Nouriel Roubini on the ‘green shoots’ sentiment currently doing the rounds:
Related links:
The Susan Boyle Factor - FT Alphaville
Optimistically, pessimistic in the US - FT Alphaville
The WSJ survey of forecasts has just come out [link]. One key finding is that the mean forecast has barely budged since March. In other words, unlike previous months, the perceived outlook has ceased deteriorating.
That being said, the dispersion of forecasts is pretty high, even q4/q4, ranging (-3.5%, 3.4%).
One is tempted to ask who is forecasting 3.4%. That would be James F. Smith, of Western Carolina State University and Parsec Financial Management. Dr. Smith has been extremely consistent in his forecasts for q4/q4 growth, having forecasted 3.4% in the December 2008, as well as in the January, February and March 2009 surveys (I didn't go further back than December...). Note that once his forecast is removed, the distribution of the survey responses is approximately Normal (i.e., a Jarque Bera test can't reject the null of a Normal, at the 43% msl). In addition, the mean growth rate drops to -1.48%.
I noted in the first paragraph that the mean forecast had ceased deteriorating. One can see this if one plots the March and April mean forecasts. The forecasted trajectory of GDP is essentially unchanged. One has to go back to the February forecast to see the detioration, as is shown in Figure 2.
In this sense, the statements by several individuals that the outlook has stopped deteriorating are consistent with forecasters' views. [0] [1] However, this is not the same as saying economic conditions have stabilized. In fact, the mean GDP forecast still indicates continued decline into 2009Q2. And of course, means by definition do not show the variance in forecasts.
Because of the aforementioned sensitivity to outliers (I'll call it the James Smith problem), I've plotted in Figure 3 (log) real GDP, the mean WSJ forecast from the April survey, and trimmed high and low forecasts (that is, looking at the 6th highest and 6th lowest q4/q4 forecasts; thus I've dropped the top 5 and bottom 5, out of 54 forecasts).
The mean forecast implies that the output gap will be -8% (in log terms) in 2009q4. If the optimists are right, then the output gap will only be -6%.
The survey was conducted between April 3-6. Thus, they came before the trade release for February. Since the trade balance was above consensus, conditional nowcasts of GDP have probably risen [2].
On the other hand, the OECD forecast cited in this post implies continued decline throughout 2009. I'm not certain why the OECD is so gloomy (or alternatively, why the US-based forecasters are so optimistic). Using the OECD forecast and the CBO potential, the output gap will be 10.9% (log terms) by 2010q4. Perhaps this is in part due to a more pessimistic assessment of potential GDP (eyeballing the "Output Gap" table in Appendix 1.2 of the March OECD Economic Outlook, it seems that the OECD's estimate of potential is about 1.2% ppts less CBO's).
A final observation: given the substantial negative output gap under reasonable assumptions, it's hard for me to be particularly worried about inflation in the current year, as evidenced in some fevered accounts (e.g., [3]). Given that 0% of respondents perceived inflation as the biggest threat to their forecast, I think I'm in good company. (Digression: in 2000-01, when I was following the Japanese economy on the CEA staff, I also heard worries about hyperinflation in the wake of rising debt-to-GDP ratios; so far we haven't seen that outcome materialize).
Technorati Tags: recession, GDP, inflation,output gap, potential GDP, hyper-inflation, and forecast.
Posted by Menzie Chinn at April 10, 2009 09:00 PM"
Mark Perry had a nice post yesterday with an update of the Fed's model for predicting recessions and recoveries. The upward slope of the Treasury yield curve now says that the probability of recession this year is rapidly approaching zero: "the Fed's model shows a recession probability of only about 1% on average through the next 12 months, and below 1% by the end of the year."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" 
So now we're back to square one.
Neil Irwin and Binyamin Applebaum, Washington Post:
Just days before Treasury Secretary Timothy F. Geithner was scheduled to lay out his much-anticipated plan to deal with the toxic assets imperiling the financial system, he and his team made a sudden about-face.
According to several sources involved in the deliberations, Geithner had come to the conclusion that the strategies he and his team had spent weeks working on were too expensive, too complex and too risky for taxpayers.
They needed an alternative and found it in a previously considered initiative to pair private investments and public loans to try to buy the risky assets and take them off the books of banks. There was one problem: They didn't have enough time to work out many details or consult with others before the plan was supposed to be unveiled...
At the center of the deliberations with Geithner were Lawrence H. Summers... Lee Sachs, a Clinton administration official.... and Gene Sperling, another former Clinton aide. The debates among them were long and vigorous as they thrashed countless proposals and variations. Sometimes, Fed Chairman Ben S. Bernanke, Federal Deposit Insurance Corp. Chairman Sheila C. Bair and Comptroller of the Currency John C. Dugan joined in...
Senior economic officials had several approaches in mind, according to officials involved in the discussions. One would be to create an "aggregator bank," or bad bank, that would take government capital and use it to buy up the risky assets on banks' books. Another approach would be to offer banks a government guarantee against extreme losses on their assets, an approach already used to bolster Citigroup and Bank of America.
As the first week of February progressed, however, the problems with both approaches were becoming clearer to Geithner, said people involved in the talks. For one thing, the government would likely have to put trillions of dollars in taxpayer money at risk, a sum so huge it would anger members of Congress. Officials were also concerned that the program would be criticized as a pure giveaway to bank shareholders. And, finally, there continued to be the problem that had bedeviled the Bush administration's efforts to tackle toxic assets: There was little reason to believe government officials would be able to price these assets in a way that gave taxpayers a good deal.
By Wednesday, Feb. 4, Geithner was leaning toward a different approach that his former colleagues at the Federal Reserve had developed months earlier, the source said. This involved a joint public-private fund to buy up the assets. Private investors, likely hedge funds and private-equity funds, would put up capital, and the government would loan money to the fund. If the private investors made wise decisions about which assets they bought, they would be able to pay back the government and make money for themselves...
And if the private investors made dumb decisions, hey, no worries--the taxpayer would pick up the tab. (Our assumption). (Keep reading >)
Geithner had 19 months to work through this and the problems only became clear in the first week of February?
Here's a simpler plan: Temporary receivership and restructuring. Fast, simple, effective. And, most importantly, it works."
Me:Including discouraged workers ... the unemployment rate was 7.6 percent last month. Another 5.2 percent of the labor force was involuntarily working part time. These two groups bring the combined rate to 12.8 percent. ... And there appear to be several hundred thousand people — mostly men — who stopped looking for work more than a year ago but would gladly take a good-paying job if one came along. They would lift the rate above 13 percent.
As bad as the number is, it is still not that close to its 1982 peak of 16.3 percent (or anywhere near its Depression levels, which were probably above 30 percent).
Now this recession isn't over yet. By the time that it is, I wouldn't be shocked if unemployment had surpassed its 1982 levels—making this the worst economic downturn since the Great Depression. Still, all indications are that it's much closer in severity to the deep recessions of the mid-1970s and early 1980s than to the complete disaster that was the early 1930s.
The financial crisis of the past couple years has been more like that of the 1930s than anything since. But the government response—however bungled and expensive it's been—seems to have kept the economic damage within bounds. So far."
I agree.I find myself becoming increasingly irritated at so much of what is going on out there. Here is a quick list of the things I just don't care about:
I find it helpful to keep track of things I don't care about. That way I can stop paying attention when they come. It's liberating, like emptying out the garage.
Feel free to add others."
I've heard enough about:Earlier I posted some graphs from the Minneapolis Fed comparing this recession to a mildest, median, and harsh recession. Questions arose as to how the Fed was defining these categories - harshest overall? how defined? at what point? I took a look at the underlying data and saw a sensible procedure which seemed to make sense of what the Fed was doing and I posted that in the comments. After further questions, however, and after contacting the Fed it's now clear that the Fed is doing something else.
The mildest, median and harshest recessions in the Fed's graph are Frankenstein recessions, recessions cobbled together by taking bits of pieces of each past recession and assembling them to create a mild, median, and harsh recession - none of which ever occurred. I do not think this is a good way of looking at the data( I AGREED WITH THIS VIEW IN AN EARLIER POST ). To avoid some of these problems I have simply graphed all of the data below for every past recession. In the extension to this post you can also find the Fed's justification of their procedure from an email to me.
From Terry Fitzgerald at the Minneapolis Fed.
You are correct that the "mildest, median, and harshest" recession lines do
not represent single recessions. Please allow me to try to justify our
procedure. We spent considerable time weighing alternative approaches.
In drawing our timeline "length of recessions" graphs, we wanted to
illustrate where the current recession lies relative to past recessions at
each month of the recession. So for each month (or quarter), the lines
would tell you what had been the largest, median, and smallest decline in
any recession to that point.
The median line would indicate that one-half of the past recessions had
experienced larger declines, and one-half had experienced smaller declines
to that point. Similarly, no recession had a larger decline to date than
the "harshest" line. (And similarly for the mildest line.)
One feature of this approach is that the mildest, median, and harshest lines do not shift over time. So we can update just the "current" line in our graphs without all the lines shifting.
