once new claims number began declining from its peak value, the NBER subsequently dated the recovery from that recession as beginning within 8 weeks

TO BE NOTED: From Econbrowser:

"Initial claims for unemployment insurance

The Labor Department reported today that initial claims for unemployment insurance rose by 27,000 in the most recent available week. Although that's a disappointing development, it's still a small enough increase to allow the 4-week average to fall for the second week in a row. Since that declining 4-week average is one of the few encouraging pieces of news in an otherwise discouraging economic landscape, I wanted to take a closer look at just how significant a statistical signal it really sends.

The interest in the 4-week average of new claims for unemployment compensation results from the observation by Northwestern Professor Robert Gordon that, for each of the last six recessions, once the new claims number began declining from its peak value, the NBER subsequently dated the recovery from that recession as beginning within 8 weeks.

Black line: 4-week average of seasonally adjusted weekly initial claims for unemployment insurance, from Department of Labor via Webstract. Vertical lines: first week of the first month of a business cycle expansion as subsequently dated by the National Bureau of Economic Research.

Here's a close-up of the behavior of the series so far in 2009, with the raw weekly numbers in black and the 4-week average in blue.

Will the latest downward move prove to be the beginning of a recovery, or will we turn around and head back up to a new high? Let's try to pose this as a statistical question. We're trying to figure out whether the number for the 4-week average that was reported two weeks ago will turn out to be the highest value of this recession. Let s_t equal 0 if week t turns out to come before the peak value for the recession, and s_t = 1 if it turns out we're past the peak. Of course we don't know now which is the case, but if t represents a week from one of the previous 6 recessions, we now know enough to assign a value of either 0 or 1 to that week. There are 278 of those earlier observations on s_t from the recessions of 1970, 1974, 1980, 1982, 1990, and 2001.

The question we'd like to ask statistically is the following. Let's take it as given that we're currently in a recession. Let y_t denote the observed two-week percentage change in the 4-week average as of week t. The latest observation is a 1.8% decline, so the most recent value is y_t = -1.8. We'd like to calculate the probability that s_t = 1 if we've seen a 2-week decline in y_t as big as 1.8%, that is, we'd like to find the value of

From the definition of a conditional probability, this can be found by dividing the joint probability by the marginal probability:

We know the denominator of this fraction by looking at the number of those earlier known recession weeks between 1969 and 2001 for which we observed a 2-week decline in the 4-week average for new claims of 1.8% or more. It turns out that there were 46 weeks as favorable or more so as our most recently available datum:

To get the numerator, we count how many of those favorable declines proved to be the real McCoy. The answer is, 17 of them were part of the eventual trip down and out of the recession, but the other 29 represented temporary relief on a path that would eventually reach a new peak before turning down. The answer to our original question of interest, namely what's the probability we're on our way out of the recession this time, is thus given by

In other words, there's a 63% chance that new unemployment claims will go back above the recent peak before they finally start to head back down.

The key factor that leads to this pessimistic assessment is the fact that we're conditioning on the knowledge that our current week t is definitely still part of the recession, which seems to me an entirely safe bet. Given that we are in a recession, that fact in itself would lead you to expect to see new unemployment claims go up rather than down (as they did in the vast majority of our 278-week earlier sample). The fact that we've seen the average decline for a couple of weeks now isn't enough to get you to change your mind, if you're convinced that as of right now the recession has not yet ended.

What would it take to get you to change your mind? A 2-week drop of more than 3.4% would bring the probability above 0.5. But you'd never get much more confident than that based on this line of reasoning, because you'd always be factoring in the possibility that we'd see a repeat of the big drops in new unemployment claims that were observed in the 1970 and 1974 recessions, which ended up being followed by even bigger increases. The fact we're conditioning on for these calculations-- that we're currently in a recession-- is by itself a strong enough predictor that future unemployment claims are headed higher that you'd never be completely sure the peak is behind us based on just a few weeks worth of decline.

In other words, you'd never be completely persuaded, if the only variable you had to look at was a few weeks of unemployment claims, that a recession is just about to end.

The latest number might turn out to be a green shoot, no question. But the odds are two to one that it's just another dead twig.

---

Technorati Tags: employment, recession, macroeconomics, economics

Posted by James Hamilton "

Here’s a chart of all US recessions since 1900 and their length

TO BE NOTED: From Trader's Narrative:

"Published April 3rd, 2009 in Economy Tags: 1929 crash, depression, economy, federal reserve, NBER, recession, SEC, unemployment, US recessions.

While the stock market has perked up slightly, the economy continues to be mired in a deep recession. Unemployment, housing and other measures are still negative with no real sign of improvement.

Since 1900, there have been 22 recessions which works out to one about every 5 years. While recessions are labeled officially by the NBER, in January 2008 I pointed to a specific indicator which I believed meant that we were in a recession (by late 2007). A while later, this was confirmed by NBER.

Here’s a chart of all US recessions since 1900 and their length:

Source: Chart of the Day (using data from the National Bureau of Economic Research)

The outlier, of course, is 1929. The G-20 leaders huddled together in London to do everything to keep it an outlier and prevent an equally devastating world-wide depression..

