis, a sharp deceleration in money and credit growth, and a precipitous fall in output.
   Despite our humble performance as economists in forecasting this specific sequence of events, no one can credibly claim that what actually materialised was the most likely among a range of possible scenarios. I think it is fair to say that in order to contain risks to price stability – whether to the up or the downside – there was a pressing need to head off these excesses, instead of dealing with them after the fact.
<...>
   Because of the current financial stability issues, we have been applauded for the monetary analysis, but we are again called to limit its scope. Previously we were asked to plug monetary information into an inflation forecast. Now we are being asked to plug it into the emerging framework for macro-prudential analysis. As a by-product, monetary analysis may both help and be helped by the analysis of bank balance sheets for macro-prudential purposes. However, we do not want to limit monetary analysis to this end. We need to maintain a comprehensive view of the transmission of money to the economy and to focus on pursuing price stability, in line with our mandate."

Really great links - Misallocating resources - Death of paper money - Austerity - DeLong vs. Rogoff

2010-07-26T12:04:00.004+03:00

John Hussman - Misallocating resources - "Since the late 1990's, many employees have earned paychecks for producing capital goods that did not turn out to be worth what companies spent, and consumers have received loans for amounts which they are not actually able to repay. Both of these outcomes have been the economy's way of forcing a large but rather overlooked "correction" in the income distribution back from corporate profits (and by extension shareholders) and toward the average American worker.
   All of this is extraordinarily inefficient, because some people have effectively received windfalls (for example, those who sold their homes at the top of the real estate bubble, and those who have defaulted on large amounts of consumer credit), while other hard-working people have been stiffed. But one way or another, the equilibrium outcome of the economy has been to ensure - whether the transfer of purchasing power was voluntary or not - that American workers were able to purchase the output that was actually produced by the economy.
   What's fascinating about this, however, is that shareholders are still ignoring it. They also ignore the large percentage of reported earnings that are actually quietly distributed to corporate insiders through the issuance of stock and options. They blindly accept that "share repurchases" are somehow a pleasant distribution of earnings, whereas the majority of share repurchases are actually made by companies to do nothing more than offset the dilution from stock shares and options granted to insiders. A good question to ask in the years ahead, immediately after profits are reported, is "how much of this figure is actually delivered to shareholders?" If you've been attentive over the past decade, the answer turns out to be much closer to the dividend yield than to the operating earnings yield that companies have reported.
   For a moment, at least, it is good to be a corporate insider, particularly at major financial companies. First, you get to report productivity gains and "operating profits" - not by making smart investments in productive assets, but instead by writing up debt thanks to Treasury intervention, by misstating your balance sheet thanks to FASB changes last year, and at industrial firms, by cutting the number of workers per unit of capital. Next, you quietly write off large losses on bad investments and unrecoverable loans as "extraordinary expenses," to which investors pay no notice. And to add insult to injury, you deliver a significant portion of the remaining profits to yourself as "incentive compensation," followed by buybacks of stock to offset the dilution, which investors actually cheer because they don't realize they've been taken for suckers."

Ambrose Evans-Pritchard - Velocity of paper money - "The crucial passage comes in Chapter 17 entitled "Velocity". Each big inflation -- whether the early 1920s in Germany, or the Korean and Vietnam wars in the US -- starts with a passive expansion of the quantity money. This sits inert for a surprisingly long time. Asset prices may go up, but latent price inflation is disguised. The effect is much like lighter fuel on a camp fire before the match is struck.
   People’s willingness to hold money can change suddenly for a "psychological and spontaneous reason" , causing a spike in the velocity of money. It can occur at lightning speed, over a few weeks. The shift invariably catches economists by surprise. They wait too long to drain the excess money.
   "Velocity took an almost right-angle turn upward in the summer of 1922," said Mr O Parsson. Reichsbank officials were baffled. They could not fathom why the German people had started to behave differently almost two years after the bank had already boosted the money supply. He contends that public patience snapped abruptly once people lost trust and began to "smell a government rat".
   Some might smile at the Bank of England "surprise" at the recent the jump in Brtiish inflation. Across the Atlantic, Fed critics say the rise in the US monetary base from $871bn to $2,024bn in just two years is an incendiary pyre that will ignite as soon as US money velocity returns to normal."

Brad DeLong - Austerity - "Well, history tells us that there are times and circumstances when countries’ refusal to listen to calls for retrenchment and austerity has led to economic disaster. Times when a country’s supply of savings is inelastic and more government borrowing leads to sharp rises in and high real interest rates are times in which government budget deficits have drained the pool of savings, reduced private investment, and slowed growth--as they did in the U.S. in the second Reagan and the first Bush administration. Times when monetary and fiscal laxity leads to an expectation that government debt will be monetized and to rapid rises in inflation expectations are times in which policy has made a deep recession to restore price stability inevitable--as happened in the U.S. in the Nixon, Ford, and Carter administrations. And times when irrational exuberance on the part of foreign investors leads a country’s public or private sector to borrow heavily in foreign currency, it needs to pre-emptively retrench before foreign investor exuberance wears off, or else--as happened to East Asia in 1997-8, to Mexico in 1994-5, or to Argentina innumerable times since 1890."

Brad DeLong - Rogoff is wrong on debt worries - "Prof Rogoff sees the economy now as suffering from structural maladjustments generated by the expansion of the 2000s in which workers must be trained in new kinds of jobs and shifted over to different sectors in which they have no previous experience, and that that process cannot proceed rapidly without generating inflationary pressures that will destabilise confidence in price stability. I see an economy in which there is enormous slack pretty much everywhere – empty retail storefronts in Berkeley just to my left, anyone? – in which even the US housing stock is no longer above its trend, and in which we are currently building houses at half the trend pace. If output in even our single-family residential-housing sector is significantly depressed below its steady-state growth value – if, economy-wide, 10 per cent of the spending that ought to be there is missing – then we need not policies that carefully create new jobs only in the appropriate sectors but instead policies that create new jobs pretty much anywhere."

Really great links - Time for monetary stimulus - Fiscal future

2010-07-23T01:03:00.000+03:00

Joseph Gagnon - Time for a monetary boost - "Clearly, the case for monetary stimulus is strong. But what form should it take? With financial markets now in healthier shape, the Fed does not need to invoke the "unusual and exigent circumstances" clause to lend directly to the private nonbanking sector. Rather, it should return to its traditional roles of lending to the banking system and buying Treasury securities. Three actions, in particular, would be helpful at this time.
   First, the Fed should lower the interest rate it pays on bank reserves to zero. This is a small step, as the current rate is only 0.25 percent, but there is no reason to pay banks more than the rate paid by the closest substitute, short-term Treasury bills. Three-month Treasury bills currently yield 0.15 percent, and that rate, too, should be brought down to zero.
   Second, the Fed should bring down the rates on longer-term Treasury securities by targeting the interest rate on 3-year Treasury notes at 0.25 percent and aggressively purchasing such securities whenever their yield exceeds the target. That is a 65-basis point reduction from the current rate of 0.90 percent. This step would also push down longer-term yields and reduce a wide range of private borrowing rates, encouraging business investment, supporting the housing market, and boosting exports through a weaker dollar. Moreover, pushing down yields on short- to medium-term Treasury securities is precisely the strategy for fighting deflation recommended by Ben Bernanke in 2002.
   Finally, the Fed could bolster the stimulative effects of these actions by establishing a full-allotment lending facility to enable banks to borrow (with high-quality collateral) at terms of up to 24 months at a fixed interest rate of 0.25 percent."

