Suffice to say that their forecasts are no better than others, and none are very accurate

From Free Exchange: My kidney stone is making me harsher:

"Romer roundtable: Think, plan, and tell us the plan

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Romer roundtable

Allan H. Meltzer is a professor of political economy at Carnegie Mellon University, and the author of “A History of the Federal Reserve”. This discussion can be followed in its entirety here.

CHRISTINA ROMER makes two traditional mistakes. First, like generations of policymakers before her, she counsels "trust us". They will know the right time to change from stimulus to restraint. There is no factual basis for "trust us". If policymakers at the Fed and in the government had the ability to time their actions appropriately, we wouldn't be in this mess. For it was they who allowed banks to circumvent the Basel regulations, that permitted Fannie and Freddie to expand beyond any reasonable standard, that brought us too big to fail and, as John Taylor has shown, abandoned a policy that brought us almost 20 years of the Great Moderation. Suffice to say that their forecasts are no better than others, and none are very accurate. Short-term judgments are often wrong and misleading. Best to avoid them.

Second, like most other defenders of this inflationary, low productivity policy, Christina puts the choice as whether we act against recession now or against inflation now. That leaves out a multitude of options. Two of my former colleagues won the Nobel prize for showing that it is much better to think now about the policy problem that lies ahead. Yes, avoid the mistake of doing what seems urgent today while neglecting the longer-term consequences that will be the problem of the future. Much better to think about the path the economy will be on; yes, stimulate now to reduce unemployment, but avoid creating a big inflation in a year or two. And even announce in advance how you propose to reduce the high money growth rate and the excessive deficits. Don't just say you'll do it, think, plan, and tell us the plan.

Further, the administration agreed to a terrible stimulus package. Our long-term problem is to slow the growth of consumer spending, so that we can export more to service the debt we sold to foreigners. That calls for more investment and higher productivity growth. Cap and trade, health care, and the so-called stimulus either tax businesses to subsidise consumers or simply shift resources to consumption. Keynesians should read Keynes. He opposed spending to increase consumption; he favoured planning to increase investment. And if they can't stomach Milton Friedman, they should read Franco Modigliani, a leading Keynesian. Both showed that temporary tax reduction was an inefficient stimulus programme."

Me:

Don the libertarian Democrat wrote:

June 19, 2009 0:35

This post confuses me:
1) Don't trust govt officials
2) Don't trust forecasts
3) Don't trust short term judgments
4) Don't trust academics when they become policymakers
And yet:
1) Trust two Nobel Prize winners. After all, they're Nobel Prize winners, and they have shown that, paradoxically, we can't trust forecasts. But, if we do, the farther off they are in time, the better.
2) You can trust John Taylor's policies. By the way, who administered this policy? That the Great Moderation could be based on the fact that we allowed all these other policies mentioned, which occurred at the same time, is a priori false. In other words, the Great Moderation can't be the Great Forestalling.
3) Trust Keynes, Friedman, and Modigliani. Read them, and you'll be enlightened.

Essentially, the author lists four categories of mistrust, all of which he and the people who agree with him are immune to. The basis of his argument is: Trust Me.

By the way, if you subsidize consumers, and they then purchase goods, isn't somebody profiting from that? I would think that the problem is really that you borrowed money for the plan, not that people spent the money that you gave them. That's how businesses make money. Selling goods.

"That calls for more investment and higher productivity growth"

I agree. That's why we have tax incentives for investment during a recession. That's a stimulus. It's an incentive for investment.

"That leaves out a multitude of options."

That's how we make decisions. We narrow the list down. We don't keep expanding it.

"Short-term judgments are often wrong and misleading. Best to avoid them"

How do you do that? It's a temporal paradox.

What exactly is the factual proof that we should trust Allan Meltzer?

. Once upon a time, you could go for decades without seeing the default rate rise over 3%.

TO BE NOTED: From Reuters:

"When default rates spike

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Posted by: Felix Salmon

Tags: bonds and loans, credit ratings

Many thanks to Jeffrey Benner of Moody’s, who responded to my blog entry yesterday with some very useful information about downgrades and default rates.

Firstly, the 13.8% downgrade rate in the first quarter means that Moody’s downgraded 13.8% of all its corporates in the first quarter alone: it’s not an annualized rate, and Moody’s therefore downgraded a higher percentage of the companies it covers in the first quarter of 2009 than it does in a typical year.