At the start of the century there was a cluster of long recessions. These 5 recessions all happened before 1930 and were also the longest in length. The next 70+ years saw much shorter recessions.

Although you may think this was due to the institution of the Federal Reserve and its role in managing the economy, you’d be wrong. The Fed was created in December 23th, 1913. It was the SEC that came about as a result of the chaotic aftermath of the 1929 crash and ensuing depression.

Here’s a chart showing the relationship between the unemployment rate and the stock market during the past few recessions. Notice how the “bad news” of a rising unemployment rate accompanies a rising stock market. In other words, the market discounts the future and starts to rally well ahead of the turning point in the economy.

1929 crash, depression, economy, federal reserve, NBER, recession, SEC, unemployment, US recessions"

"Simeon Djankov argues for the merits of tax cuts over increased government spending as a form of fiscal stimulus"

Tyler Cowen helps Ryan Hahn of the World Bank's Crisis Talk by pointing out a paper that supports his distrust of government spending as a stimulus, as opposed to tax breaks. My view has both:

"Tax Cuts vs. Government Spending

Simeon Djankov argues for the merits of tax cuts over increased government spending as a form of fiscal stimulus, particularly in some eastern European countries. (The two policies are of course not mutually exclusive, but each will have different costs and benefits.) A new paper from NBER on What Are the Effects of Fiscal Policy Shocks? offers additional support for this line of thinking. According to the abstract:

We propose and apply a new approach for analyzing the effects of fiscal policy using vector autoregressions. Specifically, we use sign restrictions to identify a government revenue shock as well as a government spending shock, while controlling for a generic business cycle shock and a monetary policy shock. We explicitly allow for the possibility of announcement effects, i.e., that a current fiscal policy shock changes fiscal policy variables in the future, but not at present. We construct the impulse responses to three linear combinations of these fiscal shocks, corresponding to the three scenarios of deficit-spending, deficit-financed tax cuts and a balanced budget spending expansion. We apply the method to US quarterly data from 1955-2000. We find that deficit-financed tax cuts work best among these three scenarios to improve GDP, with a maximal present value multiplier of five dollars of total additional GDP per each dollar of the total cut in government revenue five years after the shock.

(Hat tip: Tyler Cowen)"

Let me state my plan again:

1) Government needs to spend money on the social safety net, including helping states with this problem .

2) Infrastructure Investment is a good use of government spending.

3) There should be tax cuts to try and alleviate the fear and aversion to risk, which I hold to be our main problem. After all, that's why consumption is down.

So, I suppose I don't disagree with the paper at all.

"Still, in current circumstances a glimmer of hope is better than nothing."

From Macroblog, some good news:

"Good news in income growth?

One of my New Year’s resolutions is to be more consistent in responding to questions and comments from the loyal readers of macroblog. Though it remains the case that time constraints prohibit a response to all worthy queries, we’re still listening. Next year we’ll endeavor to give a shout back just a little more often.

In that spirit, I received an interesting inquiry from reader Robert Schumacher:

A cursory examination of the monthly trends in real disposable income in light of the NBER official business cycles suggests to me that a sustained rise in disposable personal income (at least three if not four months) signals the end of the recession is at hand. In that real disposable income rose in October and November how are we to interpret this amidst the dire economic forecasts for the coming year?

It does seem, as Robert suggests, that a sustained rise in real disposable income is characteristic of a typical recession’s end. Using a graphical device from a few posts back, here’s a look at the trajectory of disposable income up to and after December 2007 (the start date of the current recession according to the NBER Business Cycle Dating Committee), compared with the average experience of the previous seven recessions dating from 1960:

As in the previous post, “time 0” represents the peak of a business cycle, or the month a recession begins. The average length of US recessions from 1960 through 2001 was 10.7 months, so the line indicating 10 months from the peak roughly coincides to the end of the average recession over this period.

On average, Robert’s conjecture looks right on track( I AGREE ). In the typical case, growth in real disposable income stalls and then begins to pick up three or four months before recession’s end. If you smooth through the spike associated with the stimulus package of late spring, income growth was roughly flat through August but has increased since (and at a reasonably good clip). That would seem to portend well for all of us—and I assume it is all of us—hoping for a sooner rather than later end to the current contraction.

The picture is equally encouraging if we look at the income series preferred by the Business Cycle Dating Committee, which subtracts out transfers (that is, payments made to the public by the government):

That’s all encouraging, but there is a caveat: Individual results may vary. Here are the comparisons for the long-lived (16-month) recessions of 1973–75 and 1981–82:

In these two recessions—which are arguably better benchmarks than the average at this point—income measures were not such reliable harbingers of expansion( NOTHING IS WRITTEN ).

Still, in current circumstances a glimmer of hope is better than nothing. ( I AGREE )

By David Altig, senior vice president and director of research at the Federal Reserve Bank of Atlanta

"as it is a particularly appropriate time for all of us to be at a conference focused on risk management and risk modeling for financial institutions.