Niall Ferguson - Today’s Keynesians have learnt nothing - "When Franklin Roosevelt became president in 1933, the deficit was already running at 4.7 per cent of GDP. It rose to a peak of 5.6 per cent in 1934. The federal debt burden rose only slightly – from 40 to 45 per cent of GDP – prior to the outbreak of the second world war. It was the war that saw the US (and all the other combatants) embark on fiscal expansions of the sort we have seen since 2007. So what we are witnessing today has less to do with the 1930s than with the 1940s: it is world war finance without the war.
   But the differences are immense. First, the US financed its huge wartime deficits from domestic savings, via the sale of war bonds. Second, wartime economies were essentially closed, so there was no leakage of fiscal stimulus. Third, war economies worked at maximum capacity; all kinds of controls had to be imposed on the private sector to prevent inflation.
   Today’s war-like deficits are being run at a time when the US is heavily reliant on foreign lenders, not least its rising strategic rival China (which holds 11 per cent of US Treasuries in public hands); at a time when economies are open, so American stimulus can end up benefiting Chinese exporters; and at a time when there is much under-utilised capacity, so that deflation is a bigger threat than inflation.
   Are there precedents for such a combination? Certainly. Long before Keynes was even born, weak governments in countries from Argentina to Venezuela used to experiment with large peace-time deficits to see if there were ways of avoiding hard choices. The experiments invariably ended in one of two ways. Either the foreign lenders got fleeced through default, or the domestic lenders got fleeced through inflation. When economies were growing sluggishly, that could be slow in coming. But there invariably came a point when money creation by the central bank triggered an upsurge in inflationary expectations."

Really great link - Financial reform that should have happened

2010-07-19T11:34:00.000+03:00

The Money Demand blog is on a holiday and will return on Friday. Meanwhile, here is a link to one of the better financial reform proposals. Alas, the "reform" that we have have now will do nothing to prevent the credit boom-bust cycle.

Really great links (precognition edition) - Tyler Cowen - Jeremy Grantham

2010-07-13T11:20:00.000+03:00

Tyler Cowen (January 2005) - If I believed in Austrian business cycle theory - "1. I would think that Asian central banks, by buying U.S. dollars, have been driving a massive distortion of real exchange and interest rates.
   2. I would think that the U.S. economy is overinvested in non-export durables, most of all residential housing.
   3. I would think that we have piled on far too much debt, in both the private and public sectors.
   4. I would think these trends cannot possibly continue."

Jeremy Grantham (September 2007) - Danger: Steep drop ahead - "But even if this crisis is contained, we are facing some near certainties that should be understood.
   First, house prices may move on euphoria in the short term, but long term they depend on family income - the ability to pay mortgages and rent. At levels well above the normal four times family income, the market gradually loses first-time buyers until prices break and fall back to affordable levels.
...
   Second, profit margins are at record levels around the world. They have lifted stock prices directly alongside the rising earnings. They have served to raise P/E multiples as well, for surprisingly, investors on average reward higher margins with higher P/Es. This is fine for an individual stock, but for the entire market, multiplying boom-time profits by high P/Es is horrific double counting and sends markets far too high in good times (and far too low in bad times).
...
   Third, and most important, risk will be repriced. Last year a broad base of risk measures - including volatility (VIX), junk and emerging debt spreads, CD rates, high-quality vs. low-quality stock values - reflected the lowest risk premiums in history. On some data, indeed, investors actually appeared to be paying for the privilege of taking risk."

Really great links - Macroeconomic tail risks - Keynes and Geithner

2010-07-08T13:36:00.001+03:00

Brad DeLong - Macroeconomic tail risks - "What is the "macroeconomic tail risk" which, Gabaix claims, it is individually rational for businesses to fear, and hence makes it collectively and socially rational for businesses to save and refuse to invest?
   Gabaix never says.
   Is it a fear that we will suddenly forget the past generation of progress in technology and organisation, and that only businesses with cash will be able to regroup and survive and evolve business models that will fit our reversion to the technologies of the 1970s? No. Is it a fear that workers will suddenly develop a very strong taste for leisure and that as a result real wages will have to rise massively, and that only businesses with cash will be able to regroup and evolve new business models that will fit the new higher-real-wages economy? No. Yet those are the only two "macroeconomic tail risk" shocks I can think of that would make it socially and collectively rational for businesses as a group to refuse to invest in new capacity right now—for, after all, whatever new capacity we build will be unusable if we forget our technological knowledge, and unprofitable if the real wage rises massively. Thus I believe that Professor Gabaix is hopelessly confused when he claims that "macroeconomic tail risk" makes it socially and collectively rational—"optimal" is the word he uses—for businesses to save rather than invest.
   The macroeconomic tail risk that businesses today fear is not a Great Forgetting of technology and organisation or a Great Vacation on the part of the North Atlantic labour force. The macroeconomic tail risk that businesses fear is another breakdown of the credit channel: a situation in which banks dare not lend because they cannot themselves raise funds, and they cannot themselves raise funds because every possible source fears that the bank itself is underwater—has no skin in the game of intermediating the flow of funds and every incentive to gamble for resurrection by playing a game of "heads I profit, tails you pay" with its creditors. Asset price declines that impair the capital of financial intermediaries greatly magnify the principal-agent problems of finance, and it is that magnification of principal-agent problems and consequent cutoff of their own access to additional funding when they need it that underpin business desires to boost their holdings of safe, high-quality financial assets at the expense of their ownership of real physical capital."

John Hussman - Keynes and Geithner - "The Keynesian view is that government spending is simply a monolithic letter "G." Keynes cared little about the productivity or lack thereof to which public resources were devoted, even writing " If the Treasury were to fill old bottles with bank-notes, bury them at suitable depths in disused coal-mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again... there need be no more unemployment." The only difference between Keynes and Tim Geithner is evidently that Geithner prefers to place the bottles a bit closer to Wall Street."

Really great links - Undervalued assets - Sticky wages - European stress tests - Trapped in depression - Greece

2010-07-05T10:00:00.002+03:00

Robert Hall - Interview with Minneapolis Fed - Q: What should be done by the Fed - A: "Well, it does point in the direction of focusing on things like lower rates for corporate bonds, BAA corporate bonds. They appear to be undervalued private assets, although that’s not been one of the types of assets that policy has seen as appropriate to buy or to help private organizations to buy. That would be one way to turn."

Alex Tabarrok - Sticky wage transmission mechanisms - "Tyler, for example, writes:

[Consider] illegal immigrant Mexican construction workers, a group which lost jobs in large numbers following the crash. Are they -- who often came from $1 a day environments -- also supposed to have sticky wages? They are out of work in massive numbers.

