The Long Journey Ahead

Wolfgang Munchau tells us that the unwinding of global economic imbalances may take many years.

Global Adjustment Will be Long and Painful
...It is no accident that our multiple crises – property, credit, banking, food and commodities – have been happening at the same time. The simple reason is that they are all part of same overriding narrative. The mother of all these crises is global macroeconomic adjustment – a rare case, incidentally, where the word “crisis” can be used in its Greek meaning of “turning point”.

It is a huge global macroeconomic shock. How long the financial part of the crisis will go on will depend to a large extent on how bad the economic part of the crisis gets.

The economic part of the story started more than a decade ago with a liquidity-driven global boom. Property, credit and equity bubbles were all part of this.

So was a Ponzi scheme that later became known as Bretton Woods II, a gravity-defying design that allowed the US to run persistent current account deficits. The dollar surplus in the newly industrialised countries was recycled back to the US and European markets, where various categories of asset prices were driven up and banks lured into excessive risk-taking. It could not last, and did not.

If excess liquidity was the ultimate cause of this crisis, the real estate sector was its most important driver. Experience shows that housing cycles are long and symmetrical: downturns last as long as upturns. We also know from the past that house prices undershoot the long-term trend on the way down, just as they overshoot it on the way up. You can see this quite easily when you look at long-run time series of inflation-adjusted house prices for several countries.

The last property downturn in the US and the UK lasted some six years. This is not a prediction of what will happen this time, more like a best-case scenario – because this bubble has not only been more intense than previous ones; it has also bubbled on for longer. But even if we take six years as an estimate of the peak-to-trough period, that means the housing downturn will last until 2012 in the US and a couple of years longer in the UK...

Read the rest here.

A Critique of Mainstream Monetary Economics

Mark Thoma points us to a speech by the iconoclastic Jamie Galbraith. In the speech Galbraith criticizes mainstream monetary economics or what he calls the "new monetary consensus."

...what in the “new monetary consensus,” led to a correct or even remotely relevant anticipation of the extraordinary financial crisis that broke over the housing sector, the banking system and the world economy in August 2007 and that has continued to preoccupy central bankers ever since? The answer is, of course, absolutely nothing.

Ouch! He continues his rant:

You will not find a word about financial crises, lender-of-last-resort functions or the nationalization of banks like Britain’s Northern Rock in papers dealing with monetary policy in the monetarist or the “new monetary consensus” traditions. What you will find, if you find anything at all, is a resolute, dogmatic, absolutist belief that monetary policy should not – should never – concern itself with such problems.

So what does Galbraith gives us as an alternative?

What is the relevant economics? Plainly, as many commentators have hastily rediscovered, it is the economics of John Maynard Keynes, of John Kenneth Galbraith and of Hyman Minsky...

I agree there is insight to be gleamed from these authors. However, the main policy prescription coming from these authors--more financial regulation is needed since financial systems tend to create their own crises--is general. How does one apply their insights in an dynamic world where financial innovations often are one step ahead of regulations? Also, how would these authors specifically implement monetary policy? Would they suggest a Taylor-like rule that had asset prices included in it?

For a more practical approach to monetary policy that takes seriously financial imbalances, I would suggest the work of Claudio Borio, Andrew Filardo, William White and others at the Bank for International Settlements. They have been thinking about these issue for some time and raised similar concerns prior to the outbreak of financial crisis in August 2007. Here is an excerpt of their work I discussed in a previous posting:

Economic historians will no doubt look back on the last twenty years of the 20th century as those that marked the end of a long inflationary phase in the world economy.... And yet, the same decades will in all probability also be remembered as those that saw the emergence of financial instability as a major policy concern, forcing its way to the top of the international agenda. One battlefront had opened up just as another was victoriously being closed. Ostensibly, lower inflation had not by itself yielded the hoped-for peace dividend of a more stable financial environment.

Is this confluence of events coincidental? What is the relationship between monetary and financial stability? What is an appropriate policy framework to secure both simultaneously?

[...]

We would like to make three points.

First, posing the question in terms of the desirability of a monetary response to "bubbles" per se is not the most helpful approach. Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions. Booms and busts in asset prices... are just one of a richer set of symptoms...

Second, while not disputing the fact that low and stable inflation promotes financial stability, we stress that financial imbalances can and do build up in periods of disinflation or in a low inflation environment. One reason is the common positive association between favourable supply-side developments, which put downward pressure on prices, on the one hand, and asset prices booms, easier access to external finance and optimistic assessments of risk, on the other

Third, achieving monetary and financial stability requires that appropriate anchors be put in place in both spheres. In a fiat standard, the only constraint in the monetary sphere on the expansion of credit and external finance is the policy rule of the monetary authorities. The process cannot be anchored unless the rule responds, directly or indirectly, to the build up of financial imbalances. In principle, safeguards in the financial sphere, in the form of prudential regulation and supervision, might be sufficient to prevent financial distress. In practice, however, they may be less than fully satisfactory...

Read more here.