Yesterday, Eric S .Rosengren of the Boston Fed gave a talk focusing on some principles for future regulatory reform, which I found out about on the WSJ:

"I am very pleased to be with you today, as it is a particularly appropriate time for all of us to be at a conference focused on risk management and risk modeling for financial institutions. I am very pleased to be with you today, as it is a particularly appropriate time for all of us to be at a conference focused on risk management and risk modeling for financial institutions.[Footnote 1] As you know, many banks around the world have, of late, found themselves needing equity infusions from governments, or expanded guarantees for their liabilities."

Actually, a more appropriate time for a conference on risk management and modeling is when things are seemingly going very well, but this is now a step in the right direction.

Banks have needed:
1) Money from government
2) Implicit guarantees made explicit

"A widespread need for banks’ recapitalization has occurred at least twice in the past century, and in many countries has occurred much more frequently than that. Many banks’ risk models were supposed to be calibrated for “once-in-a-thousand-years” events; however, these models seriously underestimated risk."

They not only underestimated risk, but, in doing so, were magnifying risk. That's the reason a " Once-in-a-thousand-year" event occurred in about five years.

"Certainly there is much still to study and understand about the recent financial turmoil that emerged in the summer of 2007. But it seems abundantly clear, and not all that surprising, that risks calibrated from a few years of data from good times can dramatically under-estimate risk exposure for a particular asset, as well as the high correlation of risks across asset classes during periods of significant stress. "

When you read how little data they had to base their predictions on, there's no way but to consider that ridiculous and negligent behavior. You have to ask what incentives or goals predisposed people to accept such preposterous presumptions.

"Furthermore, while capital models were intended to suggest minimum capital requirements that would keep institutions sound during risky times, the models were frequently used to justify expansion of dividends and stock buybacks, because they suggested that banks were overcapitalized during boom times. So this conference occurs at a good time, as we all try to re-evaluate how best to model and manage risk."

Lowering capital requirements is inherently risky. Period. This was a conscious and obvious attempt to find investments with lower capital requirements. Period.

"And it is not only our risk models that need to be reevaluated. Our regulatory framework clearly needs to be reconsidered, in light of recent events. Both in the U.S. and globally, we had in place a complex set of regulations and supervisory structures intended, in part, to increase the likelihood that financial intermediaries would remain well capitalized without government assistance. Like the risk models, bank regulators did not foresee the dramatic illiquidity that could emerge during a period of acute financial turmoil – nor the changes in the value of assets on balance sheets, or the degree of correlation of those asset values."

We've had a system, at least since the S & L Crisis, of implicit and explicit government guarantees to intervene in a financial crisis. We've had a pretty well established set of precedents from the S & L Crisis and Tech Bubble that fraud, negligence, fiduciary mismanagement, and collusion, are rarely and arbitrarily prosecuted. We've had a regulatory structure that did not do much regulating, and which was easily influenced by lobbying. Put those in your risk pipe and smoke it.

"While regulatory reform proposals are already beginning to surface, I see value in first evaluating the principles that should frame the discussion. Before we begin to work on regulatory details we need to evaluate whether the problem was poor execution of a well-considered regulatory framework, or that important principles were absent from the framework. While in my view the recent experience shows elements of both, I want to focus today on regulatory principles rather than their implementation."

It's more like the pool is being drained down to the level where regulatory reform proposals are being taken seriously. Was the problem:
1) Poor enforcement of good rules
2) Poor rules
3) A combination of both ( Yes. And he agrees )

He will focus on 2. Better to focus on rules than people. They might be offended.

"But before discussing regulatory principles, I would like to briefly discuss our current economic situation, in order to put the recent crises in context.

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Recent Economic Conditions

Many countries have already experienced two consecutive quarters of negative GDP growth and the NBER has recently declared that the U.S. entered the recession at the end of last year. In the U.S., GDP in the second quarter was positive, helped in part by a fiscal stimulus package. In the third quarter, GDP declined by 0.5 percent, and it looks like in the fourth quarter it will decline somewhat more significantly – since consumer and investment spending appear to be dropping quite precipitously. This is due, in part, to the interplay of developments in asset markets and the real economy. U.S. consumers – and, increasingly, consumers across Europe – have been buffeted by declining housing prices and falling stock prices. The resulting loss of consumer wealth, coupled with a rapidly rising unemployment rate, suggests the holiday buying season will not be robust as was hoped earlier this year."

What's with the constant use of "robust"? We're in a recession.

"The likelihood of further weakening of labor markets, and a reluctance of consumers or businesses to increase spending until economic conditions are more certain, together imply a continued difficult environment for banks. There are several conditions necessary for financial markets to resume a more normal state, and I would like to briefly discuss each."

Fire away.

"First, we need short-term credit markets to return to normalcy. Conditions in short-term credit markets have improved significantly since the end of September. As shown in Figure 1, rates in the market for high-grade financial commercial paper have resumed a more normal relationship to the Federal Funds rate target, compared to the mid September to mid October timeframe. This improvement in what was a very large spread has been greatly aided by the various short-term credit facilities established by the Federal Reserve to help reduce the stress in short-term credit markets. These facilities have also enhanced the ability of financial firms and issuers of commercial paper to extend the maturities on commercial paper issues (see Figure 2), which at the end of September had become dependent on overnight financing. The facilities have also reduced the risk that financing would not be available over the year end, as many commercial-paper issuers have now financed themselves beyond that point. But despite these improvements, short-term credit markets remain strained. Figure 3 shows that the spread between Libor[Footnote 2] and the Overnight Index Swap rate has fallen from its late-September peak but remains well above the level that prevailed prior to the outbreak of financial turmoil in summer of 2007."