   The focus here is on the unemployed workers with the argument implicit that it's the stickiness of their wages which counts (which makes sense given the standard story). But suppose that the problem is that firms can't get capital to expand--perhaps because the banking system is not working well--then what matters for firm expansion is free cash flow. But sticky wages keep firm costs high, reducing free cash flow "

Yves Smith - European stress test - "Imitation is the most sincere form of flattery. The ECB and European bank regulators are copying the US playbook for the stress tests, with results for 100 banks expected to be released around July 23. But the European authorities seem to have failed to understand why the US effort worked. The first was that Team Obama is particularly good at PR, and it used those skills to full advantage. Despite considerable evidence otherwise, it got the press to convey the message that the tests were tough, and the banks really were sound. Second, Geithner & Co. had a kitty they could draw on.
   By contrast, the Europeans have been simply dreadful at the optics of their various rescue operations, with disarray and disagreements covered extensively by the media. Admittedly, this exercise is being conducted by bank regulators, so it is likely to be more cohesive, but “more cohesive”, with a process involving agencies in different countries, may not be cohesive enough. And “show me the money” is a major problem. The reason for this exercise is concern over possible sovereign debt losses. Who is going to back up the banks at risk? Um, sovereign states, admittedly ones not considered at risk of default (France and Germany), but whose ability to bail out their own banks is limited for practical and political reasons."

Ambrose Evans-Pritchard - Trapped in depression - "It is obvious what that policy should be for Europe, America, and Japan. If budgets are to shrink in an orderly fashion over several years – as they must, to avoid sovereign debt spirals – then central banks will have to cushion the blow keeping monetary policy ultra-loose for as long it takes.
   The Fed is already eyeing the printing press again. "It's appropriate to think about what we would do under a deflationary scenario," said Dennis Lockhart for the Atlanta Fed. His colleague Kevin Warsh said the pros and cons of purchasing more bonds should be subject to "strict scrutiny", a comment I took as confirmation that the Fed Board is arguing internally about QE2.
   Perhaps naively, I still think central banks have the tools to head off disaster. The question is whether they will do so fast enough, or even whether they wish to resist the chorus of 1930s liquidation taking charge of the debate. Last week the Bank for International Settlements called for combined fiscal and monetary tightening, lending its great authority to the forces of debt-deflation and mass unemployment. If even the BIS has lost the plot, God help us."

John Dizard - It’s no secret: Greece is restructuring debt - Healthcare system liabilities - "You don't need to be a secret agent to find out that Greece has started to restructure its state debts"

Really great links - Panic of 2007 - Pass the parcel - Tax cuts - Marginal product of capital

2010-07-01T13:29:00.000+03:00

Joseph Tracy, Executive Vice President, NY Fed - Panic of 2007 - "There are many parallels between the Panic of 1907 and the events of 2007. In both cases, credit intermediation had shifted outside of the core banking sector. An investment boom preceded each panic—the earlier in copper and the later in housing—with much of the credit being funded by sources outside of any existing liquidity protections. When the bubbles began to deflate and prices began to fall, loan defaults quickly developed precipitating funding runs on the institutions involved in extending this credit. What seemed like large liquidity buffers by individual firms were quickly drawn down. Funding withdrawals precipitated asset sales, which put further downward pressure on asset prices. The resulting credit contractions adversely affected the real economy, setting up an adverse feedback loop that exacerbated the initial losses.
   Given the parallels between the events of 1907 and 2007 and, more importantly, the similarities of the lessons learned from those episodes, I believe the most instructive name for our latest financial crisis is the "Panic of 2007." In the rest of my remarks, I will explore in greater detail the factors behind the panic, as well as the responses by the Federal Reserve.
...
   If the lessons from the panics of 1907 and 2007 are incorporated into the reforms, we may well avoid the Panic of 2107."

Martin Wolf - This global game of ‘pass the parcel’ cannot end well - "Our adult game of pass the parcel is far more sophisticated: there are several games going on at once; and there are many parcels, some containing prizes; others containing penalties.
...
   So here are four such games. The first is played within the financial sector: the aim of each player is to ensure that bad loans end up somewhere else, while collecting a fee for each sheet unwrapped along the way. The second game is played between finance and the rest of the private sector, the aim being to sell the latter as much service as possible, while ensuring that the losses end up with the customers. The third game is played between the financial sector and the state: its aim is to ensure that, if all else fails, the state ends up with these losses. Then, when the state has bailed it out, finance can win by shorting the states it has bankrupted. The fourth game is played among states. The aim is to ensure that other countries end up with any excess supply. Surplus countries win by serially bankrupting the private and then public sectors of trading partners. It might be called: “beggaring your neighbours, while feeling moral about it”. It is the game Germany is playing so well in the eurozone.
   What have these four games to do with the G20 summit? In a word, everything. The first game scattered toxic assets across the financial system. The second left the non-bank private sector with a debt overhang and deleveraging. The third duly damaged the finances of states. The fourth helped cause the crisis and is now an obstacle to recovery. Above all, these games are all linked to one another and so have to be changed together."

Gauti Eggertsson - What fiscal policy is effective at zero interest rates? - "Tax cuts can deepen a recession if the short-term nominal interest rate is zero, according to a standard New Keynesian business cycle model. An example of a contractionary tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it increases deflationary pressures. Another example is a cut in capital taxes. This tax cut deepens a recession because it encourages people to save instead of spend when more spending is needed. Fiscal policies aimed directly at stimulating aggregate demand work better. These policies include 1) a temporary increase in government spending; 2) temporary tax cuts directly aimed at stimulating aggregate demand rather than aggregate supply, such as an investment tax credit or a cut in sales taxes. The results are special to an environment in which the interest rate is close to zero, as observed in large parts of the world today."

Tweet of the day - Garett Jones - "Marginal product of capital that matters is net, not gross. MPK-depreciation rate<0 likely true when K not very useful."

Really great links - Germany - Dysfunctional Fed - Greece

2010-06-28T11:22:00.005+03:00

George Soros - Germany - "To be sure, Germany cannot be blamed for wanting a strong currency and a balanced budget but it can be blamed for imposing its predilection on other countries that have different needs and preferences - like Procrustes, who forced other people to lie in his bed and stretched them or cut off their legs to make them fit. The Procrustes bed inflicted on the eurozone is called deflation.
   Unfortunately Germany does not realize what it is doing. It has no desire to impose its will on Europe; all it wants to do is to maintain its competitiveness and avoid becoming the deep pocket to the rest of Europe. But as the strongest and most creditworthy country it is in the driver's seat. As a result Germany objectively determines the financial and macroeconomic policies of the eurozone without being subjectively aware of it. When all the member countries try to be like Germany they are bound to send the eurozone into a deflationary spiral. That is the effect of the policy pursued by Germany and - since Germany is in the driver's seat - these are the policies imposed on the eurozone."

Scott Sumner - Fed and fiscal policy - "My point is that fiscal stimulus must always be examined in the context of monetary policy. If you have conservative central banks that are rigidly targeting the price level, then fiscal stimulus may be ineffective. But in fairness to the other side, I’m sure you could build a plausible argument that under the sort of dysfunctional Fed described above, it might have a stimulative effect. Perhaps Bernanke is not strong enough to take any unconventional policy initiatives, but is strong enough to prevent the conservatives from inhibiting fiscal stimulus through a premature exit strategy. But as I said, I don’t think fiscal policy is very powerful even if there is no push-back from the Fed."