Preview of 1st Quarter GDP Growth

This week we learn what happened to the U.S. economy in 2007:Q1. The folks at Real Time Economics argue the numbers do not add up for an outright Q1 contraction. This conclusion is supported by the coincident indicator from the Philadelphia Fed which grew on an annualized basis about 1% in Q1. Below is the same coincident indicator over Q1 plotted for the 50 states:

In words, "for the past three months, the indexes increased in 31 states, decreased in 14, and were unchanged in the other five." Not bad, but wait... things look different over the last month, March: "The indexes increased in only 19 states for the month, decreased in 22, and were unchanged in the remaining nine..."(Source). So even though we may have escaped negative growth in Q1, economic conditions may be getting worse going forward if March is any indicator of things to come. This is consistent with what famed investor Mohamed El-Erian thinks as well as those observers who believe we are only 1/3 of the way through a $1 trillion dollar loss. Hang in there America.

Macro Reading List

1. The changing housing cycle and its implications for monetary policy.
2. Could IMF have prevented this crisis?
3. How much do we understand about the modern recession?
4. Don't blame China for the rise in inequality.
5. How to spend it.
6. Ut-oh! Is China starting to blame the US for its currency losses?
7. Surplus countries depreciating when they should be appreciating.

Getting Real

In a previous posting I reprimanded Paul Krugman for not being more cheery about the future of commodity prices. I argued human ingenuity in the face of increased scarcity has been the source of many innovations over the past couple hundred of years and this commodity price crisis should be no different. However, I was probably too sanguine about the transition to this new world--it is and will be a painful ride. The Economist did a good job last week documenting the pain and the dynamics behind the transition: surging demand from growing Asia, possible speculation due to loose monetary policy, and diversion of farming capacity to biofuel production. This last factor is particular frustrating since some of the biofuel production is more about special interest groups than cleaning up the environment (e.g. ethanol). I would encourage you to take a look at The Economist article on this issue as well as Trade Policy for a New Deal on Hunger.

Update: Josette Sheeran, executive director of the U.N. World Food Program, on the food crisis via Foreign Policy:

I’m optimistic because the world knows how to beat the cycle of hunger and the world knows how to produce enough food for the global population. A lot of global hunger is an infrastructure and distribution problem—maybe half. We see up to half the food lost in developing countries simply because there’s no way to get it from farm gates to markets. We see virtually nonexistent agricultural markets, so there’s no place for buyer and seller to meet. These are things that can be solved. They don’t require a new scientific breakthrough or a Nobel Prize-winning team to find out how to produce enough food for the world. So, we need to focus our attention on a green revolution in Africa that will help break this cycle. In a way, the higher food prices may inspire more people to stay in farming as they see that it’s a good investment. But there will be a lag between what I hope will be a pretty robust response to world demand, and what I know will be a pretty difficult three to four years.

Economic Conditions and Religiosity

Andrew Gelman graciously takes note of my research on the business cycle and religiosity over at Statistical Modeling, Causal Inference, and Social Science. One of his blog readers emailed me and requested I explain more thoroughly how macroeconomic shocks could affect religiosity. Below is an excerpt from a forthcoming article where I attempt to explain the relationship in less technical terms :

The first thing economic theory says is that the cost of being religious can change over the business cycle. During an economic boom individuals may find increased opportunities for higher earnings. The potential for higher earnings, in turn, make time-intensive religious activities like church attendance costly for these individuals. Consider, for example, a Southern Baptist from a low-income family being offered the opportunity of getting overtime pay to work at a retail store on Sunday morning. For this Southern Baptist, going to church suddenly becomes a lot more costly and thus, increases the likelihood of him opting for work instead of church. On the other hand, during an economic downturn, time-intensive religious activities become less costly as opportunities for earnings decline. Here, the overtime opportunity for the Southern Baptist disappears and church attendance suddenly becomes more affordable. This idea that higher earnings lead individuals to substitute out of leisure activities, like going to church, into more work and vice versa is called the substitution effect. It implies there should be a countercyclical component to religiosity.

There are, however, two countervailing forces against the substitution effect. The first one is called the income effect and says that the higher earnings also mean individuals can work fewer hours than before and still get the same pay. They, therefore, have more time for leisure activities, like church attendance, without a loss of income. Consider, for example, an Episcopalian whose consulting business was able to increase its fees because of the increased demand for its services during an economic boom. The Episcopalian can now afford to take on fewer consulting projects, without a loss of income, and enjoy more time at church. During an economic downturn, however, the consulting fees would drop. The Episcopalian would now have to work more hours to maintain his income, leaving less time for church. The second countervailing force is something called the wealth effect. The wealth effect says that as individuals’ wealth increases from valuations gains in their homes, stocks, and other assets they have less need to save and thus less need to work. In turn, there should be more time for church attendance and vice versa. Imagine now that the Episcopalian had a large amount of funds in the stock market during a stock market boom. His wealth would increase dramatically and make leisure activities like church attendance more affordable. Both of these effects imply there could be a procyclical component to religious activities.

Economic theory is generally silent on which of these effects dominates the decision to work. Research has shown, however, that evangelicals Protestants typically fall into a lower socioeconomic grouping than mainline Protestants (Pyle, 2006). This suggests that the substitution effect should be more important for evangelical Protestants. In other words, since evangelical Protestants are starting from a lower income level, like the Southern Baptist above, they should be eager to take advantage of higher earning opportunities, whereas mainline Protestants, like the Episcopal above, who already have relatively high income levels may see less need to do so. Moreover, mainline Protestants have more wealth and should therefore be more sensitive to the wealth effect compared to their poorer evangelical Protestant brethren. A priori, then, the changing cost of being religious perspective points to evangelical Protestants being more countercyclical in their religiosity than mainline Protestants.