This makes sense.

"Second, we need to see some improvement in the housing market before financial markets will resume a more normal state. In the U.S., residential investment began declining in the first quarter of 2006 and has declined in each quarter since. And as Figure 4 shows, house prices have declined nationally, and in some markets the declines have already exceeded 25 percent. A number of proposals have been floated to help stem foreclosures, but to date there has been relatively modest progress – faced, as we are, by the dual problems of falling housing prices and rising unemployment. Stabilization in house prices and a drop in foreclosures would help the overall economy as well as the banking sector that is exposed to construction loans, residential mortgage loans, and mortgage-backed securities."

This makes sense. How to do this is where we disagree.

"Third, officials must take into account – and develop policies and actions that reflect – the degree to which monetary policy tools are currently deployed. The stance of U.S. monetary policy reflects our rate reductions, with the Federal Funds rate target currently at 100 basis points. Given that interest rates cannot be negative, further monetary-policy actions are limited by the zero lower bound for interest rates. While other monetary policy tools can be employed, increasingly many observers and commentators are suggesting that fiscal stimulus will be an important element of economic recovery."

The word"deployed" again. Strange. We need a stimulus. Yes.

"Principles to Guide the Design of Regulatory Structure

With actions already taken to stabilize short-term credit conditions, and the widely-reported likelihood of further fiscal measures, I would hope that over the next year there can be a broader discussion of lessons learned from our recent problems, and what measures can be taken to reduce the risk of a recurrence. There can sometimes be a tendency to move to proposals for regulatory design before building a consensus on the underlying principles that should guide the debate. To that end, I would like to use my remaining time to discuss a few key principles that I hope will inform the many proposals that are likely to emerge."

I agree that principles should be developed first.

"Principle 1:
Financial regulation must be more clearly focused on the key goal of macroeconomic stability as well as the safety and soundness of individual institutions.

I lead with this principle, because I believe it has not necessarily received sufficient attention in our current regulatory structures. There is a clear link between the financial regulation of institutions and the stability of markets and the macroeconomy. Some countries have had frequent and severe banking crises, while other countries have been much more successful at weathering periods of international financial turmoil.

On the one hand, too conservative a regime of financial regulation can stymie innovation and creativity, thus preventing borrowers and lenders from interacting in the most efficient ways. On the other hand, inadequate oversight can cause periods of financial turmoil that are quite destructive to the financial infrastructure and the real economy. Future regulatory design must allow for innovation without increasing risks to the financial infrastructure and the real economy."

This is what I believe. The main objective should be to examine financial innovations as they occur as to whether they:

1) Transfer Risk

2) Magnify Risk

Whether regulation or supervision is needed is secondary to a clear and thorough examination of the new financial products or arrangements.

"Principle 2:
Because it is a key determinant of macroeconomic stability, systemic financial stability must receive greater focus, with roles and responsibilities during a financial crisis more clearly articulated.

Regulatory structures should be designed to minimize the probability of systemic disruption or instability. In the future, the definition of a “systemically important” firm must be clear in advance, and the regulatory structure should be designed to minimize the chance that such firms will take actions that would put systemic stability at risk. In addition, should a crisis arise despite the best efforts of regulators, the conditions and processes to “save” such firms must be well understood in advance."

I agree with this and have said so over and over. All government guarantees must be made explicit and agreed upon beforehand, as well as there being a minimal but clear and effective mode of regulation, involving rationalization and oversight of the regulators themselves as to their effectiveness and competence.

"Importantly, care must be given to the design of rescue options to minimize the incidence of moral hazard, or additional risk-taking by a party that is insured, “saved,” or otherwise insulated from the consequences of its activities. Of course, the best way to avoid moral hazard is to avoid crisis situations in which organizations need “saving.” The next best way is to have well-defined processes in place in advance, which minimize the effects of moral hazard.[Footnote 3]"

This is the most important point for me. We need to clearly differentiate between businesses that have government guarantees and those that don't, and regulate risk accordingly. What I've called Bagehot's Principles need to be applied, including killing off insolvent businesses quickly and effectively to enforce moral hazard as an ongoing regime. If you let it slide, your actions will overcome your words, and moral hazard will be significantly increased.

One addition to Bagehot's Principles might be:

We might save your bank, but you and and the people responsible for the bank's problems will not be saved, and might even suffer personal losses.

"Essential to determining which institutions are systemically important is a comprehensive view of what you might call the “financial entanglements” – interdependencies – among financial instruments and institutions.[Footnote 4] In an ideal situation, financial institutions could fail or have their assets transferred to other organizations with little disruption to counterparties or markets. Recent experience indicates that the uncertainty around counterparty risk in non-exchange-traded transactions is significant during periods of market stress. And it is difficult to ascertain the true extent of counterparty risk and whether a failure will result in significant disruptions in markets where the financial institution serves as a key player."

