Wednesday, December 26, 2007

How Much Time Do Americans Allocate to Religion?

This past November I presented a paper at the SSSR/ASREC annual meetings that looked at the relationship between the business cycle and religiosity (see previous posting on this paper). I was privileged to present my paper in a session where Ariela Keysar and Barry Kosmin gave their paper titled "Measuring Religious Commitment and Secularization Through Time-Use Data." This paper examines the standard labor economic question of how individuals in the United States allocate their time, with special emphasis on how much time is spent on religious and spiritual activities. The study looks at allocation of time for a typical weekday as well as for the presumably religious Sunday.

This study uses data from data from the Bureau of Labor Statistics’ American Time Use Survey (ATUS) over the years 2003 to 2006. Ariela and Barry explain that the "ATUS asks people to keep a diary and describe in detail their daily activities, without the prompts or cues that are a feature of interviewer surveys. There is therefore no reference to religion or any other domain. This methodology reduces over-reporting of religious practice by minimizing the tendency towards a social desirability bias that has been identified as a problem of many surveys of American religion especially of Sunday worship." This study, therefore, provides a more robust measure of religiosity in America than past studies.

Okay, what exactly do they find? Here are some key excerpts:

"The average American spends a total of 3 minutes on 'religious and spiritual activities' on the normal weekday. This is because only 4.4% of the population actually reports participating in this form of behavior. Among this small minority of participants, 1.12 hours on average are actually spent on religious activities. Weekdays are for work and ATUS confirms this. The average American spends 4.55 hours working on the normal weekday. Participants in work are 58% of the adult population and among these workers the time spent on work related activities averages 7.81 hours."

3 minutes a day? Wow! If us highly religious Americans spend only 3 minutes on average a weekday on religious and spiritual activities, then what is the time spent on religious and spiritual activities in other advanced economies that are less religious?

"This imbalance between work and religious activities on ordinary weekdays is to be expected though the actual figures are stark. One can assume that Sundays will be much different. Sunday is historically the Lord’s Day and a day of rest when government and educational facilities are closed as are many business establishments. Indeed the average American spends a total of 33 minutes on religious activities on a Sunday that is 11 times the amount of a weekday. In fact 25% of Americans attend Sunday worship services; more that 6 times the weekday norm. The average worshipper spends 2.06 hours on religious activities on a Sunday. Sunday is evidently the time for religion but participation at the beginning of the 21st Century is very much a minority interest."

Here again, I wonder what is the time spent on religious and spiritual activities on Sundays in other advanced economies?

"The ATUS findings indicate that the pattern of the traditional American Sunday has changed and the U.S. is becoming a more secular society."
Below are two tables from the paper.

So even on Sundays, religious and spiritual activities are far from the most important activity. In fact, the work category on this 'holy' day is allocated more time. One discussant made the point that maybe these numbers understate/overstate the quality of time allocated to each activity. This point made me wonder if it were possible to have a positive productivity shock to religious and spiritual activities? If so, less time would be needed to generate the same religious and spiritual outcome. Could this possibility explain some of the relatively low share of time allocated to religious and spiritual activities?

Monday, December 24, 2007

More on Stabilization Policy

Mark Thoma had an interesting post on stabilization policy in the form of changes in tax rates. He makes the following points:

(1) Changes in tax rates to 'lean against the wind' during the business cycle should be temporary.

(2) Changes in tax rates to 'lean against the wind' should be consistently applied. Cut taxes when output falls below its potential, but also increase taxes when output exceeds its potential.

(3) As a result of (1) and (2), the budget should balanced over the business cycle. There should be no sustained budget deficits.

(4) Political realities make (1) - (3) difficult to implement in practice. Always count on a politician to cut taxes when the economy weakens, but never expect one to increases taxes during an unsustainable economic boom. Throw in the upward spending bias of most politicians and sustained budget deficits become an almost certainty.

(5) The number of steps in implementing even a thoughtful countercyclical fiscal policy makes this form of stabilization policy almost intractable. If anything, the implied lag in implementing fiscal policy could make it destabilizing rather than stabilizing. (However, automatic stabilizers do provide timely but limited countercyclical aggregate demand management. See related post on structural versus cyclical budget balances here.)

For all these reasons fiscal policy typically plays second fiddle to monetary policy when it come to stabilization policy. However, given the challenges the Fed the ECB have had with credit markets some observers like Martin Feldstein and Lawrence Summers are suggesting fiscal policy supplement monetary policy. Over at the WSJ, David Weasel provides a good overview of this view. Meanwhile, Greg Mankiw tells us that monetary policy is up to the task now at hand and that Congress and the White House (i.e. fiscal policy) should do "absolutely nothing."

Wednesday, December 19, 2007

The Probability of A Recession in 2008

From Intrade, here is the market's wisdom on the latest probability for a U.S. recession in 2008.
Note that it spiked in September, came down in October and then picked up again in late November and has stayed there ever since. Does this pattern sound familiar? Take a look at the below graph.

Non-Profound Conclusion: the economic outlook is tied very closely to the credit market outlook.

Is 'Pump Priming' the Solution?

Is 'pump priming' the solution to the weakness in our economy? Does the U.S. economy need a a large policy-induced positive aggregate demand shock? Nouriel Roubini and Larry Summers both scream "Yes!"

As I discussed in a previous posting, Nouriel's view is that monetary policy easing now will not put off the necessary real adjustments needed "for the credit excesses, the asset bubbles, the reckless leverage, the lack of minimal appropriate supervision and regulation of financial markets of the last few years." He goes on to say a "sharp recession is unavoidable and necessary to cleanse the financial system and the economies from such excesses." Nouriel, however, is concerned that the looming recession of 2008 could turn into the next Great Depression if massive monetary easing is not attempted now. Consequently, he is calling for central banks of the world to aggressively cut interest rates.