The second thing economic theory had to say about this issue is that individuals generally desire to have a steady stream of housing, clothes, food, and other consumption over the business cycle. During a recession individuals may become unemployed or find their earnings fall. To prevent these developments from being disruptive, individuals may turn to churches for consumption needs such as shelter and groceries. Individuals may also turn to churches for less tangible consumption needs such as a sense of certainty and divine guidance in a job search. Such a response implies there should be a countercyclical component to religiosity. Note, however, that the wealthier mainline Protestants are in far less need of churches to provide consumption for them. In addition, mainline Protestant denominations often place less emphasis on absolute truths than evangelical ones and, as a result, are not able to create the same sense of certainty or appeal to an all powerful, job-providing God. Individuals, therefore, may choose to join an evangelical Protestant denomination rather a mainline one during a recession.[1] Consequently, the consumption smoothing ability of churches also points to a stronger countercyclical component for evangelical Protestants.

[1] Conversely, these same individuals may find a mainline Protestant denomination more appealing than an evangelical one during an economic upturn when the need for certainty and employment are less pressing concerns.

Update: If the SSRN link to my paper is not working, try this one.
Update 2: WSJ's Real Time Economics the Economist's View also take note of my research.

What the Fed is Fighting

More Real Wages and Productivity

As a follow up to my previous post on whether real wages have tracked productivity, here is a graph from Edward Lazear that has real compensation calculated the way suggested by Martin Feldstein:
Using this approach, real compensation does generally track productivity. Zubin Jelveh, however, notes that

health care and other fringe benefits make up a greater portion of total compensation now than in 1970. Back then, wage and salary payments made up 89.4 percent of compensation, but that figure declined to 80.9 percent by 2006 ...

Health care and other fringe benefits, then, are taking up a good portion of these real gains.

Q&A on Dollar's Reserve Status

Stephen Jen at Morgan Stanely's Global Economic Forum weighs in on this ongoing discussion:

Question 1. Are Central Banks Aggressively Diversifying from USD Assets?
There are different ways of thinking about this question. The most popular data that investors refer to are the IMF’s COFER quarterly data on the currency composition of the world’s reserve holdings... According to these data, the USD’s share in total world foreign reserves has declined from 72.7% in 2001 to 63.9% as of end-December 2007, with developed economies having a higher (69.4%) concentration of USD holdings than developing countries (60.7%). During the same period, EUR’s share rose from 17.6% to 26.5%, with developing economies having a higher exposure to the EUR (29.0%) than developed countries (22.2%). Thus, the short answer to this question is ‘yes’, there has indeed been a decline in the USD’s share in the world’s official reserve holdings in the past few years.

While this may be the short answer, it is not a complete answer. First, to conclude that the world’s central banks have been diversifying out of USD, one would also need to address the question of how the swings in the exchange rates may have affected the COFER currency shares... more than 100% of the change in the currency composition of reserves reported by the COFER database can be explained by changes in the exchange rate...The USD’s share seems low mainly because of the weak dollar, and its share was high in 2002, similarly, due to the strong dollar then...

Second, while at 63.8%, the USD’s share in total reserve holdings may be low, certainly lower than the 72.7% registered in 2001, the dollar’s share actually declined to below 50% in the early 1990s. Thus, the decline in the USD’s share is unremarkable, from a longer-term perspective, despite the angst.

Question 2. Will the Euro Challenge the Dollar’s Hegemonic Reserve Currency Status?
Again, the answer to this question is not straightforward. There are several considerations in thinking about this question. Some academic works on this matter have taken a quantitative approach to calculating the currency share of official reserves that can be explained by fundamental variables such as the size of the economy in question, the rate of return and the liquidity in the financial markets of the reserve currency. On these measures, the EUR seems to be a very serious challenger to the dollar. Further, if the UK joins the EMU, many of the liquidity and market size measures for the EMU could surpass the size of the capital markets of the US. For example, the combined market capitalisation (bonds and equities) of the EMU and the UK in 2007 was US$37.4 trillion, representing 30% of the world. The same metrics for the US would be US$43.5 trillion and 35%.

Having said the above, there are two reasons to believe that the EUR will not be able to supplant the USD’s hegemonic reserve currency role, even though the former can take some market share away from the USD. (Similar to car racing, it may be easy to catch up to another car. Passing it is another story.)

First and foremost is the advantage of being the incumbent. Increasing returns to scale are immensely powerful. In our previous writings on this topic, we have used the analogy of languages, that English is the preferred international language not necessarily because it is superior to other languages, but because it is ‘in the lead’ as the most widely spoken foreign language in the world, and so it will most likely remain in the lead as more people around the world learn English in order to communicate with the rest of the world. The positive characteristics of other currencies will need to be much superior to those of the dollar to offset this ‘incumbent advantage’...

The second consideration is related to the first, that the issue is really not the US versus Euroland. Rather, we need to ask what currency standard the rest of the world (that does not have a reserve currency) will have. Specifically, Asia, in our view, will likely remain on a dollar standard for a very long time to come. Even though few Asian currencies are now pegged to the dollar, most of the international transactions are still conducted in USD, reflecting the less-than-full convertibility of most currencies and the preference of Asian countries for invoicing and settling trade and transactions with each other in US dollars rather than each other’s currencies. For example, we hear people comment that Asia now trades as much, if not more, with Euroland than with the US. Statements like this one miss the point, because Asia trades with itself in dollars, and 43% of Asia’s trade is with other Asian countries.