...I knew that insightful readers might wonder about this point, and I hoped that the note would at least explain what we did.
We are not trying to do anything deceptive or misleading with these charts.
Our aim is only to provide some empirical context to the current recession."
Per capita real GDP was slightly negative 'year over year' through the 3rd quarter.
Many forecasts project this recession to be the worst since the Great Depression. If true, expect this figure to drop significantly below the -4% level seen in the recessions of the 1970's or early 1980's.
Note that the ten year rolling annual average real GDP growth per capita has slipped to 1.3% as of September 2008, which is the lowest print since 1984.
Source: BLS / BEA"
As recession fears cause the nation to embrace greater state control of the economy and unimaginable federal deficits( THIS IS TRUE. THAT'S WHY WE DON'T WANT THEM GENIUS ), one searches in vain for debate worthy of the moment( WE CAN HAVE THE DEBATE LATER, RIGHT NOW WE NEED ACTION. THE TWO AREN'T SYNONYMOUS ). Where there should be an historic clash of ideas, there is only blind resignation and an amorphous queasiness that we are simply sweeping the slouching beast under the rug( DON'T BE DAFT. YOU'RE WRITING IN THE WSJ AND YOU'VE BEEN ALL OVER THE TELLY AND BLOGS. THERE ARE PLENTY OF DISSENTING VIEWS. THEY'RE SIMPLY NOT CONVINCING TO MANY OF US ).
With faith in the free markets now taking a back seat to fear and expediency( SILLY ), nearly the entire political spectrum agrees that the federal government must spend whatever amount is necessary to stabilize the housing market, bail out financial firms, liquefy the credit markets, create jobs and make the recession as shallow and brief as possible( TRUE ). The few who maintain free-market views have been largely marginalized( THEIR VIEWS WON'T WORK. WE DON'T HAVE A FREE MARKET. WE HAVE A HYBRID ).
Taking the theories of economist John Maynard Keynes as gospel( IT'S MORE LIKE A NARRATIVE, BUT YOU OBVIOUSLY FAVOR PEJORATIVES AND OVERSTATEMENTS. YOU'VE BEEN READING MENCKEN, PERHAPS. HE WAS ONE OF A KIND ), our most highly respected contemporary economists imagine a complex world in which economics at the personal, corporate and municipal levels are governed by laws( LAWS? LIKE NEWTONIAN MECHANICS? ) far different from those in effect at the national level.
Individuals, companies or cities with heavy debt and shrinking revenues instinctively( THEN WHY HAVEN'T THEY BEEN DOING THAT UNTIL NOW? ) know that they must reduce spending, tighten their belts, pay down debt and live within their means. But it is axiomatic in Keynesianism that national governments can create and sustain economic activity by injecting printed money into the financial system( IT CAN. AN ECONOMY ISN'T A HOUSEHOLD. BY THE WAY SCIENTIST, THE LAWS OF NATURE ALSO APPLY DIFFERENTLY AT DIFFERENT LEVELS OF EXPLANATION, OTHERWISE WE'D HAVE KEYNE'S CAT OR SOME SUCH MONSTROSITY ). In their view, absent the stimuli of the New Deal and World War II, the Depression would never have ended( MORE LIKE TOTALITARIANISM MIGHT HAVE WON ).On a gut level( IS THAT A DIFFERENT LEVEL THAN THE NATIONAL? WHAT ARE ITS LAWS? ), we have a hard time with this concept( WHAT IS IT AGAIN? ). There is a vague sense( QUITE SPECIFIC AREN'T YOU GALILEO ) of smoke and mirrors, of something being magically created out of nothing( LIKE THE BIG BANG? ). But economics, we are told, is complicated( MORE LIKE OF LIMITED USE ).
It would be irresponsible in the extreme for an individual to forestall a personal recession by taking out newer, bigger loans when the old loans can't be repaid( ACTUALLY, MANY PEOPLE HAVE MAXED OUT THERE CREDIT CARDS, GONE BUST, AND THEN STARTED OVER AGAIN. PRESUMABLY, ON THIS MODEL, COUNTRIES COULD THIS AS WELL. IT DOES APPLY TO CITIES. ). However, this is precisely what we are planning on a national level.( IT'S A SILLY ARGUMENT )
I believe these ideas hold sway largely because they promise happy, pain-free solutions( ARE THOSE NOT TO BE DESIRED? ). They are the economic equivalent of miracle weight-loss programs that require no dieting or exercise( ENOUGH OF THE ANALOGIES ). The theories permit economists to claim mystic wisdom, governments to pretend that they have the power to dispel hardship with the whir of a printing press, and voters to believe that they can have recovery without sacrifice( MAYBE THEY'D LIKE MUTUAL SACRIFICE ).
As a follower of the Austrian School of economics I believe that market forces apply equally to people and nations( I'VE POSTED ON THE PHILOSOPHY OF THE AUSTRIAN SCHOOL. IT HAS SOME VERY USEFUL INSIGHTS, BUT THIS ISN'T ONE OF THEM. ). The problems we face collectively are no different from those we face individually( OF COURSE THEY ARE ). Belt tightening is required by all, including government( FOR A SCIENTIST, YOU THROW AROUND A LOT OF CLICHES ).
Governments cannot create but merely redirect( IS THIS LIKE THE DEBATE ABOUT WHETHER GOD CREATED THE WORLD FROM NOTHING, OR JUST REARRANGED MATTER? ). When the government spends, the money has to come from somewhere( SAME THING WHEN I SPEND ). If the government doesn't have a surplus, then it must come from taxes( THE GOVERNMENT CAN INVEST. YOU'VE JUST GIVEN A WHOLE TREATISE TELLING US THAT THE NATION AND PEOPLE ARE THE SAME ). If taxes don't go up, then it must come from increased borrowing. If lenders won't lend, then it must come from the printing press, which is where all these bailouts are headed( I SHOULD HOPE SO ). But each additional dollar printed diminishes the value those already in circulation ( AND? ). Something cannot be effortlessly( HOW MUCH EFFORT DOES IT TAKE? ) created from nothing.
Similarly, any jobs or other economic activity created by public-sector expansion merely comes at the expense of jobs lost in the private sector( MORE OR LESS ). And if the government chooses to save inefficient jobs in select private industries, more efficient jobs will be lost in others( THERE'S NO WAY TO KNOW THAT A PRIORI. IT'S CONCEIVABLE THAT THE PRIVATE ECONOMY COULD CREATE EVEN LESS EFFICIENT JOBS ). As more factors of production come under government control, the more inefficient our entire economy becomes( OVER THE LONG RUN THAT IS TRUE ). Inefficiency lowers productivity, stifles competitiveness and lowers living standards( TRUE ).
If we look at government market interventions through this pragmatic lens( WHAT'S PRAGMATIC ABOUT WHAT YOU JUST SAID? IT'S ALL THEORY ), what can we expect from the coming avalanche of federal activism( TELL ME )?
By borrowing more than it can ever pay back( HOW'S THAT ? ), the government will guarantee higher inflation for years to come, thereby diminishing the value( NOT REALLY. PRICES WILL VARY BASED ON MANY FACTORS ) of all that Americans have saved and acquired. For now the inflationary tide is being held back by the countervailing pressures of bursting asset bubbles in real estate and stocks, forced liquidations in commodities, and troubled retailers slashing prices to unload excess inventory. But when the dust settles, trillions of new dollars will remain, chasing a diminished supply of goods. We will be left with 1970s-style stagflation, only with a much sharper contraction and significantly higher inflation( NOT ).
The good news is that economics is not all that complicated( USEFUL ). The bad news is that our economy is broken( IT'S NOT A MACHINE. GOD SPARE US MECHANISTIC THINKERS ) and there is nothing the government can do to fix it. However, the free market does have a cure( THAT MAKES THE UNEMPLOYED WHAT ? ): it's called a recession( AREN'T WE GOING THROUGH IT? ), and it's not fun, easy or quick. But if we put our faith( TRY ARGUMENTS, WHICH YOU HAVEN'T EVEN BOTHERED TO ARGUE AGAINST ) in the power of government to make the pain go away, we will live with the consequences for generations( DON'T BE SILLY. IF WE LISTEN TO YOU, WE WILL LIKELY END UP WITH SERIOUS SOCIAL DISLOCATIONS, WHICH, BELIEVE ME, YOU AREN'T PREPARED TO DEAL WITH. )"
I guess if you're rich, you're supposed to be smart. I don't believe that.
Let's go over this once again. The context determines the range of possible actions. Since he likes analogies, the same is true for human communication. The context determines the meaning of a sentence or word. Because our investor class believes in government bailouts and was preparing for them, they were entirely unprepared to handle this crisis on their own. That is the true context of this crisis. The free market does not exist here. We have a Welfare State. Most people accept its terms of operation.