Michael Pettis - Greece - "Greece’s insolvency will not be recognized for many years.
When most of the obligations of an insolvent sovereign were widely dispersed among a wide variety of bondholders, market forces acted relatively quickly to force debt forgiveness. Defaulted bonds trade at deep discounts, and it is a lot easier for someone who bought the debt at one-quarter its face value to agree to 50% debt forgiveness than for someone who made the original loan.
   But things are different with the current crop of insolvent European sovereign debts, as they were with the sovereign loans of the 1970s. They are heavily concentrated within the banking system, and the banks cannot recognize the losses without themselves collapsing into insolvency.
   That cannot be allowed to happen. The LDC debt crisis of the 1980s raged on nearly a full decade – a decade of stopped payments, capital flight, and agonizingly low growth – before creditors formally acknowledged that most struggling borrowers could not repay their debt and would need partial debt forgiveness. The first formal recognition of debt forgiveness occurred with Mexico’s Brady Plan restructuring in 1990. Growth returned to most countries only after it became clear that they would receive debt forgiveness."

Really great links - Bank equity - China

2010-06-25T02:14:00.000+03:00

Andrew Smithers - Supporters of Capitalism Should Read This - "Bankers have brought capitalism into disrepute. To their traditional enemies on the Left they have added those who favour free markets. Despite the remarkable achievement of uniting such a broad spectrum of political opponents, bankers clearly expect to avoid retribution for their misdeeds. Supporters of capitalism, who want its benefits preserved, call for large increases in banks’ equity capital. US banks have responded by buying back their equity. The Left denounce the outrageous pay levels and bankers respond by awarding themselves huge additional bonuses.
These actions suggest that bankers, as a group, are not unduly sensitive people. But it is nonetheless incredible that they do not realise that large increases in their equity will be part of the new regulations. Their motive in buying back part of their already inadequate equity calls therefore for examination."

Scott Sumner - China - "Is there anywhere else in the world where a 1076-foot skyscraper would be built for “farmers” and located not in a city, but in the “countryside?”"

Really great links - Inflation - Deficits - Germany

2010-06-22T13:04:00.001+03:00

John Cochrane - Inflation - "The scenario leading to inﬂation starts with poor growth, possibly reinforced by to larger government distortions, higher tax rates, and policy uncertainty.
   Lower growth is the single most important negative inﬂuence on the Federal budget. Then, the government may have to make good on its many credit guarantees. A wave of sovereign (Greece), semi-sovreign (California) and private (pension funds, mortgages) bailouts may pave the way. A failure to resolve entitlement programs that everyone sees lead to unsustainable deﬁcits will not help.
   When investors see that path coming, they will quite suddenly try to sell government debt and dollar-denominated debt. We will see a rise in interest rates, reﬂecting expected inﬂation and a higher risk premium for U.S. government debt. The higher risk premium will exacerbate the inﬂationary decline in demand for U.S. debt. A substantial inﬂation will follow — and likely a “stagﬂation” not inﬂation associated with a boom. The interest rate rise and inﬂation can come long before the worst of the deﬁcits and any monetization materialize. As with all forward-looking economics, no obvious piece of news will trigger these events. Oﬃcials may rail at “markets” and “speculators.” Economists and the Fed may scratch their heads at the sudden “loss of anchoring” or “Phillips curve shift.”"

John Cochrane - Deficits and default - "Put another way, the U.S. problem, large prospective deficits with a relatively small stock of outstanding debt, would otherwise put us in a real fiscal pickle, since we can’t devalue debt we haven’t issued yet. Even an infinite price level — a default of all outstanding US debt, cutting future interest payments to zero — is not enough to pay for the CBO’s projections of Social Security and Medicare deficits. On the other hand, the fact that real surpluses increase with inflation makes it much more likely that the government will choose inflation rather than explicit spending cuts. Again, one should not think of surpluses as exogenous in this fiscal analysis. Really we should think of the Government’s decision to inflate, trading off distorting taxes, useful or politically popular spending, and the distortions caused by inflation, and the ability to place blame elsewhere in making this decision."

Tyler Cowen - Understanding German fiscal policy - "The Germans see themselves as having made the necessary wage adjustments, in advance, and in a manner that Keynesian economics is skeptical of. The Germans also see themselves as having produced and maintained true credibility about future fiscal policy (how many other countries can claim that?) by a constitutional amendment, a lot of tough talk, and a relatively robust real economy. German bonds are a safe haven investment, even though Germany's numbers, such as the debt-gdp ratio, are not overwhelmingly wonderful. That's a testament to German public sector management.
   Did I mention that -- after unification -- the Germans tried (against their will, they had to) more than a decade of massive fiscal stimulus, and subsidization of consumption, starting with well under full employment, and yet with mediocre results? That wasn't long ago."

Really great links - Stability - Congressman, Heal Thyself! - Dollar crisis - IMF - Sovereign CDS

2010-06-21T11:11:00.000+03:00

Anonymous hedge funder - Financial regulation and stability - "If there's one thing that I wish the regulators understood, it's that the worst blowups are ignited by bad trades that become a consensus stampede. In emerging markets, the crashes always traced back to something everybody considered "the trade of the year." This time, it was the strong and wrong consensus around housing values. The next one may arise from the assumption that developed-markets sovereigns don't default.
Stability depends on disagreement. A constructive regulatory regime would institutionalize disagreement-by, for example, increased risk-weighting for assets that are heavily owned-and, in automatic fashion, lean against monolithic consensus. Alas, politicians so unanimous in their views about the power of regulation to prevent crisis appear to be caught in a consensus stampede of their own."

Paul Kasriel - Congressman, Heal Thyself! - "On one of this past Sunday’s morning political talk shows, I heard a congressman say that the runaway federal government spending had to stop. Congressman, sir, although the spending continues to increase, the rate of growth in that spending has slowed enormously. In the 12 months ended May 2010, the accumulated spending by the federal government totaled $3.437 trillion, enough to keep the late Senator Dirksen spinning in his grave for near eternity. Although an admittedly high level, this 12-month accumulated total federal spending was only 2.6% higher than the 12-month accumulated total federal spending for May 2009 (see Chart 1). This is quite a deceleration in growth from the 15.3% registered for the 12 months ended 2009 vs. 2008, near the trough of the last recession. Moreover, the 2.6% year-over-year growth in the 12-month accumulated total federal outlays in May 2010 is considerably lower than the 8.4% year-over-year growth in the 12-month accumulated total federal outlays in May 2006. Why do I mention May 2006? Because at that time, the congressman’s political party controlled Congress and the White House. Congressman, heal thyself!"

James Hamilton - Inflation or deflation - "The source of my concern about long-run inflation comes not from the expansion of the Fed's balance sheet, but instead from worries about the ability of the U.S. government to fund its fiscal expenditures and debt-servicing obligations as we get another 5 or 10 years down the current path. Just as many analysts have had trouble seeing how Greece can reasonably be expected over the near term to move to primary surpluses sufficient to meet its growing debt servicing costs, I have similar problems squaring the numbers for the U.S. looking a little farther ahead.
The way that I would envision these pressures translating into inflation would be a flight from the dollar by international lenders, leading to depreciation of the exchange rate, increase in the dollar price of traded goods, and possible sharp challenges for rolling over U.S. Treasury debt. We've of course been seeing the exact opposite of this over the last few months, as worries in Europe and elsewhere have resulted in a flight to the dollar and the perceived safety of U.S. Treasuries. That appreciation of the dollar has been one factor keeping U.S. inflation down. So any inflation scare is clearly not an incipient development, but instead something we'd possibly face farther down the road."