Question 3. What Is the Prospect of the CNY as a Challenger to the US Dollar?
It is a probable, not just a possible, scenario that China’s economy will exceed the size of the US economy in our generation. This makes the CNY, or a form of Asian currency unit centred on the CNY, a much likelier challenger to the USD. [Hey Stephen, you really did not do justice to this last question!]

Bottom Line
We maintain our view that the dollar will likely remain the dominant international currency for the foreseeable future. Available data do not unambiguously support the view that central banks in the world have been aggressively diversifying from the USD. While assets denominated in EUR have experienced a sharp improvement in liquidity and depth since the establishment of the EMU, Asia and other parts of the world continue to rely on the USD as the medium of exchange and unit of account. The ‘incumbent advantages’ that the dollar enjoys will be difficult to overcome. The most likely challenger to the USD will be the CNY or an Asian currency unit centred on the CNY. But the key precondition is that Asia manages to develop its financial markets.

The Opiate of the Elite or Simply the Income Effect Dominating?

Andrew Gelman et al. have a article over at Vox EU titled "Opiate of the Elites." These authors show that, contrary to conventional wisdom, religion is not the opiate of the poor masses, but of those with higher incomes or the elites. They find that being religious increases the probability of someone voting based on moral and cultural concerns if that person is in a higher income group. Being religious and in a lower income group reduces the probability. Here is one of their graphs that captures this relationship in terms of who voted for GW Bush:

The authors conclude that "income predicts how you vote—if you are religious." They explain this finding by appealing to a view of "post-materialism—the idea that, as people and societies get richer, their concerns shift from mundane bread-and-butter issues to cultural and spiritual concerns." Stated differently, "economic concerns are more important in poorer areas, with social and religious issues mattering more among the rich."

If one assumes that voting for moral and cultural reasons also implies other time commitments to these issues (staying informed by reading and watching TV, discussing issues with friends, supporting rallies, etc.), then these results could also be interpreted by using what economic theory tell us about the labor-leisure choice via the substitution and income effects. For those individuals in the lower income group, it is likely that the substitution effect--which says the opportunity costs of social activism, forgone earnings, is too high--dominates. Their time is better spent working than worrying about social issues. On the other hand, those individuals in higher income groups most likely have the income effect--which says they can afford leisure activities like social activism--dominate. Simply, as individuals become richer they can afford to become more engaged in these social issues, if that is what they want.

This is a theme I touch on in my own research that looks at the relationship between the business cycle and religiosity. I find that mainline Protestant denominations--which tend to have higher income earners--do well in terms of growth during economic booms while evangelical Protestants denominations--which tend to have lower income earners--actually struggle. (During economic downturns the outcomes are reversed--evangelicals Protestant denominations thrive.) In general, I find mainline Protestants to have a strong procyclical component to their religiosity while evangelicals have a strong countercyclical component. These findings can be explained by again appealing to the labor-leisure choice explained by economic theory.

So, in short, the fascinating findings of Gelman et al., then, can be explained using standard economic theory.

Update: Andrew Gelman responds here and I provide some clarification here.

Real Wages Have Kept Up with Productivity?

Martin Feldstein has a new working paper showing that, contrary to conventional wisdom, U.S. real wages have kept up with productivity in the nonfarm business sector.

The level of productivity doubled in the U.S. nonfarm business sector between 1970 and 2006. Wages, or more accurately total compensation per hour, increased at approximately the same annual rate during that period if nominal compensation is adjusted for inflation in the same way as the nominal output measure that is used to calculate productivity.

More specifically, the doubling of productivity since 1970 represented a 1.9 percent annual rate of increase. Real compensation per hour rose at 1.7 percent per year when nominal compensation is deflated using the same nonfarm business sector output price index.

In the more recent period between 2000 and 2007, productivity rose much more rapidly (2.9 percent a year) and compensation per hour rose nearly as fast (2.5 percent a year).

[...]

The relation between wages and productivity is important because it is a key determinant of the standard of living of the employed population as well as of the distribution of income between labor and capital. If wages rise at the same pace as productivity, labor’s share of national income remains essentially unchanged. This paper presents specific evidence that this has happened: the share of national income going to employees is at approximately the same level now as it was in 1970.

Two principal measurement mistakes have led some analysts to conclude that the rise in labor income has not kept up with the growth in productivity. The first of these is a focus on wages rather than total compensation. Because of the rise in fringe benefits and other noncash payments, wages have not risen as rapidly as total compensation. It is important therefore to compare the productivity rise with the increase of total compensation rather than with the increase of the narrower measure of just wages and salaries.

The second measurement problem is the way in which nominal output and nominal compensation are converted to real values before making the comparison. Although any consistent deflation of the two series of nominal values will show similar movements of productivity and compensation, it is misleading in this context to use two different deflators, one for measuring productivity and the other for measuring real compensation.

I want to believe these findings, but they seem too good to be true. What do you think?

Another Fed Critique

Steve Hanke gets shrill and joins the list of observers taking the Fed to task for past monetary profligacy.