As for absolute ratings quality, I haven’t managed to get good data on that. But Moody’s does have good data on default rates, and has even provided a couple of charts: the first shows how the spike in annual default rates is expected to surpass the 1991 and 2002 peaks, while the second puts those peaks into perspective going back to 1920.

The second graph is particularly interesting to me, since it really puts the Great Moderation in perspective. A couple of years from 2004 through 2007 doesn’t make a Great Moderation; for that you really want to look at the period from say 1943 to 1970. One of the consequences of the rise in the pace of financial innovation of late is that the global financial-services industry could take a really very short-lived decline in default rates and credit-market volatility, and turn it into something so dangerous as to create the worst global recession in living memory. Once upon a time, you could go for decades without seeing the default rate rise over 3%. Nowadays, the chase for return on equity won’t ever let that happen."

"demand for people who can actually judge credits on their own, rather than relying on ratings agencies and buy-side quants to do it for them. "

Felix Salmon on the Justin Fox post on low-information assets and high-information assets:

"Justin Fox has a great post on Bengt Holmström's distinction between low-information and high-information assets:

There are low-information assets--cash, bank deposits, money-market securities--where, most of the time, nobody really needs to know anything about their underlying value. Then there are high-information assets--stocks are the best example--where the value is highly uncertain, and every investor assesses it differently.

Securitization is the process of transforming low-information assets, like corporate debt, into high-information assets, like opaque CDO-squareds. And I think this insight is the best way of answering Richard Wagner's exam question about securitization:

The burden of non-performing loans is thus dispersed throughout the economy rather than residing with the original lender. Does this development weaken the incentive offenders of lenders to monitor borrowers and thereby weaken overall economic performance?

Classically, the answer to this question -- the one which all of Wagner's students gave -- was no. Investors in CDO-squareds, under the kind of assumptions commonly made by economists, have perfect information about all the underlying loans."

There comes a point when these assumptions become depressing rather than comical.

"In reality, of course, they don't. But more to the point, it's orders of magnitude harder to understand a CDO-squared than it is to understand a single loan -- and single loans are hard enough to understand themselves. You can start making correlation assumptions and the like in an attempt to simply matters, but that only pushes off the moment of reckoning: you still need to crunch a lot of data to come up with empirically-based correlation assumptions, and no one ever had either the ability or the inclination to do that."

They had a theory and a model, but not the data. Instead, apparently, they inserted data from other investments into their models.

"Financial innovation nearly always involves a move towards higher-information assets from lower-information assets. This is not a good thing. It's easy to say things like "don't invest in something you don't understand", but how on earth is anybody meant to understand something as high-information as the stock market, let alone things like CPDOs?"

I'm not sure of the point. Also, I'm beginning to lose the thread about High-Information. I'd need to know more about what else this phrase applies to. I'm also a bit confused about "understand".

"A lot of the boom in debt markets during the Great Moderation, I think, was a result of buy-siders being seduced by instruments which they believed required little if any sleeves-rolled-up credit analysis. Maybe one surprising consequence of the credit crunch will be an increase in demand for people who can actually judge credits on their own, rather than relying on ratings agencies and buy-side quants to do it for them."

I still believe that it was Wishful Thinking. However, I completely accept his conclusion.

"Big bets on the “great moderation” throughout the economy helped to create the financial basis for a potentially big slump."

Brad Setser talks about the Great Moderation:

"The great moderation – a theory that become quite popular once the big financial party of this decade really got going after 2004 (see the New York Times graphic on LBOs) – had two components.

One: Macroeconomic volatility was a historical relic. Downturns were not going to be as severe as in the past – in part because of the success of counter-cyclical monetary policy.

Two: Financial volatility also was a thing of the past. The combination of reduced macroeconomic policy and the credibility of monetary policy meant that financial markets weren’t as subject to wild gyrations.

The implication of course was that leverage was safe. Financial firms could enhance their returns by borrowing more and taking bigger bets. And everyone else could increase take on more debt too – whether firms or households.

I guess it is now time to go back to the drawing boards."

It might be time to read some philosophy and history. Exactly how long was this "Great Moderation"? Was it even 20 years? Did it include the S & L Crisis, the Tech Bubble, the Inflation of the 70s?