In a similar vein, Larry Summers is calling (also see here) for dramatic action since he believes that "slow growth is a near certainty, that a recession is more than a 50% chance, and that there's a distinct possibility of a more serious recession that will lead to the worst economic performance since the late 1970s and early 1980s.
" Larry is therefore calling for a $50 -$75 billion tax cut and spending package by the federal government as well as more aggressive easing by the Federal Reserve.

Do these calls for more 'pump-priming' make sense? Ken Rogoff says no. He notes "[s]harper Fed interest rate cuts today might well mute the housing price collapse, at least in nominal terms. However, if the Fed should ease too far, too fast, it could get hit by a boomerang a couple of years down the road, in the form of sustained higher inflation." I would add that contrary to Nouriel's assertions it may also mean a postponment of the necessary economic adjustements needed in the housing and financial sector.

Maybe Nouriel and Larry are right and we should nip this one in the bud with a massive policy-induced positive aggregate demand shock. No need to go through the Great Depression again. On the other hand, I keep going back to Japan and its lost decade that started in the 1990s. There too was massive government intervention in a post-bubble bursted economy. Some argue this intervention allowed banks and other sectors of the economy from making the painful changes that were needed to bring back robust economic growth (although without the intervention the deflationary pressures may have been worse). Are we headed down that path? Will the massive government stimulus to the macroeconomy proposed by Nouriel and Larry put off the needed economic adjustments until a later, more painful time? Or are they correct?

Monday, December 17, 2007

More on the Solvency Crisis

Here are several interesting pieces that lend support to the view that more liquidity--even if creatively injected through the new term action facility--will not solve the lack of interbank lending. The reasons is because this is not crisis of liquidity, but of solvency.
John M. Berry

This is more of a credit and confidence problem than a liquidity one similar to that which followed the Sept. 11 attacks on the World Trade Center... The issue now is the large losses -- both announced and unannounced -- that many financial institutions have experienced from securities backed by subprime mortgages, many of which have gone into default.
Stephen Cecchetti
(This is a great piece for understanding the new term action facility)

Why are big private banks unwilling to lend to each?
Clearly, they were worried about the quality of the assets on the balance sheets of the potential borrowers. My guess is that banks were having enough trouble figuring out the value of the things they owned, so they figure that other banks must be having the same problems. The result has been paralysis in inter-bank lending markets. Banks have not been able to fund themselves. And, as I will discuss in a moment, non-US banks faced an added problem – they could not get dollars. This was either because they could not get euros or pounds to then sell for dollars, or once they got their domestic currency they were unable to make the exchange.

Is Nouriel Roubini Losing his Religion?

Nouriel Roubini is one of the few economists to early on make the call that our current financial quagmire was a solvency crisis rather than one of just illiquidity. As a result, Nouriel concluded back in August that "liquidity injections and lender of last resort bail out of insolvent borrowers--however necessary and unavoidable during a liquidity panic--will not work; they will only postpone and exacerbate the eventual and unavoidable insolvencies." I found his reasoning then and now to be compelling.

Recently, however, it appears that Nouriel has begun to lose his religion. He wrote a post to his blog a few days titled "Why monetary policy easing is warranted even in the current insolvency crisis." In this piece, Nouriel makes that argument that there should be global easing of monetary policy so as to

"... reduce the length of such a recession and dampen its depth. Monetary policy may be impotent in affecting the likelihood of a economic downturn... but it is not impotent in affecting how deep and long such a recession will be."

Nouriel goes on to say he believes monetary policy can dampen the severity of the recession without (1) postponing the needed real economic adjustments, (2) creating new asset bubbles elsewhere, or (3) generating excessive inflationary pressures. So Nouriel now is articulating the following: let the recession happen, but do not let it get out of hand. In other words, let's avoid the Great Depression scenario of the 1930s where bad policies let a normal recession--that may have been necessary to purge the excesses of the 1920s--turn ugly.

The Great Depression is one scenario. Let me propose another one that I believe fits our current situation better: Japan in the 1990s. Here, there was an asset bubble that popped and similarly led to rot in the banking system--large amount of non-performing loans--that was not quickly removed. The rot, in turn, contributed to a stagnant economy for almost a decade. The non-performing loans and government support programs in Japan sound eerily familiar to the situations in the U.S. today. If the Japan scenario is the right one, then Nouriel's proposal simply postpones and potentially creates more problems down the road.

Paul Krugman
, who has not lost his religion on this topic, says the following
How will it all end? Markets won’t start functioning normally until investors are reasonably sure that they know where the bodies — I mean, the bad debts — are buried. And that probably won’t happen until house prices have finished falling and financial institutions have come clean about all their losses. All of this will probably take years. Meanwhile, anyone who expects the Fed or anyone else to come up with a plan that makes this financial crisis just go away will be sorely disappointed

I hope Nouriel's concerns over a Great Depression type scenario are wrong, but the alternative Japan scenario is not much better. Hang in there world.

Monday, December 10, 2007

The Laffer Curve Showdown at the Mark Thoma Corral

Okay, it is not quite a showdown at the OK Corral, but Mark Thoma comes out swinging in a response to Justin Fox and Brad DeLong who suggest there is some truth to the Laffer curve. First, a recap of the statements that caused Mark to respond:

Brad DeLong: "As I read the evidence, Arthur Laffer is probably right at the top end: reducing the top tax rate from 70% to 50% is probably a revenue gainer and surely not much of a loser. From 50% to 28% is, I think, very different: a big revenue loser."