Mark Copelovitch - IMF - "The domestic financial interests of the IMF's largest shareholders have been a critical determinant of variation in IMF lending policies over the last three decades. As the Fund's largest quota contributors, the "G-5" countries (the US, Germany, Japan, UK, and France) exercise de facto control over IMF lending decisions. At the same time, the G-5 countries are also home to the largest private creditors in global markets, including the world's largest commercial banks. Consequently, G-5 bank exposure heavily influences these governments' preferences over IMF lending policies. In particular, I find that IMF loan size and conditionality vary widely based on the intensity and heterogeneity of G-5 governments' domestic financial ties to a particular borrower country. When private lenders throughout the G-5 countries are highly exposed to a borrower country, G-5 governments collectively have intense preferences and are more likely to approve larger IMF loans with relatively limited conditionality. In contrast, when G-5 private creditors' exposure to a country is smaller or more unevenly distributed, G-5 governments' interests are weaker and less cohesive, and the Fund approves smaller loans with more extensive conditionality."

Deus Ex Macchiato - Sovereign CDS - "This is a classic example of unintended consequences. One element of Basel 3 is a capital charge for the variation of counterparty valuation adjustment – basically the adjustment derivatives traders take to reflect the credit quality of their counterparties. The CVA is largest on uncollateralised swaps: collateral reduces it massively. And which is the most significant class of counterparties who refuse to post collateral? Sovereigns and supranationals. Therefore making banks hedge their CVA better has the effect of forcing them to buy more sovereign CDS, which in turn may increase government borrowing costs. Spread widening isn’t necessarily caused by the evil CDS market speculating on sovereign default; instead it may well be regulatory action that is the cause."

Really great links - Fiscal policy - Carmen Reinhart - Financial repression - Twitter panic - Toward a More Efficient Labor Market

2010-06-18T15:55:00.003+03:00

Brad DeLong - Fiscal Policy - Words of wisdom - "For a couple of years now--ever since we slammed into the zero nominal interest rate lower bound--I have been wandering around saying:

The obvious policy is the long-term debt neutral stimulus: spending increases and tax cuts for the next three years, standby tax increases with triggers and spending caps with triggers thereafter, all calculated to guarantee that the debt is no larger ten years from now than in the baseline.

   I haven't found takers--even though those who believe in stimulus spending should think that the short-run gain outweighs the long-run pain, those who believe in confidence think that the long-run pain is good for us and worth the short-run bacchanalia, and the thing should pass unanimously."

Arnold Kling - Capital inflows - "Start with Reinhart. I find her a bit like Paul Samuelson, in that she seems to have a lot of thoughts running through her mind, and only a sample of those thoughts get processed through her vocal cords. This leaves many thoughts unexpressed.
   For example, here are three things I thought I heard her saying.
       1. Large capital inflows end badly. They are the predecessor for financial crises.
       2. Financial liberalization promotes capital inflows.
       3. Financial liberalization is a good thing.
   The opposite of financial liberalization is financial repression. Under financial repression (think China), about the only savings vehicle available is government bonds. The government then allocates capital. Private capital inflows are minimized, because who wants to invest overseas in low-yielding bonds? Domestic savers get stuck with low yields and low incomes. Reinhart thinks we will see more financial repression in debt-ridden western countries, so that governments can continue to market their debt. Have a nice day.
   I assume that some of Reinhart's unexpressed thoughts help to explain how to reconcile the benefits of financial liberalization with a desire to avoid crises caused by large capital inflows. Maybe somebody can look up what she has written and find the answer."

Michael Pettis - Financial repression - "There have periods of inflation in China in recent years, and even a brief inflationary scare in 2007 and 2008, but on average inflation has been far less than what was needed to revalue the currency sufficiently.
   So what happened? Why has inflation been muted – as it has by the way in other countries that followed the so-called Asian growth model, including most importantly Japan in the past several decades?
   Two months ago University of Chicago economist, Robert Aliber, came to speak at my central banking seminar at the Guanghua School of Peking University. In a fascinating discussion he explained that in fact there was another possible resolution of the imbalances caused by relatively rapid productivity growth in the tradable goods sector.
   He pointed out that if the nominal exchange rate is not allowed to rise, policymakers can still contain inflation by what economists call financial repression, made possible by their control over the banking system in countries where banks completely dominate the financial system. In the Chinese context, financial repression exists because the vast bulk of Chinese savings is in the form of bank deposits, and the deposit rate is set at extremely low levels.
   This has the effect of transferring large amounts of income away from net savers, which for the most part consists of Chinese households, and in favor of net users of capital. Net users, of course, consist primarily of large, capital intensive businesses, real estate developers, infrastructure investors and local and central governments, including the People’s Bank of China, the largest net borrower of renminbi in China. Net savers are forced into subsidizing net users, in other words.
   The consequence is that monetary growth is channeled not into household demand but rather into the production of more goods, and the inflationary impact of monetary expansion is muted. Financial repression is an alternative to currency appreciation or inflation."

Steven Pinker - Twitter panic - "Media critics write as if the brain takes on the qualities of whatever it consumes, the informational equivalent of "you are what you eat." As with primitive peoples who believe that eating fierce animals will make them fierce, they assume that watching quick cuts in rock videos turns your mental life into quick cuts or that reading bullet points and Twitter postings turns your thoughts into bullet points and Twitter postings."

Steve Landsburg - Toward a More Efficient Labor Market - "An anonymous math department chairman reports on his own strategy for cutting down on the workload. He believes that one of the most important determinants of a successful career is luck. So each year, he randomly rejects half the applicants without even reading their folders. That way, he eliminates the unlucky ones."

Really great links - Intra-Eurozone competitiveness - Inflation vs. socialism - Ego and politicians

2010-06-15T14:34:00.000+03:00

Daniel Pfaendler - Intra-Eurozone competitiveness: A solvable task - "It is frequently stated that SGIP need an internal devaluation in the magnitude of 20-30%. However, this estimate appears wrong on several counts. They are usually derived by comparing the development of nominal unit labour costs (ULC) in Germany with those in SGIP. For example, nominal unit labour costs increased by approx. 8% in Germany since 1999 whereas they increased by approx. 36% in Greece. This suggests that Greece has lost 28% in competitiveness vs. Germany and hence needs an internal devaluation of the same magnitude.
   However, one should not forget that Germany joined the Eurozone at an uncompetitive exchange rate. It took Germany several years to restore competitiveness vs. the other monetary union members which was one factor for its weak economic performance early last decade. Assuming that Germany had re-established competitiveness by the end of 2003, reduces the gap in nominal ULC between Greece and Germany to 15% (and 14% for Spain and Ireland and 13% for Portugal). Finally, SGIP need not restore competitiveness vs. Germany but rather vs. the average of the Eurozone. Nominal unit labour costs in SGIP since 1999 increased by 34% whereas ULC in the rest of the Eurozone increased by approx. 21% (see chart below). The difference between these two developments is substantial but not insurmountable. SGIP either need a reduction in nominal unit labour costs of 10% or the rest of the Eurozone needs an increase in nominal ULC of 11% to restore competitiveness in SGIP. More likely though is that we will get a mixture of the two, falling ULC in SGIP and rising ULC in non-SGIP."