From Bernanke:

"One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility. In a recent article, Olivier Blanchard and John Simon (2001) documented that the variability of quarterly growth in real output (as measured by its standard deviation) has declined by half since the mid-1980s, while the variability of quarterly inflation has declined by about two thirds.¹ Several writers on the topic have dubbed this remarkable decline in the variability of both output and inflation "the Great Moderation."

I lived through it and I didn't even know it. 20 years. Great. What are we going to call what we're going through now? Tiny.

"Financial volatility has come back, with vengeance. And not just in the equity markets. After a period of (relative) stability, there have been a series of sharp moves in the foreign exchange market. The yield on the thirty year bond has swung wildly. The pros are amazed at some of the strange permutations that derivatives markets have churned up under stress.

And Friday’s employment data leaves little doubt that macroeconomic volatility is back with a vengeance. The pace of contraction in economic activity in the US – and probably globally – this quarter is likely to be brutal. Wall Street economists are increasingly starting to sound like Dr. Doom.

Alas, adjusted to a more volatile world won’t be easy. Belief in the great moderation meant that the US economy was operating with a smaller buffer of capital and liquidity than it had in the past. And here at least much of the world seems to have emulated the US. The easy way to increase equity returns over the last few years was to take on more debt. That in turn is likely to augment the amount of volatility in the economy.

The risk, obviously, is that firms that borrowed to buy back their stock – or hadn’t run down their cash reserves – won’t be able to avoid Chapter 11. Or Chapter 7. And financial firms won’t be able to support their existing balance sheets with their now-depleted capital and will have to scale back (even after government capital injections), adding to the downturn.

Ideas have consequences. Big bets on the “great moderation” throughout the economy helped to create the financial basis for a potentially big slump."

Ideas have consequences. Yes, I suppose they do. So do foolish and shallow views of Human Agency and of Reason and of Mathematics and of what we can actually know. Why do people have to make every hypothesis and theory grand? Isn't it enough to accumulate some general wisdom that actually proves useful in helping us meaningfully and successfully lead our lives? In reality, that's all we do.

Instead of a drawing board, how about something less grand? Like a notebook?

"but if history is a guide, it's only going to get worse from here."

Although we've seen that there's no way to tell where the employment figures will trend from here, Zubin Jelveh isn't optimistic:

"It's probably the last thing anyone wants to hear so soon after news of the gawk-inducing 533,000 lost jobs suffered last month -- but if history is a guide, it's only going to get worse from here."

My opinion is that history can't tell us.

"That's because the majority of job losses in the 11 previous downturns came in the second half of the recession. We're 11 full months into the current one and most forecasters (what else do we have to go by?) think the recession will last through the end of next year."

Yes, these are projections.

"Let's assume that's somewhere near the truth. Out of all the jobs that were lost during the average recession since 1945, 26 percent of them came in the first half and 74 percent in the second half. There've been 1.9 million jobs lost thus far in the current downturn, so the historical average would mean we could lose another 5.7 million jobs, for a total of 7.6 million by the end. That would be the most jobs lost during a post-Great Depression recession. (If you factor in population, the short 1945 recession, which saw the evaporation of 3.3 million jobs, was worse.)"

When we looked at the averages earlier, there was just no way to tell where we're going.

"But there's at least one reason to have some optimism. Job losses in the three most recent recessions, including the 16-month 1981-82 downturn, were more evenly spread out with an average of 42 percent of all lost jobs gone in the first half and 58 percent in the second half.

What happened to cause the more balanced jobs picture?

One likely explanation is the Great Moderation, and now we just have to hope that the GM is not over with the collapse of the securitization market."

And so we're back where we started, unable to predict the future. What's new?

"to underestimate the amount of risk they faced and overestimate the amount of leverage they could handle"

Thomas F. Cooley gives the general consensus view of risk in Forbes:

"There is another, deeper possible link between the Great Moderation and the financial crisis that is worth thinking about, because it may help to inform the financial regulation of the future. The idea is simply that the decline in volatility led financial institutions to underestimate the amount of risk they faced and overestimate the amount of leverage they could handle, thus essentially (though unintentionally) reintroducing a large measure of volatility into the market.

Financial institutions typically manage their risk using what they call value at risk or VaR. Without getting into the technicalities of VaR (and there is a very long story to be told about the misuse of these methods), it is highly likely that the Great Moderation led many risk managers to drastically underestimate the aggregate risk in the economy. A 50% decline in aggregate risk is huge, and after 20 years, people come to count on things being the same.