Wittgenstein had a sentence about meaning that applies here:
"If a lion could talk, we could not understand him."“We should( THERE IS NO SHOULD ) have a recession,” Cochrane said in November, speaking to students and investors in a conference room that looks out on Lake Michigan. “People who spend their lives pounding nails in Nevada need something else to do.”( CREATIVE DESTRUCTION )
So the hangover theory, which I wrote about a decade ago, is still out there.
The basic idea is that a recession, even a depression, is somehow a necessary thing, part of the process of “adapting the structure of production.” We have to get those people who were pounding nails in Nevada into other places and occupation, which is why unemployment has to be high in the housing bubble states for a while ( TO THE EXTENT THAT THEY WERE EMPLOYED IN CONSTRUCTION, THAT COULD SIMPLY BE THE CASE ).
The trouble with this theory, as I pointed out way back when, is twofold:
1. It doesn’t explain why there isn’t mass unemployment when bubbles are growing as well as shrinking — why didn’t we need high unemployment elsewhere to get those people into the nail-pounding-in-Nevada business( BECAUSE THEY WOULD IMMEDIATELY BE EMPLOYED )?
2. It doesn’t explain why recessions reduce unemployment across the board, not just in industries that were bloated by a bubble.( FEAR AND AVERSION TO RISK. IN ALL RECESSIONS, THERE IS SOME PROACTIVE AND UNNECESSARY FIRING OF WORKERS )
One striking fact, which I’ve already written about, is that the current slump is affecting some non-housing-bubble states as or more severely as the epicenters of the bubble. Here’s a convenient table from the BLS, ranking states by the rise in unemployment over the past year. Unemployment is up everywhere( HENCE, MY POINT. THE FUNDAMENTALS CAN'T BE THE SAME EVERYWHERE ). And while the centers of the bubble, Florida and California, are high in the rankings, so are Georgia, Alabama, and the Carolinas.
So the liquidationists are still with us. According to Brad DeLong,
Milton Friedman would recall that at the Chicago where he went to graduate school such dangerous nonsense was not taught
But now, apparently, it is.( THERE WILL PROBABLY BE RECESSIONS, BUT WE SHOULD TRY AND STOP THEM. )
Update: Not to mention the idea that employment is dropping because workers don’t feel like working."
(Update: someone in comments has made the perfectly legitimate point that Paul Krugman may only be saying that a Great Depression has broken out in Ukraine, and obviously only he can say what he really thinks, but as far as I am concerned, since one of the hallmarks of the original Great Depression was a sudden sharp drop in output, sustained over a number of years, and in a large group of countries, accompanied in several cases by outright price deflation, then I do think that a depression rather than a recession( DON'T AGREE ) is what we now have on our hands, and what makes me more or less sure about that is looking not only at what is happening in Ukraine, but also at neighbouring Russia, and China, and so on and so on. Evidently, since history never exactly repeats itself, I am certainly not saying that this is going to last a decade, or end in a big war, or anything like that, but that it is already in the history books, and already in the class of large and unusual economic phenomena, and that we can learn things about how to handle our present problems by looking at the experience of 1930s, of all of this I am absolutely sure, and I have a pretty good idea that both Bernanke and Krugman are too, if you look at the constant references to those years in almost everything they say and do these days( THE 1930s ARE OF LIMITED USE. IT WAS A COMPLETELY DIFFERENT CONTEXT )
Now For Some Charts
Japan industrial output isn’t exactly falling at the same dramatic pace as Ukraine, but a 16.2% year on year fall isn’t to be sniffed at either, and this is what they informed us today happened in November. Worse still, according to Japan’s Economy Ministry output is expected to decrease by a further 8.0% between November and December, which, if accurate, will surely push the year on year decline in December over the 20% mark, not the great depression, but then again, not exactly enjoyable.
And exports, which drive the Japanese economy, were down by 26.7% in November. Even more to the point, deflation is baaack, or almost back, since “core” core prices hit zero (or 0.1% below current overnight BoJ interest rates) in November, and outright deflation surely isn’t far behind.
You can find more detail on all today’s Japan data over at the Japan Economy Watch Blog, and for those of you who want some more deflation background on Japan, well, Krugman has the goods here (extremely wonkish).
Moving nearer to home we have Germany. Here is the latest (flash) December manufacturing PMI for Germany, which is just about as point of the spear as you can get in terms of just in time data.
The slope of that line looks pretty telling doesn’t it, especially if you are into depression economics. Then we have the November new orders chart, another shocker, and indicator of much worse to come, I think.
Now going back to this point:
“There is a burgeoning economic crisis in the European periphery,” Krugman said on the ABC network Dec. 14. “The money has dried up. That’s the new center, the center of this crisis has moved from the U.S. housing market to the European periphery.”
I think this is largely true, if we mean by the periphery the UK, Ireland, Eastern and Southern Europe, but the periphery in a very literal sense always ends up biting the hand that feeds it, since German industry depends on exports to that periphery perhaps more than to anywhere else, so it is not surprising that once the periphery folds, the shock wave moves on in towards the centre. I don’t know if the blast which is about to hit Germany next year will count as a depression, but if it doesn’t, it is going to be a damn close call. And the hard part for Germany is when you get to ask yourself where exactly the new demand will come from to drive the exports( THE GOVERNMENT COULD SPEND, WHICH IS WHAT WILL HAPPEN )?
Moving off now towards the periphery, we have Spain to the south, where the money certainly has dried up, and with it internal demand for Spain’s manufactured products. The November PMI showed Spanish industry contracting at an all time series maximum for any country.
Central Europe
The whole of central European manufacturing is now contracting rapidly. First off, the Czech Republic
Then Poland
And finally (for this little illustration) Hungary
Then There Is Russia
Moving on now to Russia, industrial output was down by 8.9% year on year in November, so it hasn’t yet reached Ukraine levels, but at the rate of contraction they are experiencing I wouldn’t be too confident that that state of affairs will last too long.
And Finally China
Where the November PMI also showed quite a strong contraction:
So where does that leave us? Well basically I’m not sure. We still need to see more data. (Do I sound horribly like Jean Claude Trichet at this point?). If we look at the chart for US industrial output which Krugman presents, the first thing which is pretty obvious is that the 1928-1930 boom-bust was a pretty rapid affair.
After that output dropped very sharply, going in the space of twelve months from a 20% expansion to a near 30% contraction, and the contraction continued at those levels until mid 1932, when the position started to improve - although all this year on year % contraction data is a bit misleading for non specialists, since to have a 30% contraction in mid 1932, following near 30% contraction in mid 1930 and (what) a 15% contraction in mid 1931 (taking into account base effects) then the drop is really massive, and I doubt even Ukraine (barring very worst case scenarios where the country simply disintegrates) will get this. But where this current output slump (or call it what you will) in a number of key countries already does resemble the 1930s more than any other drop in activity since (remember, Japan’s November fall in output is greater than anything that has happened in the entire lost decade-and-a-half) is in the sharpness of the drop, and in the sequencing of events. By sequencing I mean the fact that we have had a pretty dramatic financial crisis, which has lead to a generalised loss of confidence in the banking sector( THIS IS TRUE. THE AVERSION AND FEAR OF RISK ), and this in turn has produced a credit crunch, which is now working its way right through the real system( TRUE, IT'S ALL THE FEAR AND AVERSION TO RISK ). And nothing, but nothing, at this point, seems to be barring its pass( IT WILL SUBSIDE NEXT YEAR ). That is the worrying bit, and that is why I don’t think we are going to see a generalised “turnaround” in activity in 2010, or even 2011, this show is going to run and run, at least in some of the worst affected countries. And we still don’t know just how many icebergs there are lying out there for our convoy to hit. Life, as we know, is always full of surprises, and we should ever be ready for them, for good or for ill."
I don't see things this way. For one thing, the steep decline tells you that it can't be fundamentals, which don't fall off a cliff like that. Rather, like a Bank Run, this is a generalized Fear and Aversion to Risk and the Accompanying Flight to Safety. Because it began in the US, it has rippled around the world. When the US turns around, that will ripple around the world as well. The movement of information is also a main cause of the speed of this tsunami of fear.One way to view aggregate demand is by its spending components such as consumption, investment, and government spending. This "Keynesian approach facilitates a focus on fiscal policy( TRUE ).
An equally valid approach that highlights monetary policy is to treat aggregate demand as the money supply (M) times its velocity (V). MV gives you the same spending totals as above( YES ).
A third approach, rarely used, is productivity (output per hour worked) times the number of hours worked. That too gives the same result. It's like describing the same thing in different languages.( OK )
Productivity growth came into prominence in the late 1990s because its acceleration had very positive results. It enabled employers to give pay increases without increasing their unit labor costs. That permitted an easier monetary policy with less worry about inflation. We had faster growth with falling inflation( YES ).
Remarkably, faster productivity growth continued as we climbed out of the recession in 2002. That was a mixed blessing since business expanded with little or no expansion in employment. Rising output coinciding with rising unemployment led to the term "jobless recovery."( YES. THAT'S SOMETIMES AN ODDITY OF AN INCREASE IN PRODUCTIVITY )
While rising productivity was increasing our standard of living, it also depressed employment growth, which is probably not a desirable tradeoff when the economy is weak( I AGREE ). Rising employment spreads the benefits of growth more widely( YES ).