Justin Fox
: (from initial posting) "Some tax cuts do raise revenues, of course.... (later posting) Just two off the top of my head: The 1964 Kennedy reduction of the top marginal income tax rate from 91% to 70% (it was enacted after JFK's assassination, but it was his bill), the 1981 Reagan reduction of the top marginal rate from 70% to 50%. I'm not at all an expert on this, but I don't think it's too controversial among economists to assert that those particular changes (but not the rest of the of Kennedy and Reagan tax legislation) were a break-even or better for the Treasury... The common thread is that these were cuts in punitively high marginal rates. They paid off in large part because they removed incentives to shelter income from taxes."

Mark begins his response by quoting two intermediate macroeconomic texts that essentially say "large budget deficits of the early 1980s = failure of the Laffer curve." He then goes on to say that one cannot look at the 1960s tax cut in isolation since the Fed monetized the public debt, providing an added economic stimulus that masks the true budget deficit reality. What I believe Mark is getting at here in this latter point--and something that is too often glossed over in these Laffer curve debates--is that one should distinguish between the structural budget balance and the cyclical budget balance when passing judgement on the merits of the Laffer curve. Okay, I will give him that point, but it cuts both ways. The Reagan budget deficits--that are supposedly evidence against the Laffer curve according to the cited textbooks--must also be parsed for the structural and cyclical components. After all, the sharpest post-WWII economic downturn occured during Reagan's tax cuts. What part of Reagan's deficits were due to the double-dip recessions in the early 1980s versus his tax policy?

The Congressional Budget Office provides data to answer this and other structural vs. cyclical budget balance questions. The figure below (click here for a larger picture) shows this decomposition as a percent of GDP from 1962 to 2006. (Other adjustments in figure consist of deposit insurance, receipts from auctions of licenses to use the electromagnetic spectrum, timing adjustments, and contributions from allied nations for Operation Desert Storm.)

Consistent with Mark's claim, this figure does show a positive cyclical contribution to the overall budget balance following the 1964 tax cut. The cyclical contribution, however, only turns positive in 1964 so one could argue it came from the tax cut itself. Regarding Reagan, the cyclical component clearly dragged down the budget balance during the early-to-mid 1980s, although the structural budget balance was the most important component overall. This figure also makes clear that both cyclical and structural forces were at work with Clinton--it was a combination of his tax policies and a booming economy that generated the budget surplus.

I am not sure this figure settles any questions, but it does highlight the importance of distinguishing between a structural budget balance and a cyclical budget balance. Personally, I find the nuanced Laffer curve view--if I can call it that--of Justin Fox, Brad DeLong, and Greg Mankiw a reasonable position to hold.

Thursday, December 6, 2007

Rogoff on the Dollar's Reserve Status

Kenneth Rogoff tells us why the dollar's decline does not necessarily mean the loss of reserve status:

"The good news for Americans is that there is enormous inertia in the world trading and financial system. It took many decades and two world wars before the British pound lost its super-currency status. Nor is there any obvious successor to the dollar yet. Indeed, the sub-prime crisis has made the European financial system look just as vulnerable as that of the US. Likewise, while the Chinese Yuan might be king in 50 years, China's moribund financial system will prevent it from being crowned anytime soon. A huge share of world trade is denominated in dollars, even if some Opec presidents, such as Venezuela's Hugo Chávez, openly preach mutiny. Central banks still hold more than 50% of their foreign exchange reserves in dollars."

Read the rest of the article.

Why the U.S. Needs A Recession to Correct Global Imbalances

I have argued in previous postings that past monetary policy profligacy in the United States has contributed to the global imbalances (here, here, here, and here). Here is an article by Gilles Saint‑Paul that takes a similar view and follows this line of reasoning to its logical conclusion: the current easing by the Federal Reserve puts off the correction of these imbalances--and allows them to continue to build--until a later time when correcting them will be more painful.

It is refreshing to see a thoughtful article on global imbalances that does not bow at the altar of the 'saving glut' goddess. This article takes seriously the 'liquidity glut' view of global imbalances and shows why the conduct of monetary policy for the world's reserve currency can be distortionary for the global economy.

: Saint-Paul mentions Volker's recessions in the early 1980s. See here for comments on this experience

Update II: Bill C at Twenty-Cent Paradigms cautions us not to put too much faith in the ability of monetary policy to correct the global imbalances.

How the US imbalances can be corrected
Gilles Saint‑Paul

There is agreement among many analysts that the Fed should pursue a low interest rates policy in order to prevent the US credit crisis from degenerating into a recession. On what grounds are we told that? The bottom line is that monetary policy is supposed to fine-tune the economy by targeting inflation and the output gap. Thus, monetary policy is supposed to become tighter when there are fears of inflation, and looser when there are fears of a recession and no sign of inflation. Consequently, the fed’s recent moves to lower interest rates seem perfectly orthodox.

This focus on macroeconomic aggregates ignores any other effect that interest rates can have on the economy. It totally ignores that interest rates are a price which affects many allocative decisions and has important distributive consequences. In 2001, the Fed engaged in a policy of drastic reduction of interest rates, for fear that the conjunction between the end of the so-called “Internet bubble” and the attacks of September 11 would drive the US economy into a recession. These considerations were compounded by the increasingly popular view that inflation was no longer a problem. The strong expansion of the late 1990s had been accompanied with little inflationary pressures and there were fears that the deflationary experience of Japan might hit the United States.

The result of these policies is that the US was in a regime of very low real interest rates. From 2002 to 2004, the federal funds rate did not exceed some 1.5 %, while inflation moved from 1.6 % to 2.7 % during that period. Thus short-term real interest rates were clearly negative. As for longer maturities, some real rates fell to 1.5 %. Many would argue that this was the right thing to do; GDP stayed at its potential level, or below it, and the incipient increase in unemployment was reversed.

The problem is that low interest rates not only stimulate the economy, they do plenty of other things. In other words, focusing only on GDP has costs and may generate mounting problems—the low rates policy makes a current recession better, but the next one may be worse.