Scott Sumner - A little more inflation or a little more socialism? - "In the 1930s the right had to choose between a modest amount of inflation (returning prices to the pre-Depression levels) or more socialism. They weren’t thrilled with big government, but their strongest opposition was reserved toward policies of inflation. So we ended up with deflationary policies between 1929 and 1933. Of course the voters wouldn’t accept 25% unemployment, so we got big government instead of the inflation.
   As this video shows, we are essentially facing the same choice today. We could pump up the economy through monetary policy, or we can have Fannie and Freddie continue to throw $100s of billions down the drain, socialize the auto industry, extend unemployment benefits to 99 weeks, etc. And if that isn’t enough there are also calls to move away from free trade policies. And then there’s the higher taxes we’ll pay in the future to cover the costs of debts run up in a futile attempt to stimulate the economy.
   Just as in the 1930s, the right seems to have decided that a little bit of socialism is better than a little bit of inflation. What do I mean by a little bit of inflation? I mean enough so that the post-September 2008 trend rate of inflation is the same as the pre-September 2008 trend rate of inflation. Apparently even that little bit of inflation is more distasteful than massive government intervention in the economy."

Barry Ickes - Ego and politicians - "Now we read that Meg Whitman spent at least $85 million to win the Republican nomination for Governor in California. She presumably will spend even more in the general election campaign.
   Now Whitman is a billionaire supposedly, so I suppose that this is not much to her. But the question I want to ask is can she not find a better use for this money? What about charity? She could give this to the Gates Foundation, for example, and improve health around the world. Or if she is only concerned with California, then to some California charities.
   To choose spending this on her campaign, she has to believe that she is better for California than the next best candidate by more than the value of the charitable contributions. Now most politicians hardly ever make a difference. So she must have a really, really, big ego."

Really great links - Krugman - Eurozone breakup - Haircuts - Scott Sumner - Gold

2010-06-14T09:07:00.000+03:00

Paul Krugman - Strange Arguments For Higher Rates - "Rajan’s argument boils down to two assertions:
   1. Raising rates a bit wouldn’t significantly deter investment.
   2. “Unnaturally low” interest rates are distorting asset prices.
   The first thing to say about these two assertions is that they are essentially contradictory. If the difference between current rates and the rates Rajan wants is trivial — just a wafer thin mint — how can that same difference be leading to a major distortion in financial markets? Are we to believe that an interest rate change that matters not at all to firms making real investments somehow has huge effects on speculators? And actually, don’t asset prices themselves matter for real investment?"

Dino Kos - German bonds aren’t the havens they appear to be - - "One compelling reason to hold Bunds (or German bank deposits) is if investors believe a euro break-up is likely and wish to position themselves to have holdings converted into Deutschemarks. That scenario cannot be ruled out. However, euro area officials have been clear: monetary union will be defended and defaults are not on the agenda. That suggests peripheral countries will remain in the euro area and taxpayers in the core are susceptible to additional “calls” for cash in the future."

John Dizard - Euro bondholder haircuts would help - "After the Lehman collapse, only Kazakhstan systematically resorted to bondholder haircuts to pay part of the cost of bank restructuring. I believe they’ll be followed by other authorities."

Scott Sumner - Post-modern macroeconomics - "So why does The Economist imply that a policy of “price stability” failed to ensure economic stability? I think there are two reasons. First, they think the financial crisis (not falling inflation) caused the recession. And second, they don’t think monetary policy could have done much to prevent the fall in inflation."

James Hamilton - Gold and inflation - "There's a common thread to all the above figures, and it's not fears about inflation. Instead it's worries about the level of real economic activity, showing up in a flight to safety. U.S. Treasuries remain the instrument of choice for investors who think nothing looks safe.
   But with the long-run fiscal challenges facing the United States, are 10-year Treasuries really the safest place to put your money? The yellow metal seems to be one way some people are hedging that bet."

Really great links - Fed - Central banks and stockmarkets

2010-06-11T14:24:00.002+03:00

Andy Harless - Fed and Mankiw rule - "Basically, once we recognize that quantitative easing is an option – and one that is no longer being pursued – we can draw the conclusion that the Fed is much tighter today than what the Mankiw Rule would suggest. Indeed, relative to the Mankiw rule, the Fed is much tighter than at any time during the Greenspan-Bernanke years. Since 1957, when the core CPI data series begins, there have only been two times when the Fed was as tight as it is today relative to the Mankiw Rule. One was in 1973, when the effect of Nixon’s price controls was artificially reducing the retrospective inflation rate used in the Mankiw Rule. The other was during the early 1980’s, when the Fed was targeting monetary aggregates rather than interest rates and attempting (with great success) to reduce the inflation rate dramatically."

Roger Farmer - How to reduce unemployment - A new policy proposal - "A fiscal stimulus is ineffective in my model because it can shift one of the equilibrium relationships, but not the other. In terms of Figure 2, a fiscal expansion shifts the ME curve to the right but leaves the NA curve in its depressed state. As a consequence, the interest rate rises and crowds out private consumption expenditure. I see two possible resolutions to this problem.
First, an investment tax credit that changes the trade-off between holding private capital and government debt would act to shift the NA curve to the right. In combination with a fiscal expansion, this seems to be a promising avenue to explore.
Second, an extension of the quantitative easing that has been engaged in by national central banks throughout the world holds some promise to directly influence asset markets. An extension of this policy would involve the direct intervention of central banks in national stock markets by offering to exchange government debt for private equity at a fixed price."

Really great links - Tinkerbell in New Keynesian models - Trust - Germany and Spain - Happiness

2010-06-09T10:09:00.001+03:00

Nick Rowe - Tinkerbell in New Keynesian models - Absolute must-read - "Framing matters. Tinkerbell is real and all-pervasive. She flies in New Keynesian models all the time.
   A. In the IS curve in old Keynesian models, a fall in the real rate of interest causes an increase in demand.
   B. In the IS curve in New Keynesian models, a fall in the real rate of interest causes an increase in current demand, relative to planned future demand.
   C. In the IS curve in New Keynesian models, a fall in the real rate of interest causes a decrease in planned future demand, relative to current demand.
   A and B sound very similar. It's just that B adds an extra variable (planned future demand) that can shift the IS curve. An increase in planned future demand will shift the IS curve to the right. That sounds quite plausible from an Old Keynesian perspective anyway. If planned future demand increases, expected future incomes should increase too, and so people will want to consume more today, and firms will want to invest more today. So B makes the New Keynesian IS curve sound very similar to the Old Keynesian IS curve. It isn't. They are very different.
   C sounds totally different from B. But it's not. C and B are logically equivalent. They are just different ways of describing the same Euler equation that underlies the New Keynesian IS curve. C is a way of describing the New Keynesian IS curve that forces you to realise that it is very different from the Old Keynesian IS curve."

Tyler Cowen - Trust - "Call me naive, but I believe that most of these politicians would in fact prefer to spend the money and hand out goodies to favored constituencies.
   What may be destroying economic recovery is not fiscal contraction, but rather lack of trust, "Trust" is an underused word in macroeconomics."

Edward Chancellor - The dreadful potential of frugality - "Germany wants countries, such as Spain, to get their public finances in order. Yet if Spain is to reduce its fiscal deficit without too much pain, two conditions are necessary. First, the country’s trade position must shift into surplus. This is problematic since labour costs are high relative to Germany and Spain cannot devalue its currency. Second, the private sector must move back into deficit. Yet it is difficult to see Spanish households and companies wanting to borrow more given the ongoing problems caused by the collapse of the property bubble."