As 2002 progressed, the recovery sputtered and a double dip recession threatened. Falling inflation threatened to morph into actual deflation. Fear of deflation, was the main reason the Greenspan Fed allowed the Federal funds rate to go so low, eventually reaching one percent. Alan Greenspan is routinely blamed for those low interest rates fueling the housing boom, but the critics never mention the reason for the low rates nor their benefits( TRUE. SAME PLAN AS THIS TIME ).
Whether the policy was justified or not, I left my fingerprints at the scene. At the September 2002 FOMC meeting, I dissented, along with Governor Ned Gramlich, in favor of reducing rates. We didn't prevail at that meeting, but the vote to ease was unanimous at the next meeting, on November 6.
I wrote the following rational for the minutes, which are now public:
Messrs. Gramlich and McTeer dissented because they preferred to ease monetary policy at this meeting. The economic expansion, which resumed almost a year ago, had recently lost momentum, and job growth had been minimal over the past year. With inflation already low and likely to decline further in the face of economic slack and rapid productivity growth, the potential cost of additional stimulus seemed low compared with the risk of further weakness.
So, you see, it wasn't Chairman Greenspan's fault. It was mine."
Casey B. Mulligan is an economist at the University of Chicago.
President-elect Barack Obama was not the first University of Chicago professor to serve in the United States Senate. More than 50 years ago, a professor named Paul Douglas became a United States senator representing Illinois.
As an economics professor, Professor Douglas wrote about the supply and demand for labor. Some of his techniques can lead us to a surprising conclusion about today’s recession: The recent decrease in employment may be due less to employers’ unwillingness to hire more workers( DEMAND ) and more to workers’ unwillingness to work( SUPPLY ).
As you’ve probably heard, employment has been falling over the past year. After peaking in December 2007, employment fell 1.4 percent over the next 11 months. Hours per employee also fell. As a result, if total hours worked had continued the upward trend they had been on in the years before the recession, they would be 4.7 percent higher than they are now.
Explanations for the decline — like most everything in economics — can be classified in two ways: supply or demand.
In many recessions, the demand for labor gets much of the blame. The demand explanation says that, with orders for their products down, many companies have trouble finding productive uses for employees. Some workers are then let go( I SAY THAT THIS IS HAPPENING OUT OF FEAR ). In this view, productivity — the amount produced per hour worked — should decline because reduced productivity is a driving force of layoffs. (Gross domestic product thereby declines for two reasons: fewer workers and less productivity per worker.)
Indeed, hourly productivity did decline in the 1981-82 recession, falling three out of four quarters for a cumulative peak-to-trough decline of 2.3 percent. Productivity fell faster and longer during the Depression.
The second type of explanation is reduced labor supply( SUPPLY ).
Suppose, just for the moment, that people were less willing to work, with no change in the demand for their services. This means that employees would have to be more productive because they have to get by with fewer workers.
Of course, people have not suddenly become lazy, but the experiment gives similar results to the actual situation in which some employees face financial incentives that encourage them not to work and some employers face financial incentives not to create jobs( HERE'S WHERE I SEE THE PROBLEM ).
Professor Douglas gave us a formula for determining how much output per work hour would increase as a result of a reduction in the aggregate supply of hours: For every percentage point that the labor supply declines, productivity would rise by 0.3 percentage points.
As mentioned earlier, in late 2008, labor hours were 4.7 percent below where trends from previous years would predict the number to be. According to Professor Douglas’s theory, this means productivity should rise 1.4 percent above its previous trend by the fourth quarter.
So let’s take a look at the numbers. Unlike in the severe recessions of the 1930s and early 1980s, productivity has been rising( TRUE ). Through the third quarter of 2008, productivity had risen six consecutive quarters, with an increase of 1.9 percent over the past three, or 0.7 percent above the trend for the previous 12 quarters.
Because productivity has been rising — almost as much as the Douglas formula predicts — the decreased employment is explained more by reductions in the supply of labor (the willingness of people to work) and less by the demand for labor (the number of workers that employers need to hire).
Why would some people have fewer incentives to take a job in 2008 than they did in 2006 and 2007 (and employers fewer incentives to create jobs)?
I will tackle that question in my next post, but even without a specific answer we learn a lot about today’s recession from the conclusion that labor supply – not labor demand – should be blamed. First of all, it suggests that a fundamental solution to the recession would encourage labor supply (perhaps cutting personal income tax rates, so people can keep more of their wages), rather than tinker with demand.
Second, the recent supply reduction may be more short-lived than the demand reductions of past severe recessions. In particular, as people adjust to the reality of depleted retirement accounts and vanished home equity, many of them will decide to make up for some of the shortfall by working more and retiring later.
And on another note, the department of economics at the University of Chicago does not conform to stereotypes: Professor Douglas ran for senator on the Democratic Party ticket and was occasionally accused of being a socialist. I teach his formula frequently and with admiration."
It’s official. As everyone now knows, the US economy is in recession and has been since December 2007. If the contraction continues for another four months, which at this point seems inevitable, this downturn will match the two longest peak to trough slides in the Post-WWII period, the first from November 1973 to March 1975, the second from July 1981 to November 1982. Whether the current recession achieves the dubious distinction of matching unemployment rates of the earlier ones (9% in May 1975 and 10.2% in November 1982) remains to be seen, but the dramatic rise in unemployment announced on 5 December 2008 is worrisome. As for the stock market, the decline of the Dow Jones Industrial Average from its peak in July 2007 to its low point on 20 November 2008 actually exceeds by a few percentage points the 40% drop between October 1972 and October 1974. And, of course, the catastrophic fall in house prices continues unabated. In short, the economy is in serious trouble and it is likely to get worse before it gets better.( TRUE )
Nick Bloom, in a recent Vox column, uses links he has identified in his academic research between uncertainty shocks as measured by changes in expected volatility of the S&P 100 – the so-called investor fear index – and GDP growth to predict the length and depth of the current downturn. He predicts, on the basis of a dramatic jump in expected volatility caused by the credit crunch, a GDP decline of 3 percentage points in 2009 with recovery starting at the very end of year, assuming favourable government policies and a drop in volatility. Fear and uncertainty with all its associated collateral damage – postponed investment, limited structural change, and delayed consumption – indeed would seem to stalk the land.( I BELIEVE THAT THE FEAR AND AVERSION TO RISK IS THE MAIN CAUSE OF OUR CURRENT SITUATION )
From Wall Street to Main Street
Bloom’s argument depends heavily on the reliability of the expected volatility index( I BELIEVE THAT IT IS GOING DOWN ) as an indicator of uncertainty. Although his research results are compelling, it is still reasonable to wonder if his results are sensitive to his uncertainty measure. Or, to put it another way, are the forces that shape expectations among the Wall Street crowd the same as those that affect the folks on Main Street? In short, would the use of a more broad-based indicator of uncertainty alter the observed link between uncertainty shocks, output, and productivity? This is the question we are addressing in our current research. In brief, here’s what our preliminary results tell us.
Uncertain times, uncertain measures
We base our index of economic uncertainty on the number of articles that appear in the New York Times which use the terms uncertain and/or uncertainty and economic and/or economy( I'VE NO IDEA HOW RELIABLE THIS IS ). The beauty of the measure is that it is consistent over a very long time span (the New York Times searchable data base extends back into the nineteenth century), it is transparent and unfiltered (as they say, all the news that’s fit to print), and it approximates what the average Main Street resident knew about current events. In Figure 1, we present our monthly uncertainty index (adjusted for the days of each month) with NBER business cycle reference dates in the background, to show it adheres closely to business cycle dates. Moreover, as Figure 2 illustrates, the timing of the uncertainty shocks identified by Bloom’s uncertainty index (based on S&P volatility) and ours are quite similar.
Our statistical results suggest that uncertainty shocks act on economic activity with remarkable swiftness (the shock has an almost immediate negative impact on growth and productivity), strength (they explain over 25% of the variance of output and productivity within two years), and durability (the effects linger for a number of quarters). Moreover, the current uncertainty shock - that effectively dates from the Bear Stearns bailout( THIS INTERESTS ME ) - is the largest of the twentieth century, greater even than that associated with the October 1929 stock market crash.
The dreaded D-word
Of course, the obvious question is what does all of this mean for Main Street and its inhabitants? Many are now prepared to put the current crisis in the same league as the dreaded Great Depression. They point out that in both periods there were significant bank failures, sharp declines in equity and housing prices, and a severe credit crunch. However, the current policy responses have been vastly different, in large part because Federal Reserve Chairman Bernanke, an expert on the Great Depression, has used his deep knowledge of that event to avoid the errors of the past. Unlike in the 1930s, the monetary authorities have moved swiftly to increase liquidity, push down interest rates, and bolster the stability of the financial system. As it happens, our regression results suggest that these policy responses make a big difference. That is, when we introduce interest rates (the policy variable) into our regressions, we find that the economic contraction is likely to be closer to the 1%( I TEND TO AGREE ) predicted by the OECD than to the 3% predicted by Bloom.1
Could the worst be over soon?