U.S. Treasury Secretary Henry Paulson... rolled out a grand plan to crown the Federal Reserve as the nation's new financial stabilizer. The Fed a stabilizer? That's who created the financial mess we're in.

[...]

During the Greenspan-Bernanke era the Fed has embraced the view that stability in the economy and stability in prices are mutually consistent. As long as inflation remains at or below its target level, the Fed's modus operandi is to panic at the sight of real or perceived economic trouble and provide emergency relief. It does this by pushing interest rates below where the market would have set them. With interest rates artificially low, consumers reduce savings in favor of consumption, and entrepreneurs increase their rates of investment spending... And then you have an imbalance between savings and investment. You have an economy on an unsustainable growth path.

The current U.S. financial crisis follows the classic Fed pattern. In 2002 then governor Bernanke set off a warning siren that deflation was threatening the U.S. economy. He convinced his Fed colleagues of the danger. As former chairman Greenspan put it, "We face new challenges in maintaining price stability, specifically to prevent inflation from falling too low." (Given the U.S. economy's productivity boom, the Austrians viewed the prospects of some deflation as just what the doctor ordered.)

In the face of possible deflation, the Fed panicked. By July 2003 the Fed funds rate was at a record low of 1%, where it stayed for a year. This set off the mother of all modern liquidity cycles...

Paul Krugman Needs a Dose of the Julian Simon Cheer Up Elixir

Paul Krugman is concerned about the rising prices of commodities and their long-term economic implications:

[T]he global surge in commodity prices is reviving a question we haven’t heard much since the 1970s: Will limited supplies of natural resources pose an obstacle to future world economic growth?

How you answer this question depends largely on what you believe is driving the rise in resource prices. Broadly speaking, there are three competing views.

The first is that it’s mainly speculation — that investors, looking for high returns at a time of low interest rates, have piled into commodity futures, driving up prices. On this view, someday soon the bubble will burst and high resource prices will go the way of Pets.com.

The second view is that soaring resource prices do, in fact, have a basis in fundamentals — especially rapidly growing demand from newly meat-eating, car-driving Chinese — but that given time we’ll drill more wells, plant more acres, and increased supply will push prices right back down again.

The third view is that the era of cheap resources is over for good — that we’re running out of oil, running out of land to expand food production and generally running out of planet to exploit.

I find myself somewhere between the second and third views.

[...]

[R]ich countries will face steady pressure on their economies from rising resource prices, making it harder to raise their standard of living. And some poor countries will find themselves living dangerously close to the edge — or over it. Don’t look now, but the good times may have just stopped rolling.

Krugman needs to cheer up. Yes, soaring commodity prices are causing economic and political strains across the globe, but increased scarcity and the resulting higher prices are the mother of innovation. Higher prices in a market system send the signal--dare I say the profit motive--that there is a need to find new, more efficient ways to produce those goods and services that are sorely needed. This process can take time and there may be some market failure along the way, but by and large the advances humanity has made over the last few hundred years are a testament to how this process works.

Look at oil. Prior to the 1850s, sperm whale oil was the preferred fuel for lighting. However, sperm whales were and are a limited natural resource. Consequently, as sperm whale oil consumption increased, the sperm whale population decreased and the price of sperm whale oil shot up. Commodity prices were soaring and concerns were being aired about what we would call 'peak' sperm whale oil production. It was no coincidence then that around the 1850s people like Edwin Drake were looking for alternative energy sources. The price signal was screaming to entrepreneurs to "innovate...find new energy sources...high financial rewards to those who do" And so the petroleum industry took off and sperm whales were spared. I suspect the same is happening today to fossil fuels. There is increased petroleum scarcity given the growth of China et al. and the limited oil reserves in the world. As a consequence, the resulting high prices over time should lead to (1) increased efficiency with existing oil reserves (e.g. better mpg technology) or (2) alternative energy sources altogether. And this is just what the world needs in terms of pollution control and oil-influenced politics.

The key point is that this increased commodity scarcity should lead to new innovations that will, if anything, lead to higher standards of living in the future. Of course, all of this is not new. The late Julian Simon wrote about this process in his book "The Ultimate Resource II." Simon's argument is that human creativity when faced with increased scarcity is the ultimate resource. Don Boudreau has a nice discussion here on some of Simon's insights.

So, yes, Paul Krugman there are reasons to be hopeful. I would recommend a dose a day of the Julian Simon Cheer Up Elixir until your anxiety symptoms disappear.

P.S.
Of course this entire discussion is premised on the notion that the run up in prices is due to fundamentals. There, of course, is an alternative explanation for the surge in prices: loose monetary policy and speculation. See Jim Hamilton for more.

UpdateI : Michael Mandel tells us to "Throw Malthus Off the Bus!"
Update II: Tyler Cowen gives a rebuttal to Krugman's rebuttal.

Empirical Evidence on the Fed as a Monetary Hegemon

I recently made the following claim:

[The] Federal Reserve is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are pegged to dollar. Thus, it's monetary policy is exported across the globe. This means that the ECB, even though the Euro officially floats, has to be mindful of U.S. monetary policy lest its currency becomes too expensive relative to the dollar and all the other currencies pegged to the dollar.