One reason why the US economy is less inflation-prone than in the past is that a bigger share of any increase in domestic demand is absorbed by imports: the economy is more open than it used to be. Thus, instead of having “overheating” because demand is greater than supply, the gap between the two is filled by trade deficits. Hence, low rates stimulated consumer spending and the trade balance deteriorated by two percentage points of GDP. The US is rapidly accumulating foreign debt and that may lead to a brutal correction with a sharp drop in consumer spending and a large depreciation of the real exchange rate. In fact, that correction may have already begun. Yet the Fed is not supposed to look at the net foreign asset position of the US economy, even though both its deterioration and rising inflation are the symptom of the same problem – excess domestic demand.

The other issue is asset prices. When interest rates are very low, and expected to remain so, asset prices can be very high. In fact, when interest rates fall below the growth rate, assets become impossible to price. Consider, for example, a share that pays a dividend which grows at 5 % a year. With a 2% interest rate, it is profitable to buy that asset regardless of its price, because I only need to hold it for a sufficiently long time for the dividends to eventually exceed the interest payments. So the price of the asset is in principle infinite. In fact, people do not live forever, so they will have to sell the asset back at some point; but one can show that any change in markets' expectations about that future price can be validated by a corresponding change in the current price—so, the current price can be anything.

In particular, low interest rates may start asset bubbles. One mechanism is as follows. As the price starts rising due to lower interest rates, irrational speculators start buying the asset on the grounds that the price increases are going to continue. That fuels the price increase which may eventually develop into a bubble where all speculators, including the rational ones, pay a high price for the asset because they expect the price to be even higher in the future. So one by-product of the fall in interest rates is that real house prices started to go up very quickly.
To summarise, the low interest rate policy led to a wrong intertemporal price of consumption – consumption was too cheap today relative to the future – which led to excess spending and trade deficits. It also led to a mis-pricing of housing, which led to excess residential investment and excess borrowing by households. That is the price that was paid to make the 2001-2002 slowdown milder.

These imbalances have to be corrected. In principle, consumer spending can be brought down without the economy having to go through a recession, provided there is a sharp real depreciation of the US dollar, which would shift the structure of demand away from domestic spending and in favour of exports. On the other hand, the correction in house prices is likely to be contractionary. Some consumers have borrowed against the capital gains they made on their house, to purchase, for example, a second house or consumer durables. They are going to cut their consumption since they are more likely to become insolvent. As the collateral value of their houses falls, consumers will get less credit; hence a further drop in consumption. Furthermore, the securities backed by mortgages, subprime or otherwise, have been used as collateral by financial institutions; that collateral is worth less, thus reducing credit between those institutions. As a consequence, they will have more trouble lending to firms, so that investment will also be hit. The housing bubble has jeopardised the financial sector both because people have borrowed to hold it and because institutions have used the corresponding securities as collateral.

Because of this gloomy scenario, the Fed has been under pressure to cut rates. The problem is that such a policy is likely to perpetuate the current imbalances. Indirectly, it amounts to bailing out the poor loans and poor investment decisions made by many banks and households in the last five years. The bail-out comes at the expense of savers and new entrants in the housing market. The signal sent by the Fed is that it is sound to join any market fad or bubble provided enough people do so, because one will be rescued by low interest rates once things turn sour. Worse, the more people join, the greater the lobby in favour of an eventual bail-out.

All this suggests that the US has to go through a recession in order to get the required correction in house prices and consumer spending. Instead of pre-emptively cutting rates, the Fed should signal that it will not do so unless there are signs of severe trouble (and there are no such signs yet since the latest news on the unemployment front are good) and decide how much of a fall in GDP growth it is willing to go through before intervening. As an analogy, one may remember the Volcker deflation. It triggered a sharp recession which was after all short-lived and bought the US the end of high inflation.

Tuesday, December 4, 2007

High Oil Prices Will Save the World Economy?

Daniel Gros makes an interesting argument in the Financial Times today. Current high oil prices, he says, may just save the world economy from the intensifying credit squeeze. How so?

"The core of the issue is simple: oil producers tend to save about half of their windfall gains from higher oil prices. If the oil price stays around $90 a barrel, oil producers will increase their current account surpluses by $200bn-$300bn a year. The question will then be: who is willing and able to run corresponding deficits?"

In other words, the oil producing nations generate far more income than they spend and thus have excess savings. The excess savings will be lent out to (or used to buy assets from) countries willing to live beyond their means (i.e. run current account deficit). Since the world economy is being weighed down once again by tightening credit conditions that have emerged from the subprime mess, this injection of excess savings will provide the needed infusion of funding to keep the world economy going. Daniel Gros goes on to say,

"This prognosis implies, provided oil prices stay high, an ex ante savings surplus (in which surplus countries offer more savings than needed by deficit countries). That should lead to lower global real interest rates and/or higher asset prices – depending on the way petrodollars are recycled."

So excess savings from the oil exporters will keep real interest rates low and push asset prices back up. While I find this to be an interesting argument, I also find it confusing. Are we not in this current credit quagmire, in part, because of similar past excess savings from these same countries (and Asia) finding its way into the U.S. economy? (I say "in part" because I believe past U.S. monetary policy also played an important role) And why will there be more ex ante savings surplus this time around? If it is that oil prices are higher now, then why has there not been any impact already? I hope Daniel Gros is right and we soon see a lowering of spreads and easing of credit markets.

If, in fact, there will be more loanable funds coming to credit markets how will the underlying real economic distortions be worked out? Brad Sester provides one possibility in his posting "Should China buy Countrywide?": sell off U.S. assets, particularly troubled financial institutions invested in U.S. housing. He quotes Stephen Jen who says,

“We all know that SWFs [sovereign wealth funds] will have a very difficult time in the future, because of their vilified reputation. Buying cheap, strategic assets and appearing to be rescuing the US will carry immense long-term reputational benefits. More SWFs should jump in now, in my view. Countrywide would not be a bad choice. How much does it cost? Three weeks’ of reserve growth for China? Also, this may be the best time to buy US banks and financial institutions, as there would be the least political impediment to such inflows."