In spite of the very real threats to the US (and world) economy, a little perspective is in order. First, we have survived sharp jumps in uncertainty in the past – July 1971, January 1991, September 2001 (see Figures 1) – and will do so again( TRUE ). In this respect, it is also worth noting that the pattern displayed by our uncertainty index for the current crisis resembles more the sharp, short-lived ups and downs of the 1970s and early 2000s than it does the long drawn out rise and sluggish fall of the Depression years. This would seem to suggest that the current crisis, despite its gravity, does not mark the end of the world as we know it( I AGREE ). Second, in keeping with the old adage that it is often darkest just before the dawn, the numbers in Table 1 indicate that the light of a new day may just be visible on the horizon. Our uncertainty index, in this case based on data from six major US newspapers, shows a sharp run-up in uncertainty through October 2008 and a modest decline since. Two months do not make a trend but the drop is definitely encouraging( IT IS ). Although the negative economic consequences of the severe shock are likely to dog the economy for some time, we would guess that the worst is, indeed, behind us. Or, to employ Bloom’s horror film metaphor, the credit crisis has us (with good reason) perched on the edge of our seats, white-knuckled and wide-eyed. But, it is well to remember that the heroine while a little worse for wear, usually lives to welcome the dawn of a new day.
| Newspaper | Average daily number of articles with keywords ("uncertainty” or “uncertain” & “economic” or “economy”) | Average week-day circulation | ||||
| 2007 | 2008a | Selected months | 30 Sept. 2008 | |||
| October | November | Decembera | ||||
| New York Times | 1.09 | 2.33 | 4.13 | 3.87 | 3.11 | 1,000,665 |
| LA Times | 0.65 | 1.07 | 2.00 | 1.27 | 1.44 | 739,147 |
| USA Today | 0.23 | 0.47 | 0.68 | 0.60 | 0.75 | 2,293,310 |
| Wall Street Journal | 1.98 | 3.38 | 5.29 | 3.43 | 2.56 | 2,011,999 |
| Washington Post | 0.76 | 1.58 | 3.48 | 1.90 | 2.22 | 622,714 |
| Chicago Tribune | 0.56 | 1.07 | 1.32 | 1.60 | 1.67 | 516,032 |
| Circulation-weighted average | 0.95 | 1.75 | 2.88 | 2.10 | 1.85 | na |
a. Values reported for 2008 are through 9 December 2008.
Alexopoulos, M. and Cohen, J. 2008. Uncertain Times, Uncertain Measures. Manuscript. University of Toronto, 2008.
Bloom, N. 2007. The impact of uncertainty shocks. National Bureau of Economic Research, Working Paper W13385. Issued in September 2007.
Bloom, N. 2008. The credit crunch may cause another great depression. VoxEU, 8 October 2008.
Bloom, N. 2009 will be the Nightmare on Main Street. VoxEU, 18 November 2008.
OECD. 2008. Economic Projections for the US, Japan & Euro area. Press Conference 11 November 2008.
1. Our predictions are made from standard Vector Autogression (VAR) forecasts. While our bivariate analysis suggests a decline of approximately 3%, the addition of interest rates into the system cut the forecasted decrease to 1%."
My own opinion comports with this. As the level and breadth of the government guarantees are absorbed, and the government reacts with various incentives against the fear and aversion to risk, and as the Bush Administration departs, it's possible that uncertainty and fear will start declining in earnest. I'm leaving it at this just in case this opinion turns out to be idiotic.
Ben Bernanke should publicly bet $1 trillion dollars that the US economy will recover quickly from deflation and recession. He should make that bet on the Fed's behalf. The Treasury should publicly disavow all responsibility for bailing out the Fed if Bernanke loses the bet. If he loses the bet, it would be paid for by printing money.
This is how people would react to the bet.
If they expect deflation and recession to continue, so they expect Bernanke to lose the bet, they will expect the Fed to print an extra $1 trillion, which would be highly inflationary.....which is a contradiction.
If they expect the economy to recover quickly, so they expect Bernanke to win the bet, they expect the Fed will not print an extra $1 trillion, so they will not expect hyperinflation, just a normal recovery, which confirms their expectation.
By making such a bet, and making it publicly, the Fed creates the very expectations it wants to create: that deflation and recession will not continue, and that the economy will recover, and return to the normal rate of inflation.
We need to refine the bet a little. It shouldn't be an all-or-nothing bet. It needs to vary continuously with the speed and extent of the recovery, so that the quicker GPD and inflation and financial markets recover, the less money the Fed will have to pay on Bernanke's bet. This creates a benign negative-feedback loop, helping people's expectations, and the economy, self-equilibrate.
The bet introduces considerable uncertainty into future money creation. But we are equally uncertain about how much money the Fed will need to create to promote recovery. The bet makes those two things, each uncertain, correlated with each other. That's good, just as the uncertain payoff of my home insurance policy is good, since it is correlated with the uncertain damage that fire will do to my home.
One way to implement such a bet would be for the Fed to buy a large amount of risky assets, where those assets would have a very high value if the economy recovers quickly, and a very low value if the economy did not recover.
Oh, wait....."
So Nick likes TARP in its original form, I assume. First, I believe that the prices on these toxic assets will rise if the government intervenes, just as they fell when the government didn't. It is true that John Paulson and a few other hedge fund managers are buying the Toxic Assets now, as I've posted, and that's my second concern. These savvy investors will snatch up a lot of the best deals as the market because more liquid, or priced and available. There is also the conflict of interest problem, as to who will purchase these assets for the US Government. William Gross has said he'll do it for free, but then there's the problem that PIMCO will be involved in the process. Finally, there is the problem of the quality of these assets. I don't know that anyone has a real grip on their quality. Nick's solution seems to answer that, but I still would rather that we left them to private investors. I believe that the market is getting easier to buy into because sellers are no longer convinced that the government will intervene, and so they are no longer holding out as much. They're starting to fear that they've held these Toxic Assets too long.
Here's my solution: Have Paulson and Gross surreptitiously buy these assets for the government. Of course, that plan would go nowhere. I can't say that I totally discount the proposal.
It was used again by the Bank of Japan to rationalize its unwillingness to counteract the deflation and recession of the 1990s. In both cases, constructive monetary policies were in fact available but remained unused( TRUE ). Fed Chairman Ben Bernanke's statement last Tuesday made it clear that he does not share this view and intends to continue to take actions to stimulate spending( TRUE ).
There should be no mystery about what he has in mind. Over the past four months the Fed has put more than $600 billion of new reserves into the private sector, using them to discount -- lend against -- a wide variety of securities held by a variety of financial institutions. (The addition is to be weighed against September 2007's total outstanding level of reserves of about $50 billion.)
This action has been the boldest exercise of the Fed's lender-of-last-resort function( I AGREE THAT THIS IS WHAT IT IS ) in the history of the Federal Reserve System. Mr. Bernanke said that he is prepared to continue or expand this discounting activity as long as the situation dictates( I AGREE WITH HIM ).
Why do I describe this as an action to stimulate spending? Financial markets are in the grip of a "flight to quality"( FLIGHT TO SAFETY ) that is very much analogous to the "flight to currency"( I AGREE. IT'S LIKE A BANK RUN. HOWEVER, I SEE IT AS A FLIGHT TO EXPLICIT GUARANTEES FROM IMPLICIT GUARANTEES ) that crippled the economy in the 1930s. Everyone wants to get into government-issued and government-insured assets, for reasons of both liquidity and safety( TRUE. IT'S BOTH. ). Individuals have tried to do this by selling other securities, but without an increase in the supply of "quality" securities these attempts do nothing but drive down the prices of other assets( TRUE ). The only other action people can take as individuals is to build up their stock of cash and government-issued claims to cash by reducing spending. This reduction is a main factor in inducing or worsening the recession( TRUE ). Adding directly to reserves -- the ultimate liquid, safe asset -- adds to supply of "quality" and relieves the perceived need to reduce spending( TRUE. STILL THE FLIGHT TO SAFETY ).
When the Fed wants to stimulate spending in normal times, it uses reserves to buy Treasury bills in the federal-funds market, reducing the funds' rate. But as the rate nears zero, Treasury bills become equivalent to cash, and such open-market operations have no more effect than trading a $20 bill for two $10s. There is no effect on the total supply of "quality" assets.
A dead end? Not at all. The Fed can satisfy the demand for quality by using reserves -- or "printing money" ( GO FOR IT )-- to buy securities other than Treasury bills. This is the way the $600 billion got out into the private sector.