I suspect the most contentious part of this claim is the part where I said the ECB has to be mindful of the Fed's actions. I made a case for this view based on a figure that showed the path of the policy rates for the Fed and the ECB. Fortunately, I can now point you to more rigorous empirical work by John Taylor that supports my position:

...Many central bankers, even those with flexible exchange rate policies, watch the U.S. federal funds rate carefully when making policy decisions.

To illustrate this issue consider the relationship between Eurozone interest rates and U.S. interest rates during the past few years. Consider in particular the deviation of the overnight interest rate target for the European Central Bank from a simple guideline for that interest rate—the Taylor rule...

Now if one examines the relationship between this deviation and the actual federal funds rate in the United States during the period from 2000 through 2006, one finds a close empirical correlation between the two. An estimated linear relationship with the deviation on the left hand side has a coefficient on the federal funds rate of 0.21, which means that each percentage point reduction in the federal funds rate was associated with a 1/5 percentage point reduction in the ECB interest rate below what would otherwise be desirable on European price stability and output stability grounds... The relationship is highly significant statistically... For part of this period the ECB policy rate was below this guideline and according to these estimates a significant part of the deviation is “explained” by the U.S. federal funds rate being lower than normal.

You can read the rest here.

A Great Summary of the Policy Innovations by the Fed

Previously I discussed how much of what you learned in your money and banking class is now outdated given the many policy innovations by the Federal Reserve since last summer. Stephen Cecchetti now has a nice summary of these innovations that can be found here (shorter version) or here (longer version). Read these updates and you will be current on the workings of the Federal Reserve.

An Update on Recessions and Your Health

In a previous posting I discussed the research of Christopher Ruhm and others that shows recessions can actually improve your health. Marketplace on public radio recently interviewed Ruhm and discussed his work. Below is a summary of this discussion:

A Fiscal Squeeze Might Be Good for You.
Rising gas and food prices and the credit crunch may be making it harder for Americans to make ends meet. But economist Chris Ruhm says a tougher economy may also be improving the health of the population as a whole. He explains to Kai Ryssdal.

You can listen to the interview here.

A Misguided Greenspan Defender

Alan Greenspan has been busy lately defending his legacy. He is responding to the ground swell of opinion that views him as a key contributor to the U.S. housing boom-bust cycle. Fortunately for him, he has one prominent observer coming to his defense: Martin Wolf of the Financial Times. Here is what Martin has to say:

When a wave of destruction hits, everybody looks for somebody to blame. Alan Greenspan, former chairman of the US Federal Reserve, once lauded as the “maestro”, has, to his discomfort, become the scapegoat... much of the criticism is highly unfair.

[...]

US monetary policy cannot be responsible for all these bubbles. This might not be the case if these other countries had followed US policy slavishly...

Really? What do we know about the ECB? Did it follow the Fed's lead in cutting rates? Here is a graph from the IMF's latest WEO report that sheds some light on this question:


It sure looks to me like the ECB followed the Fed's lead in cutting short-term interest rates. If we look at real short-term interest rates the picture is even more stark:

Both the Fed and the ECB pushed short-term real interest rates into negative territory for a sustained period. Negative real interest rates in a growing economy are a sure way to light an asset bubble fire. Now take a look at the following graph. It indicates these downward interest rate moves were policy-driven:
This figure shows a large spike in the policy-determined monetary base relative to the G3's GDP. In sum, these figures indicate loose monetary policy in the U.S. and the ECB coincided with the global housing bubble.

An important question these figures do not answer is why would the ECB (and other monetary authorities) follow the Fed's lead in loosening monetary policy? The answer is that the Federal Reserve is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are pegged to dollar. Thus, it's monetary policy is exported across the globe. This means that the ECB, even though the Euro officially floats, has to be mindful of U.S. monetary policy lest its currency becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. The Fed's loosening, therefore, of monetary policy in the early-to-mid 2000s triggered a global liquidity glut that set the stage for the subsequent housing boom-bust cycle. This is not to say the 'saving glut' and financial innovation had no role, but rather that loose monetary policy was a key factor behind the boom.

William Buiter writing at Financial Times does a nice view articulating this view in his article titled "The Greenspan Fed: A Tragedy of Errors":

Mr Greenspan is correct that a major global decline in risk-free real interest rates was an important factor in the housing booms that occurred in a couple of dozen countries between, say, 2002 and the end of 2006[.]

But the fact that on top of these very low risk-free long-term real rates, credit spreads became extraordinary low, had something to do with the liquidity glut created by the Fed, the Bank of Japan and, to a slightly lesser extent, the ECB. The Fed kept the Federal Funds rate target too low for too long after 2003. Because of the unique role played by the US dollar in the global financial system, the US dollar liquidity shower not only soaked the US economy, but also many others. First those who kept a formal or informal peg vis-a-vis the US dollar. Then those whose monetary authorities, without pursuing a dollar peg, kept a wary eye on the exchange rate with dollar, and ultimately most central banks in the globally integrated financial system.

Well said Dr. Buiter.

How Big is the Current Financial Crisis?

So how big is this financial crisis and how does it compare to other crises of the past? I have already alluded to the $1 trillion dollar estimate of Charles Morris. Elsewhere, Mr. Morris has said this estimate is a conservative one since it assumes an orderly unwinding in financial markets. This conservative estimate is consistent with Nouriel Roubini who makes a low-end estimate of financial losses at 1$ trillion. Martin Wolf discusses several estimates that go high as $3 trillion. He notes the following:

Losses of $2,000bn-$3,000bn would decapitalise the financial system. The government would have to mount a rescue. The most plausible means of doing so would be via nationalisation of all losses. While the US government could afford to raise its debt by up to 20 per cent of GDP, in order to do this, that decision would have huge ramifications. We would have more than the biggest US financial crisis since the 1930s. It would be an epochal political event.