Eric Falkenstein - Arthur Brooks on happiness - "Arthur Brooks, president of the AEI, has a new book out, The Battle, and he makes an interesting claim. He states that the key factor in one's happiness--not experiential happiness, but 'remembered happiness' that is more correlated with 'life satisfaction', see Kahneman on the difference--is 'perceived earned success'. This is the willingness and ability to create value in your life or the life of others. He states that if you ask someone if they feel like they are creating such value, they are happy, regardless of how much they make. Giving people money, via welfare or inheritance, does not make people happy, because this if anything discourages the effort needed to find and develop such a niche."

Really great links - Krugman on solvency - Econbrowser: recovery sluggish - Raghu Rajan - Structural crisis - Dilbert

2010-06-07T10:00:00.003+03:00

Paul Krugman - Solvency - "As you can also see, by the debt-and-deficit criteria the US, UK, and (as you can’t see) Japan look similar enough to the crisis countries that if you didn’t know better, you might expect them to be in the same boat.
   But they aren’t. As of right now, the interest rates on 10-year bonds are 3.59% in the UK, 3.36% in the US, 1.29% in Japan. CDS spreads for Japan and the UK are only about a third of the level for Italy.
   So what does one make of this? One possible answer is, just you wait — any day now there will be a Wile E. Coyote moment, the markets will realize that America is Greece, and all hell will break loose. The other answer is to note that all the crisis countries are in the eurozone, while the US, UK, and Japan aren’t — and to argue that having your own currency makes all the difference.
   I’ll choose door number 2."

James Hamilton - Current economic conditions - "Yes, we're still in the economic recovery phase, and yes, it still looks pretty sluggish."

Raghu Rajan - Response to Paul Krugman - "I reproduce Paul Krugman’s “econometric” claim above that Fannie and Freddie did not help cause the crisis above (I do not claim the Community Reinvestment Act was a big factor). I respond only because I have received hate mail from his followers. Paul is, of course, a great theoretical Nobel-prize-winning economist, so his attacks must be taken seriously (and I did take his trade theory classes at MIT, in the interest of full disclosure). Unfortunately, much of the “Fannie and Freddie did not contribute to the crisis” battalion makes arguments that have serious holes. Since these arguments are so prevalent they need to be rebutted again and again (the claimed unwillingness to listen to argument can be played on both sides).
   The key graph in Paul’s argument is Figure 4. He claims that restrictions on Fannie and Freddie starting in 2004 kept their share of originations of total residential mortgage originations down, even while housing prices inflated. But this is irrelevant to the question. What we care about though is the amount of Fannie and Freddie’s originations in the sub-prime residential mortgages. And from every source I have seen, these took off precisely in 2004. Indeed, as I argue in my book Fault Lines, in the period 2004-2006 these two giants purchased $ 434 billion in sub-prime mortgage-backed securities. A measure of the size of these purchases is that in 2004, they accounted for 44 percent of the market for these securities. Calomiris and Wallison argue that Fannie and Freddie’s arms were twisted into doing more of this kind of lending starting in 2004 precisely because Congress had them in a vice because of the scandal."

Barry Ickes - Structural Rigidities and Financial Crisis - "Sometimes it is hard to understand the connection between structural rigidities and financial crises.
...
   The specific example is rent control. This is quite severe in Portugal:

José Gago da Graça owns a Portuguese real estate company and has two identical apartments in the same building in the heart of Lisbon. One rents for €2,750 a month, the other for almost 40 times less, €75.

The discrepancy is a result of 100-year-old tenancy rules, which have frozen the rent of hundreds of thousands of tenants and protected them against eviction in Portugal.
What is the connection to the financial crisis? Well, these rules limit production of rental housing, and thus force people to purchase rather than rent housing.

The post-revolution rules helped protect tenants, but also led to a chronic shortage of rental housing. This, in turn, persuaded a new generation of Portuguese to tap recently into low interest rates and buy instead — often in new suburbs — thereby exacerbating the country’s mortgage debt and leaving Portugal with one of Europe’s lowest savings rates, of 7.5 percent.

When the opportunities to borrow at low rates -- due to the euro -- presented themselves, Portuguese households took advantage. Rather than rent and save, households were pushed, by rent control, to borrow and purchase. That would not be so bad if the price of housing was not experiencing a bubble."

Scott Adams - Dilbert - "Let's talk about morality. Can you justify owning stock in companies that are treating the Earth like a prison pillow with a crayon face? Of course you can, but it takes some mental gymnastics. I'm here to help.
If you buy stock in a despicable company, it means some of the previous owners of that company sold it to you. If the stock then rises more than the market average, you successfully screwed the previous owners of the hated company. That's exactly like justice, only better because you made a profit. Then you can sell your stocks for a gain and donate all of your earnings to good causes, such as education for your own kids."

Four myths about European Central Bank

2010-06-03T15:32:00.002+03:00

1. Losses on Greek bonds will create inflation
   No. Imagine ECB becomes insolvent after Greek default. In this case ECB will lose control of inflation only if there is a run on ECB. During a run on ECB, EUR LIBOR will become lower than ECB deposit rate, meaning that ECB's contractionary policy rate increases would not be honored by the interbank market. Some commentators have raised the possibility of a run on ECB in the form of unilateral exit of Germany from the Eurozone. In my view this is highly unlikely. It is important to recognize that only member states can execute a run on ECB, but commercial banks cannot, as they are regulated by ECB.
   Canadian economist and mega-blogger Nick Rowe has raised the possibility that inflationary expectations will arise because ECB has overpaid for Greek junk bonds. However in the comments he has conceded that ECB can successfully operate with negative equity: "Paying interest on reserves is equivalent to the ECB issuing bonds. Issuing bonds doesn't change the net worth of the ECB. But nevertheless, you have a good criticism here. The NPV of a central bank is much greater than the assets on its balance sheet. It's the NPV of all future seigniorage. In other words, it might have to buy an awful lot of really junk bonds in order to trash its balance sheet sufficiently. Hmmm."

2. ECB is sterilising purchases of Greek bonds
   No. ECB will provide unlimited 3 month liquidity in a scheduled longer term refinancing intervention on 30 June 2010. This means that any sterilisation will be reversed according to the desires of commercial banks. Only when ECB will stop full allotment in longer term refinancing operations we will be able to talk about real sterilisation. So far the purchases of Greek bonds are de-facto unsterilised.
   The instrument of ECB's sterilisation operations is one week term deposits. These deposits are eligible as a collateral in ECB's refinancing operations. Short maturity of deposits and eligibility as a collateral means that these deposits are almost as liquid as overnight deposits at ECB. This is confirmed by the tiny premium on one week deposits required by commercial banks as compared to the ECB overnight deposit rate. We can safely conclude that ECB's sterilisation operations have only minor effect on removing the liquidity in Eurozone.

3. Sterilisation of purchases of Greek bonds is needed to prevent inflation
No. Even with the enormously huge monetary base ECB can control inflation by increasing policy rates. Sterilisation might be desirable for the fine-tuning of the yield curve, but is not necessary for the containment of inflation. Stephen Williamson, the guru of new monetarism, says that sterilisation is an inefficient way of controlling inflation (his models imply that even fine-tuning of the yield curve by sterilization won't work).

4. Current tensions in interbank markets are comparable to Lehman Brothers. For example, WSJ writes: "Euro-zone banks placed a record €316.4 billion ($387.1 billion) in the ECB's ultra-safe overnight deposit facility, ECB data showed Wednesday, bringing back memories of the days following the collapse of U.S. investment bank Lehman Brothers in 2008."
   No. The use of ECB's overnight deposit facility is just an indication of the bloated balance sheet of ECB. The balance sheet is bloated precisely because ECB is successfully preventing the repeat of Lehmanesque financial tensions by adding huge amounts of liquidity. In fact, during Lehman crisis, ECB has fought the financial tensions much more successfully than the Fed. ECB started providing unlimited liquidity on October 15 2008. If only Fed had copied the aggressive liquidity stance of ECB in 2008...