This expansion of Fed lending has not violated the constraint that "the" interest rate cannot be less than zero, nor will it do so in the future. There are thousands of different interest rates out there and the yield differences among them have grown dramatically in recent months. The yield on short-term governments is now about the same as the yield on cash: zero. But the spreads between governments and privately-issued bonds are large at all maturities. The flight to quality means exactly that many are eager to trade private paper for non-interest bearing (or low-interest bearing) reserves and with the Fed's help they are doing so every day( TRUE, ALTHOUGH IT SOUNDS FOOLISH ).Could the $600 billion in new reserves be called a bailout? In a sense, yes: The Fed is lending on terms that private banks are not willing to offer. They are not searching for underpriced "bargains" on behalf of the public, nor is it their mission to do so. Their mission is to provide liquidity to the system by acting as lender-of-last-resort. We don't care about the quality of the assets the Fed acquires in doing this( WE DO CARE ). We care about the quantity of its liabilities( OK ).
There are many ways to stimulate spending, and many of these methods are now under serious consideration. How could it be otherwise? But monetary policy as Mr. Bernanke implements it has been the most helpful counter-recession action taken to date, in my opinion, and it will continue to have many advantages in future months. It is fast and flexible. There is no other way that so much cash could have been put into the system as fast as this $600 billion was, and if necessary it can be taken out just as quickly. The cash comes in the form of loans.( I'D PREFER SIMPLY PUTTING MONEY OUT AND LEAVING IT )It entails no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These seem to me important virtues( THAT'S A GOOD POINT )."
More or less, I agree.
2) The rules for LOLR( from here on down this includes any government guarantee ) intervention should be clear, public, and followed, otherwise Moral Hazard is ineffective. All guarantees must be explicit.
3) The terms must be onerous.
"Who can forget the end of "Planet of the Apes" when Charlton Heston, kneeling before the half-buried remains of the Statue of Liberty, slams his fists into the sand and cries, "You maniacs! You blew it up! Ah, damn you ... damn you all to hell!"
Now imagine the same scene, but with a half-buried Morgan Stanley building standing in for Miss Liberty and a time-traveling Walter Bagehot playing the lead and you've got the perfect Hollywood dramatization of the real-life tragedy that, with luck, is having its denouement on Wall Street.
Bagehot? The great Victorian man of letters, best remembered today as the second and most celebrated editor of the British magazine The Economist, wasn't exactly a hunk. But he certainly could have delivered those futile last lines with real conviction, for he was among the first to recognize the vast destructive potential of that newfangled weapon of Victorian finance: the modern central bank.
Bagehot first alerted readers to this potential and offered his suggestions for containing it in an article that appeared in The Economist after the great panic and credit crisis of 1866. That panic witnessed the spectacular collapse of Overend, Gurney & Co., which had long been Great Britain's premier investment house.
Bagehot understood that, during such panics, the Bank of England alone commanded the confidence needed to serve other financial firms as a "lender of last resort." But as Bagehot put it later in his book "Lombard Street: A Description of the Money Market" (1873), the bank's "faltering way" -- its arbitrary and inconsistent use of its unique lending powers -- tended only to make things worse.
"The public," Bagehot wrote, "is never sure what policy will be adopted at the most important moment: it is not sure what amount of advance will be made. ... And until we have on this point a clear understanding with the Bank of England, both our ability to avoid crises and our terror at crises will always be greater than they would otherwise be."
The ultimate source of trouble, Bagehot believed, was the very existence of the Bank of England and the special privileges it enjoyed. But because nothing save a revolution seemed likely to do away with the "Old Lady of Threadneedle Street," as it was called, Bagehot's preferred, practical solution was for the bank expressly to commit itself to lending freely during crises, though on good collateral only, and at "penalty" rates.
The restrictive provisions were supposed to limit aid to otherwise solvent firms panic had rendered illiquid.
Bagehot's recommendation has since become a sort of master precept of central banking -- albeit one that's mainly honored in the breach by central bankers.
To be fair to today's central bankers, there's never been much agreement on how to apply Bagehot's rule in practice. Just what do "good collateral" and "penalty rates" mean in times like these?
While no one might precisely be able to define good collateral -- and one can debate whether the rate at which banks offer to lend unsecured funds to other banks, known as the London Interbank Offered Rate, or LIBOR rate, plus 8 percent constitutes a "penalty" rate -- who even pretends that recent central bank lending has been based on good collateral?
But rescuing insolvent firms is the least of it. The real damage comes from the Treasury's utter lack of any consistent last-resort lending rule. The recently enacted financial institutions bailout bill does little to clarify this.
That's just the sort of thing that troubled Bagehot almost a century and a half ago, when central banks were still in their swaddling clothes. Yet central bankers and governments still don't get it, despite the lip service they pay to this great thinker from our past."
Neither Barack Obama nor John McCain had much of value to say about the financial crisis as it raged through the headlines this fall. Rather than shred their campaign strategies, they played it safe, as most politicians would have. But in the name of justice we ought to recall that there was one candidate who did foresee our predicament with considerable accuracy when it still lay far in the future. Ron Paul, in almost every speech he made during the Republican primaries, spoke of bubbles, reckless credit growth, and the "unsustainability" of present policy. So why isn't there more demand for the common-sense solutions he put forward? Because common sense is not much use in a financial panic. This was the great discovery of Walter Bagehot, the prolific 19th-century essayist and journalist, who was editor of the Economist from 1860 to 1877. (His name rhymes with gadget.) Ninety-nine percent of the time, common sense is a synonym for practicality. But in a serious banking crisis, doing the commonsensical thing--hunkering down and counting your pennies--has proved to be not practical at all. Bagehot's Lombard Street is an insider's look at the Bank of England, and at the principles on which political and financial leaders act when advanced economies come under pressure. Those principles are depressing in the extreme for anyone with an uncomplicated idea of how a democracy works. But they are effective. That is why, in the so-called Anglo-Saxon world, Bagehot's book still provides the bedrock of policy thinking during financial emergencies, including our present one. Lombard Street was published in 1873, seven years after the sudden collapse of Overend, Gurney & Co., a bank that lost £11 million, spread panic among investors, sparked a run, and became "the model instance of all evil in business." The crisis made such a deep impression on British finance and government that the country did not have another bank run for 141 years--not until Northern Rock collapsed in the summer of 2007. (English investors must have longer memories than American ones. Most of our own noxious subprime mortgages were contracted, and the securities built on them concocted, after Enron became our own model instance of evil in 2001.) It was the Bank of England that took charge of averting panic, during the Overend, Gurney crisis and thereafter. It did so by injecting credit into the economy, by bailing people out. Bagehot approved of this. Many ordinary retailers could not pay their suppliers until they got the money for the things they sold. Without credit, they would be ruined, and the ruin would spread to those to whom they owed money. This was not a question of moral failing, it was just the way a modern economy worked. But the modern economic system interacts with the modern political system--democracy--in a rather uncomfortable way. Indeed, at more than one juncture in Lombard Street, Bagehot framed the problem of booms and busts as part of the "increasingly democratic structure of English commerce." People in a democracy are most comfortable when their institutions do the same things that they would do as individuals. In a crisis, banks--like everyone else--reflexively hoard their money. But a central bank must do the opposite. It must lend freely. This was the most basic affront to common sense that the Bank of England presented, but it was not the worst. The worst was that the bank could carry out its necessary duties as a lender of last resort only by breaking the law. The basis of the bank's operating procedure--and of its soundness--was the Bank Act of 1844. We would call it a regime of sound money. It included stringent caps on the ratio of notes issued to reserves held. These caps were hewed to when the economy was running smoothly. Yet at the time Bagehot was writing, a quarter century later, the law had already been suspended three times. Not just that. "No similar occasion has ever yet occurred," Bagehot wrote, "in which it has not been suspended." So the law on which the solvency of the British nation rested was ironclad, except when someone felt a need to break it. Stranger still, never did the Bank of England acknowledge its duty as the lender of last resort. Some of its governors even denied that any such duty existed. Bagehot thought the bank should come clean about what it really was:
But there was a reason for the central bankers' dissembling. If the bank ever acknowledged a duty to rescue banks by generous extensions of credit, it would create a form of moral hazard. Thomson Hankey, a Bank of England director whom Bagehot much admired (and to whom the financial writer James Grant devotes an admiring essay in his new book Mr. Market Miscalculates), called Bagehot's lender-of-last-resort views "the most mischievous doctrine ever broached in the monetary or banking world in this country." In practice, Bagehot was right and Hankey was wrong. The bank was beyond question the lender of last resort. In principle, Hankey was right and Bagehot was wrong. Unless there was a real, credible threat that a bank would be allowed to fail, the guarantee of rescue would simply get priced into any financial bubble that developed, making things worse when the bubble popped. The situation required what we would now call "strategic ambiguity"--both Hankey's doctrine and Bagehot's practice, which contradicts it. The situation today requires the same mix. Central banking is thus often a high-stakes game of chicken. And sometimes, when banks enter the game insufficiently scared, it will be played out to the end. It certainly was in September when the U.S. Treasury terrified the financial world by not coming to the rescue of Lehman Brothers. This was a catastrophe in terms of Bagehot's practice, but it will produce benefits in terms of Hankey's principle. It will discourage people from paying more than is reasonable for assets on the belief that they come equipped with an insurance policy (the promise of a central bank rescue) that has been underwritten by taxpayers. The Republicans who nearly derailed the Treasury's Troubled Assets Relief Program in September played a similar role. A final problem is that there are limits to how accountable a central bank can be. Everyone is always hollering for clear rules and transparency. But a dirty secret of regulation is that it frequently influences conduct most effectively when it is capricious and opaque. Any regulatory system will reveal its vulnerabilities over long use. If it addresses economic problems in a predictable way, savvy investors will find a way to "game" that predictability. You can draw an analogy with antidepressant drugs. There is no permanent right match of medication for a depressive. Antidepressants work only until the mind (or is it the brain?) finds a way around them, at which point a new, unfamiliar drug must be substituted. In the same way, no matter how good the content of a regulatory regime, it must change periodically if big market players are to be kept from profiting off it. As Bagehot outlined his system, he was conscious that the practical realities of banking required him to heap paradox upon paradox. There is a hint of both Andrew Jackson and Thomas Aquinas in the way he referred to central banking as an "unnatural" thing in its very conception. "The business of banking ought to be simple," he wrote. "If it is hard it is wrong." If it is hard, the banker is either delegating poorly or has entangled his institution in complex transactions where it has no business. According to Bagehot, "Adventure is the life of commerce, but caution, I had almost said timidity, is the life of banking." Centralizing a society's cash reserves is complicated, reckless, and artificial:
In his ideas of company size, Bagehot harkened back to the 18th century rather than ahead to our own. To modern eyes, Bagehot is, as a factual matter, simply wrong. The natural tendency under free-market conditions is towards consolidation, and even monopoly. If you want small firms, you must protect them through government--whether this means Teddy Roosevelt-ian trust-busting, French-style subsidies to tobacconists, the EU's hounding of Microsoft, or the NIMBY anti-Wal-Mart campaigns aimed at preserving Mom-and-Pop stores. Bagehot sometimes contradicted himself on this point, noting also that "a large bank always tends to become larger, and a small one tends to become smaller," but his application of the word unnatural to a large central bank was frequent and must be taken as his settled view. It is curious that Bagehot, a contemporary of Marx, came to the opposite (and false) conclusion about how firms evolve. Where Bagehot would agree with Marx is in his belief that there is something predictably destabilizing about modern economies. You don't need banks to have a precarious economy, or one liable to speculation--Bagehot noted that there were no banks, as we would understand them, in 1720, at the time of the South Sea Bubble and the Mississippi Scheme. But modern banking is precarious by design. "In exact proportion to the power of this system is its delicacy," he wrote. "I should hardly say too much if I said its danger." The power, delicacy, and danger all have the same source. In fact they are just different names for the same thing: leverage. At the very opening of the book, Bagehot illustrates with exquisite simplicity how, at least in a boom economy, traders on margin can "harass and press upon, if they do not eradicate, the old capitalist." The old capitalist in question is the poor sap who believes all this stuff about neither-a-borrower-nor-a-lender-be and is foolish enough to be using his own cash:
Later, Bagehot showed that this need for leverage is no different for those selling money than it is for those selling dry goods. The banker can no more choose not to lend than the merchant can choose not to borrow:
In finance, once you can have leverage, you must have leverage. Once you have some leverage, getting more of it than your competitors is a matter of survival. And when governments and central banks debate whether to loosen or tighten up money, they face a constant clamor from the financial world to permit more leverage still. That is why, even in democracies, the instruments of monetary policy tend to be kept far from the influence of voters, and even hidden from view. Otherwise, credit tends to spiral. Bubbles result. Nothing could be more foolish than to assume that this process of spiraling speculation is unleashed by "greed," unless by greed you mean human nature. Credit spirals are a darker aspect of the world Adam Smith described in The Wealth of Nations and Bernard de Mandeville did in the Fable of the Bees. Just as society can be improved by the uncoordinated action of the selfishly motivated, an economy can collapse for reasons having nothing to do with anybody's cupidity. We should be moral in the way we think about money, but a credit system tends to make a mess of moral accounting. Bagehot described London's financial district as "a sort of standing broker between quiet saving districts of the country and the active employing districts." Decent, puritanical Suffolk farmers want to put their money in a safe place; Lancashire entrepreneurs want money to put to work. Thanks to London bankers, both can follow their wishes and make a profit in the process. We have an idea that the Suffolk dairyman is the "moral" party here (he's saving) and the Lancashire speculator the "immoral" one (he's gambling). But, once a banking system intervenes, they are both gambling and they are both saving. In good times you are welcome to mouth the folkloric cliché that holds farmers to be better people than financiers. When depression looms, you had better realize that the rain falls on the just and the unjust. Many Americans who have wound up underwater on their houses and maxed out on their credit cards are greedy, climbing, brand-intoxicated, materialistic shopaholics who thought the world owed them a living. But just as many of them are not. They are trapped, as surely as financial institutions are, in a system based on wild borrowing. Participation in this system is not exactly required, but it is not exactly optional, either. One's quality of life is determined not just by one's purchasing power but also by one's relative economic standing. Chagrin at seeing one's neighbors get richer faster may be a sign of bad character, but do not for a minute assume there is nothing to feel chagrin about! When it comes to the very goods people deem most essential--the proper mate; the schooling of one's children; the size, location, elegance, and comfort of one's house--relative standing is more important than absolute wealth. Those who kept their money in savings banks in the 1990s lost out to those who did things we are supposed to disapprove of, like "spending money they didn't have," borrowing profligately to invest in stocks and even bonds, which appreciated at an average of 15 percent a year over the decade. Among rich people, how one entered the present decade had more to do with how one had done in the stock market than with how one had done in the labor market. Is that just? Of course it's not! It's easy to see now. But while the boom was going on there was all sorts of rationalizing about why it was okay that the social hierarchy should be reordered through stock and housing speculation. One line of argument was that people who did not have a ton of money in stocks, as well as those who rented rather than bought the houses they lived in, were foolish. This line of argument peaked at the turn of the decade, when Americans elected a president who had argued that the public was foolish for not launching its retirement savings onto the open seas of the stock market. Bagehot saw that a speculative mania eventually sweeps up everyone in its path. "Every great crisis reveals the excessive speculations of many houses which no one before suspected," he wrote, "and which commonly indeed had not begun or had not carried very far those speculations, till they were tempted by the daily rise of price and the surrounding fever." Avaricious people get hurt, but it is in the nature of crashes that they are not the ones who get hurt most. A tragic figure present in almost every historic account of speculation and collapse in history is the person who believed, year after year, that the boom was an illusion, and held himself aloof until, at the very last minute, whether out of self-doubt or deference to the opinions of his fellow man, he entered the fray and was (having bought at the top, rather than the bottom, of the market) wiped out. What a wicked irony! His punishment is as much for his long and wise forbearance as for his momentary weakness. So the "cultural contradictions of capitalism" run deeper than we thought. The classic idea, as laid out in their different ways by the economist Joseph Schumpeter and the sociologist Daniel Bell, is that capitalism rewards diligence; diligence produces wealth; wealth begets idleness; and idleness undermines capitalism. But when, as now, push comes to shove, we can ask whether there is really anything particularly capitalist about the virtues of diligence and self-restraint. The real capitalist virtues appear to be optimism and luck. From a central-banking perspective, the cultural contradictions are not results of capitalism but elements of it. The problem with central banking is that it reacts to a system that has been mismanaged by rewarding the managers. That is why objections to central banking, although they can come from the right (Ron Paul, Jim Bunning) or the left (Barney Frank, William Greider), tend to be populist. Bagehot was no populist. He was comfortable with the idea that what some people think should be more important than what other people think:
Although he would surely fault Treasury Secretary Hank Paulson for many things, the criticism most often heard at present--that Paulson is too close to former colleagues on Wall Street, where he worked for years as CEO of Goldman Sachs--would strike Bagehot as misplaced. Because it is on Wall Street, alas, that "the state of credit" is to be determined:
To be blunt, credit is successfully reestablished when financial elites say, "When." Credit is close to a synonym for the mood of the ruling class. To say an economy is based on credit is to say it is based on animal mysteries. Glamour, prestige, élan, sprezzatura, cutting a figure . . . that is what the economy is made of. It is a rather terrifying thought. Viewed as Bagehot viewed it, from the perspective of a central bank in a crisis, an advanced economy looks an awful lot like a primitive economy." |
"Loyal readers, please take a moment to check out Gretchen Morgenson’s column this week. She’s taken a close look at the buyout of Bear Stearns organized by the Federal Reserve, and she has come to an intriguing conclusion: that the Fed not only wanted to prevent financial havoc - it also wanted to deter speculators who were betting on big banks to fail.
Adherents of the Walter Bagehot school of central banking - and I have been among them at times - have cried foul at the sight of big bailouts and the granting of emergency credit at low interest rates. The Bagehot argument is that emergencies that arise from the risks that banks have chosen to take should not be treated with overwhelming sympathy. Emergency credit should be offered, yes, but at rates that will make banks think twice about using the safety net again. That’s not the case this time around (neither in the United States nor in Britain, and probably not in Europe either by the time the folks in Brussels are finished), so the central banks may be telling financial institutions that they can take silly risks without fear of disaster.