This is key, if for no other reason that, and this seems silly saying this, a financial institution can actually know what it has in assets and liabilities from day to day.

"In the U.S., the central bank can provide liquidity to the marketplace, but decisions to take on credit risk that pose substantial risks to taxpayers should ideally be in the hands of the Treasury Department, with oversight by Congress. However, during this period of financial turmoil the Treasury Department did not have the pre-existing authority to intervene expeditiously in such a crisis situation. The result was that the central bank became directly involved in urgent, time-sensitive issues that involved significant credit risk."

We need one agency to be in charge.

"To be better prepared for systemic problems, “standing” fiscal and monetary facilities are needed, to provide the ability to react more quickly than was possible of late. Until the passage of the Troubled Assets Relief Program (TARP), the U.S. Treasury Department did not have the ability to react to emerging problems as quickly as it would have liked. Similarly, many of the Federal Reserve facilities required significant accounting, legal, and back-office infrastructure that took some time to put in place."

We should plan for crisis management situations.

"In addition, as you all know, liquidity has been provided to institutions and markets where previously the central bank had little direct regulatory involvement. For example, facilities that were needed to provide liquidity to investment banks and money-market funds were established despite the absence of direct regulatory oversight by the Federal Reserve at the time the facility was initiated. Also, markets such as those for asset-backed commercial paper and unsecured commercial paper were not markets in which the Federal Reserve was actively engaged prior to the crisis. In the future, it would be ideal to clarify in advance which institutions and markets could require liquidity, and make sure the central bank has sufficient information about these institutions and markets to better serve in its role as lender of last resort."

This is also key, and follows from making everything explicit and agreed to beforehand.

"Principle 3:

Liquidity risk must receive greater policy focus in determining regulatory structures.

At the outset of the recent financial turmoil, many observers assumed that liquidity risk was well contained. In the case of investment banks, many of their assets were financed by repurchase agreements – short-term loans that were fully collateralized. Because the repurchase agreements were collateralized, most parties assumed there was a relatively low risk of a “run” because the collateral could always be sold in the event of a default. However, concerns with valuations of assets used for repurchase agreements resulted in many investors refusing to continue to lend even overnight once the counterparty was feared to be at risk of failure."

You have to be able to sell assets in order to get the money you need back.

"In addition, money market mutual funds were assumed to have relatively little liquidity risk, because they were constrained by regulations that compel them to hold only investment-grade securities of short duration. However, after one well-known money market mutual fund announced that its investors would not be able to redeem their entire principal (“breaking the buck”), many funds faced a wave of redemption requests they had great difficulty meeting – until action was taken to put in place temporary U.S. Treasury insurance as well as a new Federal Reserve liquidity facility."

People have to believe that they can get their money back when they need it.

"The financial turmoil has highlighted the reality that our regulatory structure had not fully anticipated the types of liquidity shocks that have occurred. Going forward, more attention should be focused on ensuring that the causes of liquidity disruptions are better understood, and that we are better equipped to avoid liquidity problems.[Footnote 5]"

Financial institutions need to be able to sell assets in order to meet capital requirements.

"Also, we must be cognizant of an issue that has compounded these liquidity problems – the interaction with accounting rules. Regulatory and accounting frameworks need to consider how best to address periods of sustained illiquidity."

Mark-to-market, Etc.?

"In order to prevent bank runs, many countries have not only insured bank deposits but have also guaranteed other liabilities. We need to better understand how best to structure liabilities to avoid the need for such debt guarantees in the future. In the recent turmoil, for many institutions it was the unexpected lack of a stable and fluid market for short-term debt to finance their balance sheets that created liquidity problems.[Footnote 6]"

We'd rather not have the government get involved.

"Principle 4:

Careful thought must be given to coordinating the work of the various domestic and international regulators in the design of the regulatory structure.

In the United States there exists a patchwork of overlapping regulators. Much of our regulatory design results from reactions to the Great Depression. Given all the changes that have occurred since then, it is probably appropriate to take a fresh look at our regulatory structure – not just the bank-regulatory agencies but also the inter-relationship of their work with that of the Securities and Exchange Commission and the Financial Accounting Standards Board."

This is what I've already called Rationalization.

"Ideally, a new structure would minimize the adverse effects of competing regulatory goals. It will also need to consider how different regulatory bodies can be better coordinated so that information moves more freely between them. Also, international coordination is becoming much more important, as firms have become more global. And as with monetary policy, I believe that to the extent possible, creating independent regulatory agencies with clear mandates is critical to success."

Same point, including ones I've already made about how regulations should be framed.

"Principle 5:

Responsibility for strengthening market infrastructure should receive more attention in regulatory design.

The current crisis has highlighted the need for better transparency. If every transaction is unique, it becomes difficult to determine valuations during periods of illiquidity. To the extent possible, contracts governing securitization should be standardized, with clearly defined steps to resolve competing interests when the underlying assets lose value."

I don't mind this, but frankly doubt its usefulness. Better, it should happen, but room should be left for some innovation.