Such high-end estimates are alarming. Now the IMF is weighing in on the matter. It has released its Global Financial Stability Report which shows estimated financial losses coming in just under $1 trillion. It also provides an interesting graph comparing these losses with previous financial losses:

Note that the IMF figure for the current financial crisis is based on the problems with subprime mortgages. As Charles Morris explains, though, the "subprime [crisis] is just the first big boulder in an avalanche of asset writedowns that will rattle on through much of 2008...Expect the landslide to cascade through high-yield bonds, commercial mortgages, leveraged loans, credit cards and -- the big unknown -- credit-default swaps." Figuring in these latter developments leads to the higher estimates of $2-$3 trillion dollars.

Someone asked me this past weekend how bad this recession will be going foward. Taking the consensus view, I said it would be mild and over by the end of 2008. Thinking about these estimates of financial losses, especially the higher-end ones, is making me less certain of that claim. For the same reason, Nouriel Roubini says the consensus view of when the recession will end is in fact wrong. I hope he is wrong.

Update
In a Bloomberg article discussing the expected $1 trillion loss put out by the IMF, this sobering fact is stated: "The [IMF] forecast signals the worst of the credit crunch may be yet to come, because banks and securities firms so far have posted $232 billion in asset writedowns and credit losses."

Charles Morris and the Trillion Dollar Meltdown

Charles Morris has new book explaining the credit crunch. It is titled "The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash." This looks to be a great book based on some of the reviews I have seen. In the meantime, Mr. Morris has provided us with an article over at Foreign Policy that provides the steps leading up to the current financial crisis. I have posted his summary points below.

Eight Steps to a Trillion-Dollar Meltdown
1. The Fed spikes the punch bowl.
2. Leverage soars.
3. Consumers throw a toga party.
4. A dollar tsunami.
5. Yields plummet.
6. Hedge funds peddle crystal meth.
7. A ratings antigravity machine.
8. The Wile E. Coyote moment arrives.

Note which item starts the process. One can only wonder how things would have been different had the Fed taken more seriously their own Gary Stern's admonitions in 2003 or had they paid attention to calls for action from the The Economist in 2004.

More Musings on the Dollar's Reserve Status

Kenneth Rogoff chimes in on the ongoing discussion of the dollar's reserve status:

.... the euro, too, seems to have its problems. European banks remain balkanized, with a patchwork of national regulators seeking to promote their own champions. European governments' debt may all be denominated in euro, but German and Italian debt are hardly the same thing, so the government euro-bond market lacks the depth and liquidity of the US Treasury bill market.

Moreover, international investors can buy and sell real estate far more easily in the US than in most of Europe. And the absence of a Europe-wide fiscal policy creates significant uncertainty about how the European Central Bank would finance itself if it suddenly faced large losses on junk bank debt after a big bailout.

But the euro does have growing strengths. At current market exchange rates, the European Union is now larger economically than the US. New central and eastern European members are bringing enormous dynamism and flexibility. At the same time, the European Central Bank has gained considerable credibility from its handling of the global credit crisis. Indeed, if the euro zone can persuade Great Britain to become a full-fledged member, thereby acquiring one of the world's two premier financial centers (London), the euro might start to look like a viable alternative to the dollar.

Meanwhile, Jeff Frankel responds to Barry Eichengreen's recent claim that the "Euro is unlikely to eclipse the dollar":

The first two steps of [Eichengreen's] argument are:
(1) a multiple-currency system is the historical norm. The dollar-denominated system that we have experienced for more than 60 years is an aberration, so network externalities (aren’t) important.
(2) The dollar surpassed the pound in the 1924-25, not in 1948, so lags and tipping phenomena are not important.

Regarding (1), ...network externalities are... also important: there will always be an advantage to having a lead currency internationally, just as there is an advantage to having a single money within each country.

Regarding (2), I have no problem dating the pound’s loss of supremacy from the 1920s, if that’s what the eminent economic historians say. But I don’t see how this affects any of the arguments. For one thing, the US surpassed the UK in economic size in 1872, and in exports in 1915. So there is still a lag of between 10 and 53 years.

More importantly, these propositions have no bearing on the central claim that Menzie Chinn and I have made: based on our statistically estimated effects of economic fundamentals, such as the size of euroland — which has just passed the US economy — the euro now has the potential to rival or even displace the dollar as lead currency. We think we have also found statistical evidence of inertia and non-linearity, which imply a tipping point...

Finally, Michael Bordo and Harold James provide a long term perspective on the Euro. They conclude:

Low growth will ... produce direct challenges to the management of the currency, and a demand for a more politically controlled and for a more expansive monetary policy... This discussion will be more difficult if there is a widespread perception that the international role of the euro is at odds with domestic political demands that the currency should be supportive or sustaining of growth. Financial sector instability, with a potential need for bank bailouts, could also be a source of difficulty. Finally, in addition to all these threats, domestic responses to the challenge of globalisation in markets for goods and services may also be displaced into a discussion of the euro, with the single currency and the central bank that manages it taking the position of fall guy for radicalised and generalised discontent. On the other hand, if all these bumps are overcome and a process of gradual transfer of fiscal responsibility toward greater centralisation occurs, there is the possibility that the euro zone will match the achievement of other late achievers of monetary unification, such as the United States or Germany.