But if Morgenson is right, there is a long-term purpose here, too: to reduce the winnings of those who bet on failure, and thus to reduce the incentives to bring that failure to pass. And let’s face it, the speculators aren’t operating in a vacuum; their bets can start to snowball with market sentiment, as they did against Lehman Brothers last week. Still, the Bagehot argument (often called moral hazard) is also a powerful one - which one do you agree with?"
Federal Reserve Chairman Ben Bernanke, who has read his Bagehot and kept a copy in his Princeton office when he was a professor, responded to recent developments first by pumping money into the markets through the New York Fed’s open-market operations and then last week by easing the terms on loans to banks from the Fed’s discount window.
Bagehot (pictured at right) still makes for good reading at times like this.
“What is wanted and what is necessary to stop a panic is to diffuse the impression, that though money may be dear, still money is to be had. If people could be really convinced that they could have money if they wait a day or two, and that utter ruin is not coming, most likely they would cease to run in such a mad way for money. Either shut the Bank at once, and say it will not lend more than it commonly lends, or lend freely, boldly, and so that the public may feel you mean to go on lending. To lend a great deal, and yet not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies; but it is the policy now pursued.”
Robert Feldman, Morgan Stanley’s chief economist for Japan, writes in a note today that it’s key to distinguish between internal discredit — private domestic lenders retreating — and external discredit, which Bagehot defined as a foreign drain on a bank’s money. (Bagehot’s solution to the problem of external discredit is to still lend freely but “at very high rates.”) That doesn’t apply in today’s floating rate system, Feldman says, and exchange rates don’t provide a good substitute, with the dollar’s drop against the yen suggesting we have external discredit while the strengthening against the euro saying we don’t.
Feldman writes: “My view is that the modern counterpart of ‘external discredit’ is moral hazard. The credit of the U.S. IS a problem, since no one knows how big the subprime and related housing market problems really are. Given how poorly banks know their clients, the ‘high rates’ part should come into play. There is no way to re-establish confidence unless those who have made loans to questionable borrowers pay a price for rash lending. Only then will markets regain confidence that risk is under control.
“The next stage of the credit problem — and whether it affects the real economy seriously — depend on eliminating the moral hazard,” Feldman says. “The faster the moral hazard in eliminated, the less impact on the real economy.”
Fed officials are acutely aware of the moral hazard, having resisted action for weeks to not be seen as bailing out risky investments. But they also don’t want a crisis to feed on itself. The Fed stressed its statement, in lowering the discount rate for banks, that it would accept “a broad range of collateral…including home mortgages and related assets.” The central bank sought to reassure a market that had been roiled by risky investments in subprime mortgages.
That’s how the Bank of England halted a panic in 1825, as Bagehot recounts: “A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them. The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. ‘We lent it,’ said Mr. Harman, on behalf of the Bank of England, ‘by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.’ After a day or two of this treatment, the entire panic subsided, and the ‘City’ was quite calm.”
"Bagehot advocated in 1873 that a Lender of Last Resort in a crisis should lend at a penalty rate to solvent but illiquid banks that have adequate collateral. The doctrine has been criticised as having no place in our modern interbank market, but this is wrong. Bagehot’s prescription aims to eliminate the coordination problem of investors at the base of the crisis. It is still a useful guide for action when the interbank market stalls.1 It makes clear that discount-window lending to entities in need may be necessary in a crisis.
Bagehot's doctrine, however, is easy to state and hard to apply. It requires the central bank to distinguish between institutions that are insolvent and those that are merely illiquid. It also requires them to assess the collateral offered. Central banks, because of information limitations, are bound to make mistakes, losing face and money in the process. This doesn’t mean they should not try.
Poor collateral versus massive liquidity
The collateral should be valued under “normal circumstances”, that is, in a situation where the coordination failure of investors does not occur. This involves a judgment call in which the central bank values the illiquid assets. A central bank that only takes high quality collateral will be safe, but will have to inject much more liquidity and/or set lower interest rates to stabilise the market. This may fuel future speculative behavior. Some of this may have happened in the Greenspan era, in the aftermath of the crisis in Russia and LTCM, and after the crash of the technological bubble. The ECB and the Federal Reserve have accepted now partially illiquid collateral that the market would not. This seems appropriate and releases pressure to lower interest rates to solve the problem, something that should be done only if there are signs of deterioration in the real economy. The problem is that central banks are extending the lender of last resort facility outside the realm of traditional banks to entities, like Bear Stearns, that they do not supervise and, therefore, over which they do not have first hand information. How does the Fed know whether Bear Stearns or other similar institutions are solvent? It seems that the Fed is not following Bagehot’s doctrine here.
Finally, if banks and investors are bailed out now, why should they be careful next time? This is the moral hazard problem: help to the market that is optimal once the crisis starts has perverse effects in the incentives of market players at the investment stage. The issue is that only when the moral hazard problem is moderate does it pay to eliminate completely the coordination failure of investors with central bank help. When the moral hazard problem is severe, a certain degree of coordination failure of investors - that is, allowing some crises - is optimal to maintain discipline when investing and, amending Bagehot, some barely solvent institutions should not be helped."
To repeat Bagehot's Rule: "very large (domestic) loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain." The Fed, and the U.S. government more generally, have so far got it only half right."
http://findarticles.com/p/articles/mi_m2751/is_56/ai_55015114/pg_6"In a number of recent blog contributions, we have sketched the role of a modern central bank as ‘market maker of last resort’ (MMLR). This MMLR is the analogue, in a world where intermediation is increasingly through financial markets, to Bagehot’s lender of last resort (LOLR) in a world where most intermediation took place through banks (see e.g. Willem H. Buiter and Anne C. Sibert “The Central Bank as the Market Maker of last Resort: From lender of last resort to market maker of last resort"; Willem H. Buiter “Central banks as market makers of last resort, again”; Willem H. Buiter and Anne C. Sibert “A missed opportunity for the Fed”).
The market maker of last resort function can be fulfilled in two ways. First, the central bank can make outright purchases and sales of a wider range of securities than they currently do. Second, central banks can accept a wider range of securities as collateral in repos, and in collateralised loans and advances at the discount window than they currently do. Following Bagehot’s rule, the MMLR should buy these securities outright or accept them as collateral only on terms that would imply a stiff financial penalty to the owner. The central bank of course already applies a liquidity ‘haircut’ even to liquid instruments offered as collateral in repos or at the discount window. Because the MMLR would have to establish a buying price ‘in the dark’, that is, unaided by recent relevant market prices, and would inevitably take on much more credit risk than central banks have become accustomed to, the ‘haircuts’ should be severe – a financial version of ‘short back and sides’.I doubt a week has gone by since last summer during which I haven't seen some pundit or other trot out Walter Bagehot's dictum that in the event of a credit crunch, the central bank should lend freely at a penalty rate. More often than not, this is contrasted with the actions of the Federal Reserve, which seems to be lending freely at very low interest rates.
Ben Bernanke, in a speech today, addressed this criticism directly:
What are the terms at which the central bank should lend freely? Bagehot argues that "these loans should only be made at a very high rate of interest". Some modern commentators have rationalized Bagehot's dictum to lend at a high or "penalty" rate as a way to mitigate moral hazard--that is, to help maintain incentives for private-sector banks to provide for adequate liquidity in advance of any crisis. I will return to the issue of moral hazard later. But it is worth pointing out briefly that, in fact, the risk of moral hazard did not appear to be Bagehot's principal motivation for recommending a high rate; rather, he saw it as a tool to dissuade unnecessary borrowing and thus to help protect the Bank of England's own finite store of liquid assets. Today, potential limitations on the central bank's lending capacity are not nearly so pressing an issue as in Bagehot's time, when the central bank's ability to provide liquidity was far more tenuous.
I'm no expert on Walter Bagehot, and in fact I admit I've never read Lombard Street. But I'll trust in Bernanke as an economic historian on this one, unless and until someone else makes a persuasive case that Bagehot's penalty rate really was designed to punish the feckless rather than just to preserve the Bank of England's limited liquidity."
"So, we have, what I will call "Grant's Graham For Investing":
1) Decent Size
2) Current Assets Exceed Liabilities By Two Times
3) 10 Continuous Years Of Profit
4) 20 Continuous Years Of Dividends
5) 10 Years Of Earnings Growth Exceeding 33%
6) Price To Earnings Ratio Less Than 15
7 ) Price To Book Ratio Less Than 1.5"The Government will succumb and will lend taxpayers' money to non-financial companies.
In a way, there's no choice, because we'll be hobbled for years as an economy if our few remaining manufacturers and exporters are wiped out."
"Trader's Narrative's Due Diligence":
"The process of investigation undertaken by an party to gather material information on actual or potential risks involved in a financial transaction or relationship."
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