One implication, then, is that the excess savings will save the day as
foreigners indirectly (or directly in some cases) buy up the excess U.S. housing inventory. This brings a whole new meaning to home ownership in America.

Sunday, December 2, 2007

Is History Repeating Itself?

As we watch the dollar continue to free fall, one thing that really strikes me is how similar these recent developments are to those taking place before the break up of the Bretton Woods System in the early 1970s. Back then, the periphery countries were importing a loose, inflationary monetary policy from the dominant anchor economy, the U.S. The periphery countries also had piled up large amount of dollar reserves that eventually lost value when the system cracked in 1971-1973. Today, the dominant anchor country once again is the U.S. and is exporting a loose, inflationary policy to the periphery countries (i.e. Asia and the Gulf States) who have acquired vast dollar reserves. These countries too are now taking a huge capital loss as the dollar falls. Will this system, called by some the Bretton Wood II System, also crack like the original? Are we living through a time where economic history is repeating itself?

Part of what got me thinking about these historical patterns was the lead article and a subsequent longer piece in the Economist on the dollar's fall. These articles do a nice job explaining the structural reasons--the pressures from the huge U.S. current account deficits are finally being felt--the and cyclical reasons--the increasingly probability of U.S. recession and further rate cuts--for the falling dollar. The Economist also provides an interesting discussion of whether this decline means the U.S. dollar will lose its reserve currency status (answer: not necessarily) and what it means for the global economy. I then followed up by reading Brad Sester's discussion on these same Economist articles. He especially makes a good case that contrary to conventional wisdom, central banks can have a meaningful influence in foreign exchange markets--just look at the influence of the BRICs and the Gulf States.

What a fascinating time to be alive... as long as I keep my job!

Monday, November 26, 2007

Best Line on the Dollar

From the Economist lead article "America's Vulnerable Economy " comes this gem:

"The dollar's decline already amounts to the biggest default in history, having wiped far more off the value of foreigners' assets than any emerging market has ever done."

(The trade weighted dollar index is a weighted average of the foreign exchange value of the U.S. dollar against the currencies of a broad group of major U.S. trading partners. Broad currency index includes the Euro Area, Canada, Japan, Mexico, China, United Kingdom, Taiwan, Korea, Singapore, Hong Kong, Malaysia, Brazil, Switzerland, Thailand, Philippines, Australia, Indonesia, India, Israel, Saudi Arabia, Russia, Sweden, Argentina, Venezuela, Chile and Colombia)

Sunday, November 25, 2007

The Burden of Surging Oil Prices

From Kevin Kallaugher at the Economist:

The Housing Boom-Bust Cycle as a Roller Coaster Ride

Here is a great video clip that portrays real U.S. housing prices as roller coaster ride. Unfortunately, the video clip only goes through the beginning of 2007 so the 'bust' part of the housing 'boom-bust' cycle is missing. Nonetheless, the video clip helps put perspective on the magnitude of the U.S. housing boom... fasten your seat belt.

Sunday, November 18, 2007

A Deflation Article in Barron's

Barron's is running an article of mine this week titled "Deflation Isn't Always Dangerous." I make the case in the article that the failure of the Federal Reserve to distinguish between aggregate demand-driven and aggregate supply-driven deflationary pressures during the 2002-2003 deflation scare was a contributing (not sole) factor to the U.S. housing boom-bust cycle. The Fed read the deflationary pressures of this time as indicating weak aggregate demand; the evidence to me clearly points to rapid productivity gains being the source of the downward price pressure. In turn, this rapid productivity growth implied a higher neutral interest rate, but the Fed pushed its policy rate to historically low levels creating a Wicksellian-type disequilibrium.

For more details on this argument see these other related postings of mine: here, here, here, here, and here. If you read the Barron's article and are interested in the Postbellum deflation experience I briefly discussed in it, then check out my article titled "The Postbellum Deflation and Its Lessons for Today." I address some of the common critiques of this period's deflation in this article and show that this period's deflation was in fact largely benign.

For some reason, the on-line version of my essay has several typos. So in case you do not have access to typo-free print version, here is how the on-line version should read as follows:

Deflation Isn't Always Dangerous

IN 2003, AT THE HEIGHT OF THE deflation scare, Gary Stern was one of the few voices in the Federal Reserve System questioning whether the deflationary pressures of the time were truly a threat to macroeconomic stability. As president of Minneapolis Federal Reserve Bank, he was not convinced that the falling inflation rate was something to be feared. He viewed disinflation as a natural outcome of the economy's productivity gains. In his view, there was no need to cut the federal-funds rate to historically low levels.

Most officials in the Federal Reserve System, however, viewed the low inflation rate that time with alarm. They worried that it was the consequence of weakening demand in the economy. Their view prevailed and the federal-funds rate was cut to historically low levels. The inflation-adjusted, or real, federal-funds rate was pushed into negative territory and held there until 2005.

This move by the Federal Reserve appears to have been overly accommodative, and is now considered by many to be a key reason for the boom and bust in housing and related imbalances in financial markets.

Productivity was growing around 3% a year between 2002 and 2005, a rapid pace by historical standards. But today's conventional wisdom on deflation still is shaped by painful deflation experience of the Great Depression in the 1930s. Those who remember the past are afraid of repeating it.

Deflation -- an actual decline in prices -- can cause economic harm through several channels.

First, given relatively rigid input prices, such as wages, an unexpected deflation will lower firms' profit margins, reducing production and employment.

Second, unexpected deflation means debt becomes more onerous, leading to an increase in delinquencies and defaults, followed by weakening balance sheets of financial institutions and reduced lending.