Really great links - Bernanke's toxic waste - China - Greece

2010-06-03T14:08:00.000+03:00

Nick Rowe - Bernanke - "In my old post, I said that Ben Bernanke was betting on the economic recovery, using the Fed's own assets, by buying toxic waste. If there is no recovery, he loses the bet, the toxic assets become worthless, and the increase in the monetary base becomes permanent, because the Fed can't afford to retire the extra money. If there is a recovery, he wins the bet, the toxic assets are worth at least what he paid for them, and the increase in the monetary base can be temporary, because the Fed can afford to retire the extra money. That's the demand curve of recovery."

Scott Sumner - Is China a free market success - "So to summarize, to the extent that China is a free market, it is an economic success, and to the extent it is statist, it is mostly a failure (excluding some sectors like transport.) But the question “Is the Chinese miracle due to a free market economy?” is nonsensical. It isn’t a miracle at all; it is a country rapidly transitioning from being extremely poor to having a so-so economy. That is all."

Felix Salmon - Consensus on Greece - "There was quite a lot of consensus on the panel, and not in a good way: everybody agreed that the bailout of Greece was only postponing the inevitable, and many people reckoned that it wasn’t going to postpone it very long: one pair of hedge fund managers in the audience reckoned that it would last about six months before the default finally happens.
The form of the default, too, seemed pretty clear: an act of parliament in Greece would do most of the work, given that most Greek debt is issued under Greek law. It will be a par exchange — the new bonds will have the same face value as the old bonds, but with lower coupons and extended maturities — so that with a bit of accounting fudgery, no banks would need to mark their Greek debt to market and take a huge loss. And Greece, in a fiscal bind, will probably at some point start issuing its own scrip alongside the formal national currency of the euro, much as California did in 2009."

Really great links - Mistakes were made - Tax cuts - ECB - Gold

2010-06-01T15:38:00.000+03:00

Charles Evans - Policy easing was not enough - "The U.S. central bank's liquidity support was helpful in containing the 2008 financial crisis but it could have done more, Federal Reserve Bank of Chicago President Charles Evans said on Tuesday. "While the liquidity support we provided the economy was very helpful, it was clearly not enough," Evans, who is not a voting member of the U.S. interest rate-setting panel, said during a panel session at a seminar in Seoul.
   "Given the huge resource gaps, and low and declining inflation, more monetary accommodation was appropriate," he added."

Mark Thoma - Why I Changed My Mind about Tax Cuts - "Initially I was critical of how the tax cuts were targeted since so much ended up going to saving rather than consumption. This is the part I am rethinking.
   There are different types of recessions, and this one can be termed “a balance sheet” recession. It had a big impact not just on bank balance sheets, but on household (and, for that matter firm) balance sheets as well. Households were particularly hard hit due to declines in stock prices and declines in the value of housing. These losses were large, they upset plans for things such as retirement, and households needed to refill the holes in their balance sheets that had been created (this includes paying off debt).
   How do they refill their balance sheets? By saving more and consuming less (paying off debt is a form of saving). Thus, as the recession took hold, we saw a large increase in the saving rate and a corresponding fall in consumption. The tax cuts were an attempt to reverse the decline in consumption, but instead they mostly raised the amount that went into saving.
   But that has a benefit. Households are not going to start consuming normally again until their balance sheets are repaired. The faster the holes in their balance sheets are refilled, and tax cuts can help with this, the faster the households can return to their normal rates of consumption — a prerequisite for the economy to return to normal.
   So the targeting of the tax cuts that was OK after all. You don’t see the effects of balance sheet rebuilding in the data initially because the tax cuts are being used to fill up balance sheets, there’s no immediate effect on consumption, output, employment, etc., to observe in the data. But since balance sheets are refilled faster, we will emerge from the recession sooner, and that’s an important benefit of tax cuts that’s often overlooked."

Spiegel - ECB - "Bonds worth about €3 billion are now being purchased on every trading day, with €2 billion of the bonds coming from Athens. At the moment, there is no improvement of the situation in sight. "The ECB and the national central banks operating on its behalf are currently the only buyers to speak of," says one market insider.
   This policy effectively makes the ECB a so-called "bad bank" (a bank that buys up toxic assets as a means of helping out other institutions), all protestations of its president to the contrary. The pile of junk bonds on the ECB's balance sheet continues to grow. The fact that the ECB is keeping prices artificially high is downright encouraging banks to unload their risky assets onto the central bank.
   Thorstein Polleit, the chief economist of Barclays Capital Deutschland, puts it this way: "The ECB is creating excess supply by buying at overinflated prices." In other words, many creditors are more inclined to sell their risky assets to the central bank under these terms. "It's a free lunch," says a top Frankfurt banker. "Anyone who doesn't take advantage of this opportunity to get rid of his securities now only has himself to blame.""

David Rosenberg - Still bullish on gold - What would Moses buy? - "The above makes the bullish case for gold that much more alluring in terms of relative shifts in the supply curve for fiat currency against bullion. What is encouraging too is that after reading the columns in Barron’s (page 38) and the FT (page 10) over the weekend, there are still plenty of skeptics out there on the gold price outlook. Bulls need skeptics — there is nothing worse than universal beliefs as they lead to overcrowded trades. What makes gold different is that, unlike paper money backed by the good word of the government, it has withstood the test of time for thousands of years. It is malleable. It is durable. It can be trusted. It is not the liability of any government. It has an inelastic supply curve. How many times is gold mentioned in the Old Testament? Try 391 times. How many references to silver? Try 117 times. How many times is paper currency mentioned from Noah, to Abraham, to Moses? None. Nada. Efes. Gornisht. Nihil. Rien. Nichts. Niente."

Michael Woodford - Inflation Targeting during Credit Market Turmoil

2010-05-27T18:20:00.003+03:00

Run, don't walk, to read Woodford's BOE presentation "Inflation Targeting during Credit Market Turmoil".

Key takeaways:

Central bank policy stance has three independent dimensions:

quantity of reserves
interest paid on reserves
composition of asset side of CB balance sheet (credit easing)

Zero lower bound is solved by committing to maintain low interest rates for a time, even after it becomes possible to again achieve inflation target without violating the bound.
Price level targeting is essential during credit crisis

automatic creation of expectations of reflation
it is an inflation targeting regime with commitment to error correction

Credit easing may be optimal in the case of large financial disruptions

size of credit spreads as a justification for credit policy
unrelated to whether zero bound on policy rate reached (ECB in August 2007)

Interest on reserves is desirable during credit market turmoil - for credible exit strategy

Scott Sumner does not agree with Michael Woodford Woodford (and me):

Sumner says interest on reserves is a key mistake
Sumner says large financial disruptions can be avoided by credible NGDP targeting - no need for CB credit policy

What I didn't like:

Woodford says QE doesn't work when treasuries are purchased and when QE is withdrawn when conditions normalize (see Japan 2001-06). But there is a possibility that Japan would be even worse without such QE
Joint optimality of three dimensions of monetary policy not considered