Risk managers are supposed to address these problems with stress testing--computing their value at risk assuming extreme events--but they often don't. The result was that firms vastly overestimated the amount of leverage they could assume, and put themselves at great risk. Of course, the desperate search for yield had something to do with it as well, but I have a hard time believing that the managers of Lehman, Bear Stearns and others knowingly bet the firm on a systematic basis. They thought the world was less risky than it is. And so, the Great Moderation became fuel for the fire.

If there is a moral to this story it is probably to do with the filters we put on historical events. Succession and causality are often confused. As are the limits on our ability to think historically. What we see right now is only the great conflagration that consumes us, leaving us little appetite, and even less oxygen, to moderate our responses and hold onto a broad historical outlook."

I don't credit this, and now I think that I can explain why.

Many years ago, I read an essay which I've tried to find, but can't, about the modern conflict between Great Britain and the IRA. The essay started by stating that each side dated the conflict differently. For Great Britain, it began in the 20th Century, but for the IRA, it began in the 17th Century. The differences in dating led to completely opposite developments in the narrative and explanation of the problem.

So, when Cooley says this:

"Take, for example, "the Great Moderation."

The last really sharp recession in the United States was from 1981 to 1982, when real output fell by more than 4% below trend, and the unemployment rate rose to over 10%. It is often referred to as the Volcker Recession because it was triggered in part by then Fed Chairman Paul Volcker's efforts to squeeze inflation out of the U.S. economy.

Following that recession, something remarkable happened. The volatility in the U.S. economy declined sharply. Even though we have had two recessions in the ensuing years--in 1991 and 2002--both were relatively mild and short-lived.

Surprisingly, the U.S. economy remained dramatically more stable in spite of some major disruptions in financial markets in the U.S. and abroad over the same period. There was a major stock market crash in the U.S. in October 1987; the Mexican Financial Crisis in 1994; the Asian Financial Crisis in 1997 and 1998; the Russian debt crisis and the Long-Term Capital Management crisis in 1998 and the bursting of the dot-com bubble. In addition, there were the terrorist attacks of 9/11, and the U.S. got itself involved in two wars. In short, there were many dramatic events both in the U.S. and abroad--and yet the aggregate U.S. economy was relatively calm."

He leaves out the S & L Crisis. To me, the obviously most important factor. The implicit and explicit government guarantees to intervene in a crisis. So, we approach the history of this debacle from, not only philosophical differences, but historical differences. To me, the most important fact is how humans react to crises in real life, and what they are actually acting upon.

I've used this example before. Take illegal immigration. It's illegal. What do the government's actions over the last 20 years tell you about any implicit or explicit guarantees about whether the illegal immigrants will basically all allowed to remain in the end?

I don't know how to resolve this difference.

Here Comes The VIX, Here Comes The VIX

Gillian Tett in the FT:

"A couple of years ago – or before banks started to go bust – economists sometimes liked to talk about a phenomenon they christened The Great Moderation.

This was the idea that the 21st-century financial system and global economy had become so stable and sophisticated that dramatic swings in activity had seemingly disappeared. Volatility, in other words, was supposed to be an issue of the past.

These days a new phrase is needed to describe these Not-So-Moderate-After-All times (the Great Panic, perhaps?). On Friday, the Chicago Board Options Exchange Volatility Index, the Vix, rocketed 32.1 per cent to 89.53, as equity markets suffered another dramatic sell-off. The gyrations of the yen, euro, sterling and dollar have also been wild, pushing levels of currency volatility to heights barely seen in decades."

So let's:

1) Retire the phrase " The Great Moderation", and welcome in "The Great Volatility".
2) Add the Vix to our derivative plays.
3) Find risk-taking investors.
4) Retire the VAR ( Value at risk ) model for hedge funds. Too optimistic on the way up, too pessimistic on the way down. They appear here to be akin to laws.
5) Hope the policy-maker's prayers for hedge funds health works.

Anyway, read her whole post, since a couple of the suggestions are mine.

However, here we meet again our irrational and overly timid investor:

"On one level the absence of scavengers might seem “irrational”, given that plenty of cash-rich institutions still exist. On another level it makes perfect sense, given how shell-shocked many institutions now seem – and the sheer difficulty of predicting what other disorientated investors might do next."

He's turning up quite a bit.