Third, since actual interest rates reflect a real-interest-rate component and an expected-inflation component, deflation could pull short-term interest rates down to their lower bound of zero and prevent the central bank from being able to provide additional economic stimulus through cuts in interest rates.

Such events could reinforce each other in a deflationary spiral: Expectations of more deflation lead to a further fall in economic activity and push the economy into a prolonged economic slump.

This conventional wisdom, however, assumes deflation is always the result of a weakening in aggregate demand. It fails to consider that deflation may also arise from a boost to aggregate supply that is not accommodated by an easing of monetary policy. This benign form of deflation occurs as the result of productivity advances that lower per-unit costs of production and, in conjunction with competitive forces, put downward pressure on output prices. Here, profit margins are likely to remain stable even if input prices, such as wages, are relatively rigid, since the decline in a firm's sales price will be matched by the decline in its per-unit costs of production. Bank lending should not be adversely affected, either, since any unanticipated increase in the debt burden should be offset by a corresponding unanticipated increase in real income.

Productivity gains, which imply a faster growing economy, also typically imply a higher real interest rate to maintain economic stability, which in turn should prevent the actual interest rate from hitting the lower bound of zero.

Although rare today, this benign form of deflation emerged following the U.S. Civil War and persisted for almost 30 years while the economy experienced rapid economic growth and the U.S. became the leading industrial power of the world. Deflation in its benign form can be consistent with robust economic growth. Most Federal Reserve officials, however, simply failed to consider this possibility during the 2003 deflation scare.

The Fed missed the distinction and made the wrong call. It lowered real interest rates when productivity was growing. Its policy accelerated domestic spending when the economy was already being boosted by a series of positive aggregate supply shocks. The subsequent economic growth, therefore, had both a sustainable component -- the productivity gains -- and an unsustainable component -- the monetary stimulus.

Interestingly, the lowering of real interest rates and the subsequent credit boom all occurred without any alarming increases in the inflation rate -- the standard sign of overheating economy. This apparent stability, however, was illusory, since the inflation rate did indicate overheating relative to mild deflation rate that would have emerged from the productivity gains had there not been such a lax monetary policy in 2003.

The current problems in the U.S. economy are in part a failure of deflation orthodoxy. Federal Reserve officials, following conventional wisdom on deflation, misread the deflationary pressures in 2003 and fueled financial imbalances that today are just beginning to be worked out. Moving forward, it is important that the two forms deflation and their policy implications be better understood by monetary authorities. History can repeat itself, and sooner than we may now think.

Update II
The typos have been fixed in Barron's.

Friday, November 16, 2007

The Asymmetric Effects of Monetary Policy: Texas vs. Michigan

In several previous postings (here, here, and here) I have commented on the stark contrasts between the economies of Michigan and Texas. Part of my motivation for making these posts was personal. I was trying to sell a home in the depressed Michigan economy after moving to a new job in the vibrant Texas economy. Another motivation, though, is that a colleague and I have been working on a paper (for the SEA meetings in New Orleans) on the asymmetric effects of monetary policy. Specifically, we are looking at the differential impacts of monetary policy shocks across the contiguous 48 states for the period 1979-2001. We follow some previous work done on this topic--see Ted Crone's survey--but add some innovations along the way.

One of our findings, consistent with that of the earlier research, is that monetary policy shocks have a non-uniform impact across the state economies. Monetary policy shocks are particularly poignant in the Great Lakes region while they largely uneventful in the Southwest regions. Of course, my previous Texas-Michigan discussions fall nicely into these two camps. So from our paper, I have posted below graphs that show the typical response--the solid lines--of real economic growth on a monthly basis for these two economies from a typical monetary policy shock. I have also included the typical U.S. response as a benchmark. Standard error bands, which help provide a sense of precision of these estimates, are shown by the dashed lines. (Technically these graphs show the impulse response function from a near-vector autoregression of the growth rate for each state economy, as measured by the coincident indicator, to a standard deviation shock to the federal funds rate.)

The differential responses of these two states to the same monetary policy shock are striking. Texas is hardly affected relative to the steep downturn in Michigan. As noted above, these patterns fall more broadly into the regions of the United States with different sensitivities to the federal funds rate shocks. Our research confirms early studies that show these regional differences can be partly explained by the composition of output: those states with a relatively high share in manufacturing get hammered by a monetary policy shock while those states with relatively high shares in extractive industries fare much better. We also find that states with a relatively high share in the financial sector fare better as well. Finally, we find that states that have (1) a relatively high share of labor income compared to capital income and (2) a relatively high rate of unionization also get hammered by monetary policy shocks.

Here is the rest of the paper.

Thursday, November 8, 2007

Financing the Confederacy

Marc D. Weidenmier and Kim Oosterlinck have a new paper looking at the probability of the South winning the U.S. Civil War as seen through financial markets. Their paper is titled "Victory or Repudiation? The Probability of the Southern Confederacy Winning the Civil War" (non-gated version). I have posted their abstract below. If you find this research fascinating then be sure to also check out the "Money and Finance in the Confederate States of America" article over at the Economic History Net.

Victory or Repudiation? The Probability of the Southern Confederacy Winning the Civil War
Historians have long wondered whether the Southern Confederacy had a realistic chance at winning the American Civil War. We provide some quantitative evidence on this question by introducing a new methodology for estimating the probability of winning a civil war or revolution based on decisions in financial markets. Using a unique dataset of Confederate gold bonds in Amsterdam, we apply this methodology to estimate the probability of a Southern victory from the summer of 1863 until the end of the war. Our results suggest that European investors gave the Confederacy approximately a 42 percent chance of victory prior to the battle of Gettysburg/Vicksburg. News of the severity of the two rebel defeats led to a sell-off in Confederate bonds. By the end of 1863, the probability of a Southern victory fell to about 15 percent. Confederate victory prospects generally decreased for the remainder of the war. The analysis also suggests that McClellan's possible election as U.S. President on a peace party platform as well as Confederate military victories in 1864 did little to reverse the market's assessment that the South would probably lose the Civil War.