Perspective on the Dollar

The Role of the Fed in Creating the Current Financial Crisis

I have made the case for some time (here, here, and here most recently) that an overly accommodative Federal Reserve in the early-to-mid 2000s set the stage for the biggest housing boom-bust cycle in U.S. history. Some notable observers such as John Taylor and The Economist have also taken a similar view, but up until now they have been the exception rather than the rule. Others are beginning to adopt this view as well:

Jeffrey Sachs
To a large extent, the US crisis was actually made by the Fed...Today’s financial crisis has its immediate roots in 2001, amid the end of the Internet boom and the shock of the September 11 terrorist attacks. It was at that point that the Fed turned on the monetary spigots to try to combat an economic slowdown. The Fed pumped money into the US economy and slashed its main interest rate – the Federal Funds rate – from 3.5% in August 2001 to a mere 1% by mid-2003. The Fed held this rate too low for too long.

Read the Rest

Ricardo Hausmann
The discussion about avoiding a repetition of the current financial crisis has centered on the potential role of financial regulation...it is hard to see how the kind of financial regulation that would be called for would have avoided the current crisis. I believe that financial regulation is the wrong place to focus the policy discussion about the causes of the current crisis. It is macro policy, not financial policy that needs to be at center stage.

Read the Rest

Andy Laperriere
... The housing boom began in earnest when the Fed slashed interest rates in response to the 2001 recession, and kept rates too low for too long. The lower interest rates cut monthly mortgage payments and fueled the first wave of home-price appreciation, which began to take on a life of its own. Artificially low interest rates reduced returns on safer investments like government and corporate bonds, so investors moved funds into riskier assets (like subprime loans) to increase returns. Low interest rates also made it profitable to borrow heavily in order to invest in mortgage-backed securities and other financial assets, and leverage grew at a breathtaking clip.

Read the Rest

(Not excerpted above, but worth noting is Brad DeLong. DeLong sees the merit in this view, but is having a hard time coming to terms with it and wants to see it formalized. Maybe this research will meet his needs.)

A key insight from these observers is that loose monetary policy not only worked through the traditional transmission channels in creating this boom-bust cycle, but also through a 'financial innovation' channel. The Fed's holding down of short-term interest rates so low for so long lowered returns on many investments. This created a 'search for yield' and made investors more open to riskier, more exotic financial products. This increased demand for riskier projects was met by an increase in supply from the financial wizards on Wall Street and, in turn, stimulated further credit creation. An interesting idea.

So There is Hope for the Dollar

Barry Eichengreen tells us why we should not get too worked up over the figure below, which shows the current and projected share of international reserves for the Euro and the Dollar, and its implication that the Euro may surpass the dollar as the main reserve currency in ten years.


Writing in the Financial Times, Eichengreen says the following:

Judging from commentary by international economists, one would think that the dollar was on its deathbed. America’s financial crisis and the dollar’s depreciation are bringing us to a tipping point where the greenback will lose its international currency mantle to the euro. A few more losses on dollar investments, it is said, and central banks will learn to hold their reserves in euros. Other investors will follow. America’s “exorbitant privilege” will be no more.

To paraphrase Mark Twain, these reports of the dollar’s death are greatly exaggerated. They are based on a model of the demand for international reserves that does not apply to our 21st-century world.

The chief idea of this model is that international currency status is a source of network effects. Just as it pays to use the same computer software as other people in your network, it pays to use the same international currency as other official and private market participants.

Central banks thus find it attractive to hold dollars because other central banks hold dollars. With everyone doing likewise, the market in dollars is deep and liquid. Because trade is denominated in dollars, central banks find them convenient to smooth the balance of payments. This network externality is the source of the exorbitant privilege that the dollar has enjoyed for half a century.

[...]

[The network externality] logic is fundamentally flawed... The advantages to an individual central bank of holding its reserves in the same currency as other central banks range from slim to none. The real reason the dollar so dominated reserve holdings after the second world war was that only the US had liquid financial markets. Only the US market was free of capital controls. The dollar dominated foreign exchange reserves simply because there were no alternatives.

[...]

The dollar lost its role as a reserve currency in the 1930s, albeit temporarily, because of disastrous mismanagement of the US economy. Equally disastrous mismanagement today would certainly cause the dollar to disappear from the international scene, leaving the euro as the only international currency standing. That said, no matter how difficult the current situation and how contentious the US policy response to the crisis could prove to be, we are still very far from that point.

So there is hope for the dollar. I wonder what happens, though, when China and the rest of Asia grow into their income and unleash the full force of domestic demand. At that point, Asia no longer needs American consumers and therefore, no longer needs to prop up the dollar. If this potential Asian abandonment of the dollar were quickly followed by a similar move in the dollar-linked Gulf countries, would these developments be enough to undermine the dollar's reserve status? Even then, as Eichengreen indicates, the dollar would be still be an attractive currency because of the strong financial institutions in and economic power of the United States. (Yes, I am assuming the current financial crisis will ultimately make the U.S. financial system stronger.) Any thoughts?