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."
Thursday, September 30, 2010
Tuesday, September 28, 2010
Really good links - Housing bubble - Interest on reserves - Currency blocks - Mistake-based discrimination
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."
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."
Saturday, September 25, 2010
Really good link - Ben Bernanke and failure of economic engineering and management
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."
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."
Friday, September 24, 2010
Really good links - Hydraulic macro - Monetary superpower - Eurozone - Summers in 2008
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."
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."
Tuesday, September 21, 2010
Really good links - Treasuries as money - FOMC - Monetary policy - The Fed - Inflation swaps
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."
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."
Friday, September 17, 2010
Really good links - Trade wars - Basel III - Sustainable external deficits - Woodhill curve - Peer Steinbrück
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
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
Tuesday, September 14, 2010
Really good links - Global imbalances - Tim Duy - Inflation targeting
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."
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."
Monday, September 13, 2010
Really good links - Krugman on global savings glut - New Keynesian macro - Seeing like a state
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."
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."
Thursday, September 9, 2010
Really good links - Momentum and EMH - Greece - Bequests - Financial analysts and company guidance - Germany
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."
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."
Tuesday, September 7, 2010
Scott Sumner and long term interest rates
Scott Sumner writes:
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
"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
Monday, September 6, 2010
Really good links - Too much debt - Ricardian stimulus - Too big to liquidate is too big to live - Who gets the money first?
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."
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."
Thursday, September 2, 2010
Sweden tightens monetary policy, fear of asset bubbles prevents speedy closure of resource utilization and inflation gaps
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.
Wednesday, September 1, 2010
Really good links - Japan - German jobs miracle - Bernanke - Mr. Bean
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."
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."
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