"Similarly, contracts between institutions provide less transparency than transactions through exchanges. Exchange-traded assets provide a price that is widely observable – on contracts for assets that are clearly defined. To the extent that more assets move to be exchange-traded, counterparty risk is reduced, and transparency is increased."

This I agree with.

"I also believe that payment and settlement activities need greater oversight. The back-office difficulties involved in unwinding complex trades that were not exchange-traded highlight the need for more attention to settlement activities."

It might also deter graft.

"Conclusion Of course, these five principles are not the only ones of import. Others may stress other very worthy points taken from the lessons of the recent episode. For example that financial regulation must be grounded in an understanding of institutional relationships – “real world” details, which clearly do matter. "

You know you're in a strange situation when someone feels it necessary to remind everybody that we need to deal with the "real world".

"Or, as I mentioned when discussing moral hazard, that financial regulation needs to do a better job of recognizing the role of incentives. For example, compensation structures affect actions – as is evident in situations where short-term risk-taking is rewarded very lucratively and losses are not borne by the originators of the risk."

That's addressed by my addition to Bagehot's Principles.

"The current crisis provides the opportunity and impetus to reexamine a regulatory framework that originated in the Great Depression. While I believe there is a clear need to redesign the current regulatory structure, it is important that we not lose important features of the current market. It is critical that any regulatory design not stifle the industry’s innovation and creativity. However, the regulatory structure needs to be more adaptable to innovations – in order to ensure that new safety and soundness, and systemic, concerns are not ignored. And it needs to be aware of the details of the evolving financial-market structure."

That's why we need to focus on principles, and on our ability to discern what investment products are doing.

"Additional regulations do run the risk of moral hazard where the presence of a safety net creates an incentive to take additional risk. While any countercyclical monetary, fiscal, or regulatory policy runs this risk, it should be minimized. Ideally, situations requiring public support should occur only after losses have been borne by equity holders, and existing management and directors have been held responsible for the losses."

This is the main cause of the crisis for me. It stemmed from the self deception involved in the implicit guarantees, that everyone in the financial world believed were explicit. Everyone was pretending that these guarantees weren't there, while everyone was acting as if they were. This allowed a fairy tale view of what risk there was in the system, which led to an unnaturally childish view of risk by the individuals involved, since, if everything got scary, the investors had a fairy godmother called the government to bail them out. The fairy tale world turned out to be the one with no government guarantees, not the one that people were pretending wasn't real. We need a very onerous and specific set of principles for the government to be involved, and enforce moral hazard religiously from the outset. No more self deception and fairy tales, please.

"To the extent a new regulatory structure reduces counterparty risk, or requires offsets in capital for transactions involving significant counterparty risk, the likelihood of spillover effects from one firm’s failure should be significantly reduced. Ideally a new structure will reduce the likelihood of future financial turmoil of the length and severity of current financial problems."

We should raise capital requirements, and have a system in which capital can easily be raised if needed. An interesting talk.

"Thank you for having me join you today, and thank you for the opportunity to share my views on principles to guide the redesign of U.S. financial regulation."

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Complete speech, with exhibits

X Footnote 1

Of course, the views I express today are my own, not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee (the FOMC).

X Footnote 2

The London Interbank Offered Rate.

X Footnote 3

In a recent speech Chairman Bernanke, while stressing the importance of market discipline and the problem of moral hazard, said that "the failure of a major financial institution at a time when financial markets are already quite fragile poses too great a threat to financial and economic stability to be ignored. In such cases, intervention is necessary to protect the public interest. The problems of moral hazard and the existence of institutions that are 'too big to fail' must certainly be addressed, but the right way to do this is through regulatory changes, improvements in the financial infrastructure, and other measures that will prevent a situation like this from recurring. Going forward, reforming the system to enhance stability and address the problem of 'too big to fail' should be a top priority for lawmakers and regulators." The Chairman’s speech, Federal Reserve Policies in the Financial Crisis, is available at http://www.federalreserve.gov/newsevents/speech/bernanke20081201a.htm.

X Footnote 4

I discussed the benefits that central bank policymakers gain from having supervisory roles and relationships in a speech in Seoul in March. “Bank Supervision and Central Banking: Understanding Credit During a Time of Financial Turmoil” is available on the Boston Fed’s website at http://www.bos.frb.org/news/speeches/rosengren/2008/032708.htm

X Footnote 5

For more on issues of liquidity, liquidity-risk concerns, and systemic risk, see speeches entitled “Liquidity and Systemic Risk” and “The Impact of Financial Institutions and Financial Markets on the Real Economy: Implications of a Liquidity Lock.’”

X Footnote 6

Some observe that another lesson of the recent turmoil involves possible over-reliance on short-term debt throughout the financial system.

X Figure 1:
Asset-Backed Commercial Paper Rate and the Federal Funds Target Rate

July 1, 2008 - November 28, 2008

Source: Federal Reserve Board / Haver Analytics

X Figure 2:
Commercial Paper Issuance

July 2, 2007 – November 28, 2008

Source: Federal Reserve Board / Haver Analytics

X Figure 3:
Spread: One-Month London Interbank Offered Rate (LIBOR) to Overnight Index Swap (OIS) Rate

January 1, 2007 - November 28, 2008

Source: Financial Times, Bloomberg / Haver Analytics

X Figure 4:
S&P/Case-Shiller Home Price Indices: Composite and Selected Metropolitan Areas

January 2001 - September 2008

Source: S&P/Case-Shiller / Haver Analytics

"Productivity is what ultimately determines employment, and that looks good so far."