Sunday, November 4, 2007

The Taylor Rule and Boom-Bust Cycles in Asset Prices

Lawrence Christiano, Roberto Motto, and Massimo Rostagno have a new NBER working paper titled "Two Reasons Why Money and Credit May be Useful in Monetary Policy." I find this article interesting because one of the reasons the authors cite for taking money and credit seriously in monetary policy--as opposed to standard New Keynesian analysis that sees little role for money--is that focusing "narrowly on inflation [alone] may inadvertently contribute to welfare-reducing boom-bust cycles in real and financial variables." The authors show that if (1) there are positive productivity innovations and (2) monetary policy follows a standard Taylor rule that responds to deviations of inflation from its target then boom bust cycles in asset prices can be generated.

The authors explain that in "the equilibrium with the Taylor rule, the real wage falls, while efficiency dictates that it rise [following a productivity shock]. In effect, in the Taylor rule equilibrium the markets receive a signal that the cost of labor is low, and this is part of the reason that the economy expands so strongly. The ‘correct’ signal would be sent by a high real wage, and this could be accomplished by allowing the price level to fall. However, in the monetary policy regime governed by our Taylor rule this fall in the price level is not permitted to occur: any threatened fall in the price level is met by a proactive expansion in monetary policy."

In other words, these authors are arguing that by not allowing for benign deflation--deflation generated by productivity innovations--monetary authorities are generating too much liquidity and, in turn, fueling asset price boom-bust cycles. Does this sound familiar? I have been making this same point on this blog for some time, particularly with regards to the housing boom bust cycle of 2003-2005 (see here and here). Although it is refreshing it is to read prominent economists taking this idea seriously, I wish they would be a little more vocal about it. I would also point out that Borio and Lowe (2002) and Borio and Filardo (2004) made the same point several years ago. Also, do not forget George Selgin's important work on this issue.

Monday, October 29, 2007

Regional Economic Activity in the USA

I have made several postings to this blog (here and here) about my recent move from the depressed Michigan economy to the vibrant Texas economy. This move really was an eye-opener for me on the amount of variation in regional economic activity. Below is a graph of the year-on-year growth rate of real economic activity (measured by the Philadelphia Fed's state coincident indicator series) in Michigan, Texas, and the USA. Notice how Texas over the past few years has been doing better than the USA while Michigan has been doing worse.
Gene Epstein picks up on this theme in his interesting article on regional economic differences in Barrons. I have excerpted the first part of his piece below:

Fifty States, Fifty Job Rates

"IF A RECESSION IS WHEN YOUR NEIGHBOR loses his job, and a depression is when you do, then our neighbors in Michigan have been suffering a recession for some time. But if, to put a new spin on the time-worn quip, an expansion is when your neighbor gets a better job, and a boom is when you do, then if you live in Texas, you're probably enjoying a boom.

That a boom and a bust could be happening at the same time, in the same country, only highlights an underappreciated fact: While the U.S. economy is a useful abstraction, it consists of many different economies, each with its own special story. State and regional data are not as timely as national data. But the recently issued Bureau of Labor Statistics release for September 2007 on regional, state, and certain local labor markets provides a reasonably timely update.

Nationally, the U.S. unemployment rate stood at 4.7% in September '07 (the October reading is due out this Friday), up marginally from 4.6% in September '06. While that technically qualifies as a growth recession -- economic growth accompanied by a rise in joblessness -- it's at rates of joblessness that are still historically low.

Now, unravel what that 4.7% is derived from, and we find widely different stories state by state, although not quite as widely different as in previous periods in history. Michigan, to begin with, is surely suffering a full-blown recession. The Great Lakes state's unemployment rate hit a 14-year high of 7.5% in September, up from 7.1% in September '06, giving it the dubious honor of having the highest jobless rate by far of any of the 50 states. (The runner-up: Mississippi, with a jobless rate of 6.4%.)

The unemployment rate in the Detroit area is one of the highest in Michigan, at 7.9% in September, up from 7.3% 12 months ago. And that, of course, is another way of saying that the main cause of Michigan's bust is the hemorrhaging auto industry, with woes in real estate only a supporting player. While the national economy has had substantial gains in jobs of around 6% since the last peak in the business cycle in early-2001, Michigan's employment tally is down around 6% from that peak.

Texas, by contrast, seems to be enjoying a boom. The second-most-populous state in the union has seen its unemployment rate fall from 4.8% in September '06 to 4.3% in September '07, close to a seven-year low. And at 10%-plus since early 2001, job growth has been much higher than the national rate."

Friday, October 26, 2007

Asset Bubbles... and Monetary Policy

There was an interesting article this past week from Daniel Gros who reminded us that the boom-bust cycle in the U.S. housing market is not unique. Rather, there are also "House Price Bubbles Made in Europe." Here is a figure from his paper that compares real housing prices in the Euro area and the U.S. through 2006:

It is interesting how real housing prices in the Euro area follow a similar pattern to the U.S. real housing, albeit with a lag. As JMK has noted in the comment sections of this blog, this common movement in real housing prices means my often-expressed past monetary profligacy view (here, here, here, and here) cannot be the whole story. Financial innovation, low financial literacy, predatory lending, and excess saving from other parts of the world are meaningful contributors too. Nonetheless, the macroeconomist in me has a hard time believing these factors as being completely independent of--or as consequential as--loose monetary policy in advanced economies coupled with boom psychology.