Casey Mulligan with the employment numbers. Oddly, I don't much like Ricardian Equivalence if it means anything more than if you shift resources or money in one part of the economy, it will have an effect on other parts of the economy. But I do seem to agree with him on where we are going, although not on the reasons we're getting there:

"In October I predicted that U.S. nonfarm payroll employment would never fall below 134 million (a level that would make this recession almost as deep as 1982). This prediction still makes sense to me, even though I did not anticipate that the Treasury and the Fed would themselves contribute to labor market damage.

Friday's employment report put nonfarm payroll employment at 136 million, having fallen 0.5 million in a month. Thus, I am predicting that we will not have four consecutive months like last month.

Productivity is what ultimately determines employment, and that looks good so far. On Thursday we learned that output per hour grew at 1.3% (annual rate) from 2008 Q2 and Q3, which is similar to the overall pace for 2007 and exceeds the pace for 2006. For the entire calendar year 2008, it looks like productivity will have grown more than it did for either of the prior two calendar years. By comparison, productivity growth was NEGATIVE in 1982 and (according to Cole and Ohanian) in EACH of the years 1930-33.

You may have noted the contrast between this year's employment performance and GDP performance. When productivity grows, output can grow even while employment falls. We are in a recession (and have been since late 2007) by the employment definition (NBER uses this) but not yet by the GDP growth definition. We likely will finish 2008 with more GDP than in any year in history, yet less employment than in 2007. The GDP and productivity performance is quite different from "severe recessions." What is severe about the 2008 economy is the news coverage, and the assault on the taxpayer!"

I think that the drop in housing prices and bank failures and stock market drop have been quite severe, as is the rise in unemployment. However, and I know that this can sound foolish, but I agree with him that the economy, and, in fact, I'll add the world economy, is in much better shape than people think. Which is why I don't find this 1930s reminiscence all that enlightening.

I also agree with Mulligan that government is a main culprit in our current crisis. However, it is rather more the fault of the business community which, whatever the government has done, made a serious of idiotic, and sometimes criminal, decisions, that were truly of momentous proportions.

I'm sure Mulligan is glad to know that if he turns out to be completely wrong, he'll have one other idiot to point to.

"Yields on speculative-grade bonds imply a U.S. default rate of 21 percent, higher than the record set during the Great Depression in 1933"

For the second day in a row, I've been sidetracked by a post. I should be working on my first novel, which is a philosophical horror roman. What do I mean by Philosophical Horror? Imagine taking the neurons of Stephen King and Albert Camus, tossing them in a bag, adding a few synapses, and shaking them. There. That's the start of a philosophical horror book.

Now, here's the story on Bloomberg:

"By Bryan Keogh

Dec. 3 (Bloomberg) -- Yields on speculative-grade bonds imply a U.S. default rate of 21 percent, higher than the record set during the Great Depression in 1933, according to John Lonski, chief economist at Moody’s Investors Service.

The extra yield investors demand to own U.S. high-yield bonds was 19.19 percentage points on Dec. 1, according to Moody’s. Assuming a 20 percent recovery rate, the spread implies a default rate of 20.9 percent, Lonski said yesterday in a market commentary. That compares with a rate of 11 percent in January 2001, 12.1 percent in June 1991 and 15.4 percent in 1933.

Defaults and bankruptcies are accelerating as financing options for high-yield companies dwindle amid the longest U.S. economic recession in at least 26 years. The U.S. default rate rose to 3.3 percent in October, according to Moody’s, which forecasts the rate to increase to 4.9 percent in December and 11.2 percent by November 2009.

“The default rate is going to start rising quickly, soon enough it’s going to be breaking above 10 percent,” Lonski said in an interview. “Lack of access to financial capital is a very big problem for high-yield bonds.”

Now, to me this is preposterous. It's driven by an irrational aversion and fear of risk, which can cause these kind's of scenario's to come true. Of course, I could be wrong about this, but it doesn't pass my smell test.

What's the smell test? I use my nose as a kind of Bayesian filter and take a good whiff of the probabilities that might arise. I don't believe that we'll have more defaults than the Depression. Next, you'll be telling me that the Sun is more likely to Supernova than Junk bonds not default.

Would I buy these bonds? Um, um, um, sure, why not? I'll take a hundred. Put it on my tab.

"The National Bureau of Economic Research, the panel that dates American business expansion, on Dec. 1 confirmed that the U.S. economy has been in a recession for 12 months, making it the longest since 1982. The economy shrank at a 0.5 percent pace in the third quarter after expanding 2.8 percent in the previous three months. Economists expect a 2.2 percent contraction in gross domestic product for the fourth quarter, the average estimate from a Bloomberg survey.

Three companies have sold $2.7 billion of high-yield bonds this quarter, compared with $30 billion in the same period a year ago, according to data compiled by Bloomberg. Leveraged loans arranged this year total $301 billion, down more than a third from last year, Bloomberg data show.

“There’s a lot of forced selling of high-yield bonds by hedge funds owing to the need to de-lever as well as by mutual funds in response to redemptions,” Lonski said. “You’re looking at a market where the sellers well outnumber the buyers and the reluctance on the part of buyers makes sense if only because a bottom for economic activity is not yet in sight.”

High-yield, high-risk bonds are rated below Baa3 by Moody’s and BBB- by Standard & Poor’s."

Okay. Deleveraging is a problem. But I still think this is overdone.

Now I'll probably have to talk about that Bayesian post that Hsu wrote.

"the only way to accomplish this is to get America back on the course of rising median incomes."

Robert Reich has a post that I think is correct, but not necessarily for the same reasons:

"If this isn't a Great Crash I don't know how to define one. Stocks were down another 7 percent today. Since the peak of last year, major stock indexes have dropped 47 percent. We're in range of the Great Crash of 1929."

I think that this is a Stock Market Crash, but that doesn't mean it's like 1929.

"Why is the Great Crash of 2008 happening? First, because investors are beginning to understand the enormity of the bubble economy that began to form in the late 1990s when all contraints were lifted on borrowing in order to buy everything that was assumed to be increasing in value -- starting with houses and including securities and shares of stock themselves. So-called "margin requirements," first instituted in the wake of the Great Crash of 1929, were all but abandoned, as big banks and hedge funds found ways around them."

I agree that Leveraging was the problem, and that Deleveraging is the solution. However, I believe that this financial innovation has been an ongoing process, and I would offer the S & L Crisis as proof. I don't think it's that investors are beginning to understand the enormity of the problem, so much as being surprised that government action hasn't been more effective. You see, I believe that investors had a robust view of the size and efficacy of government intervention.

"Even more important, investors are starting to fathom the emptiness of American consumers' wallets. Retail sales last Friday and Saturday -- the first days of the Christmas buying season -- were disappointing. Had retailers not discounted to the point of taking losses, sales would have been abysmal. In other words, consumers have gone on strike."

I didn't see the sales being that bad given the enormity of the fear and aversion to risk now prevalent. I would say that consumers are being prudent.

"Why have they gone on strike? Not because of the difficulty of getting credit. Most consumers can barely afford to pay the interest charges on the debt they're already carrying. Consumers have gone on strike because their earnings haven't kept up. The recovery that officially ended December, 2007 (the National Bureau of Economic Research now tells us) was the first on record in which median earnings declined, adjusted for inflation. Since then, many people have also lost their jobs or are working part time when they'd rather be working full time, or else know they're in danger of losing their jobs."

Now, there's a big debate on this, which I've posted about, and I feel that Reich's figures might be off. However, he's not incorrect about how people feel, which is more important than numbers, which are only that.

"The speculative bubble still has some air in it; asset values will continue to drop before they hit bottom. That will take at least a year, possibly two. But don't expect asset values to bounce substantially back, even then. The only way to revive Wall Street is to revive Main Street, and the only way to accomplish this is to get America back on the course of rising median incomes."

I actually feel more strongly about this than Prof. Reich. Unless and until we have a Middle Class that feels itself to be middle class and not just above destitution, there will never be a serious movement to limit government. The feeling and security of wealth is necessary for a population to cut itself loose from a social safety net, which will always have to exist for the truly needy, instead of using government to remain just above destitution.

One other thing. I agree with this strategy. I would not accept a society of gross inequalities in wealth and power, and so, as Thoreau, I believe that people will only have less government when they are prepared for it.

"Can a Lender of Last Resort Stabilize Financial Markets? Lessons from the Founding of the Fed (NBER) "

Via Paul Kedrosky, this interesting article:

"Can a Lender of Last Resort Stabilize Financial Markets? Lessons from the Founding of the Fed

Asaf Bernstein, Eric Hughson, Marc D. Weidenmier NBER Working Paper No. 14422 Issued in October 2008 NBER Program(s): DAE ME ---- Abstract ----- We use the founding of the Federal Reserve as a historical experiment to provide some insight into whether a lender of last resort can stabilize financial markets. Following the Panic of 1907, Congress passed two measures that established a lender of last resort in the United States: (1) the Aldrich-Vreeland Act of 1908 which authorized certain banks to issue emergency currency during a financial crisis and (2) the Federal Reserve Act of 1913 which established a central bank. We employ a new identification strategy to isolate the effects of the introduction of a lender of last resort from other macroeconomic shocks. We compare the standard deviation of stock returns and short-term interest rates over time across the months of September and October, the two months of the year when financial markets were most vulnerable to a crash because of financial stringency from the harvest season, with the rest of the year during the period 1870-1925. Stock volatility in the post-1907 period (June 1908-1925) was more than 40 percent lower in the months of September and October compared to the period (1870- May 1908). We also find that the volatility of the call loan rate declined nearly 70 percent in September and October following the monetary regime change."

I'm not going to pay for it, instead I'm going to try and get it at my library. It does sound interesting.