To illustrate my point here is a figure (click here for a larger file) from one of my working papers:

The first graph in the figure plots the year-on-year growth rate of quarterly world real GDP against a weighted average G-5 short-term real interest rate. The quarterly world real GDP series is constructed by taking the quarterly real GDP series for the OECD area and using it with the Denton method to interpolate the IMF’s annual real world GDP series. This figure reveals that just as the global economy began to experience the rapid growth in the early 2000s, the G-5 short-term real interest rate turned negative as monetary authorities in these countries eased monetary policy. This positive G-5 interest rate gap—the difference between the world real GDP growth rate and the G-5 short term real interest—narrowed as the short-term real interest picked up in 2005, but it still fell notably short of the world real GDP growth rate by the end of 2006. Two measures of global liquidity corroborate the easing seen by the positive G-5 interest rate gap. The first measure is a ratio comprised of the widely used ‘total global liquidity’ metric, which is the sum of the U.S. monetary base and total international foreign reserves, to world real GDP. The second measure is a ratio comprised of a G-5 narrow money measure, which is the sum of the G-5’s M1 money supply measures, to world real GDP. Both measures show above trend growth beginning in the early 2000s. The bottom panel of Figure 5 shows some of the consequences of this global liquidity glut: real housing prices soar in the United States and United Kingdom and are systematically related to the positive G-5 interest gap. (I would love to get Daniel Gros' real housing price index for the Euro area and run a scatterplot of it too)

So in the end I am stuck on the view that loose monetary policy (in conjunction with boom psychology) was very important to the housing boom-bust cycle of the past few years.

Monday, October 22, 2007

Not a Pretty Sight

Menzie Chinn over at Econbrowser is feeling distressed today. He came across the below graph in the IMF's Global Financial Stability Report that shows the dollar amount of mortgage resets coming due in the future, as well as those in 2007. Take a look at the resets coming due in 2008--they are mostly subprime mortgages. Menzie looks at this sobering graph and concludes the "subprime resets in 2008 should put to rest the notion that the housing market's troubles are soon to be put behind."

C. Fred Bergsten on the Euro

Here is C. Fred Bergsten of the Peterson Institute on the fate of the Euro. His punchline is very similar to Thomas Palley (Triangular Trouble: the Euro, the Dollar and the Renminbi),
C. Fred Bergstein
Op-ed in the Financial TimesOctober 11, 2007

The euro has recently hit a succession of record highs against the dollar. A number of European leaders, including Nicolas Sarkozy, the French president, and Jean-Claude Juncker, chairman of the group of 13 eurozone ministers, have called on the United States to take action to halt the trend. The issue will be high on the agenda of the forthcoming Group of Seven leading industrialized nations and International Monetary Fund meetings in Washington. The eurozone should look to Beijing rather than Washington, however, if it wants to avoid the costs to its economies of a much stronger currency.

The bad news for Europe is that the dollar is likely to decline by at least another 15–20 percent on average. Growth differentials have now moved against the United States, which may experience the slowest expansion of any G-7 country in 2007. Differentials in short-term interest rates have correspondingly moved against the dollar. The US current account deficit is still running close to 6 percent of gross domestic product and, along with America’s own capital outflow, requires financing through an unsustainable $7 billion of foreign capital inflow every working day. The sharp pickup in US productivity growth that underpinned the strong dollar for a decade has been fading. The euro creates a meaningful international competitor for the dollar for the first time in a century and will attract continuing portfolio diversification from around the globe, including the super-rich sovereign wealth funds.

The good news for Europe is that most of the remaining decline of the dollar should take place against the currencies of the East Asians and the oil exporters. They are running the counterpart surpluses to the US deficits. They have piled up massive foreign exchange holdings that already far exceed any plausible needs. They are enjoying rapid economic growth that could most easily accommodate the reductions in external surpluses.Many of them need to shift their growth patterns to domestic expansion for internal reasons. A few of the surplus countries have moved in this direction. The currencies of South Korea, Indonesia, and Thailand have risen more against the dollar than has the euro. Kuwait has abandoned its dollar peg and let its rate float upward.

But the exchange rates of the largest surplus countries of Asia have barely budged. China is, of course, the most blatant case. Its global current account surplus is likely to exceed $400 billion in 2007, more than half of America’s global deficit. This will represent more than 12 percent of its GDP and provide one-third of its total economic growth. The renminbi needs to rise over the next several years by a trade-weighted average of more than 30 percent, and much more than that against the dollar, as part of a broader rebalancing of China’s growth strategy towards relying more on domestic consumption than on investment in heavy industry and climbing trade surpluses.

China claims to have adopted a market-oriented currency policy in July 2005. At that time, it was buying $20 billion to $25 billion monthly in the foreign exchange markets to block appreciation of the renminbi. It is now intervening at $40 billion to $50 billion per month. On that metric, its exchange rate is about half as market-oriented as two years ago. It is thus no surprise that the renminbi’s rise of about 10 percent against the dollar over this period was more than offset by the dollar’s fall against other currencies, so that China’s average exchange rate is weaker today than it was then, or in the early part of this decade when China’s current account was near balance and the dollar was at its record peak. Nor is it a surprise that China’s external surplus continues to soar.

Many other Asian countries hold their currencies down, through sizeable intervention of their own, to avoid losing competitive position to China. This is especially true of Hong Kong, Malaysia, Singapore, and Taiwan. Most of the large oil exporters intervene heavily to maintain undervalued pegs to the dollar as well. Japan’s currency is also substantially undervalued, though due to its appropriately easy monetary policy rather than any official manipulation. A substantial rise of the renminbi would almost certainly pull at least the other Asian currencies, including the yen, up with it.

The problem for Europe is that the inevitable further decline of the dollar will continue to occur mainly against the euro unless the large Asian countries and oil exporters permit substantial increases in the value of their currencies. Hence eurozone leaders should be addressing their concerns to Beijing, and to some extent Tokyo and Riyadh, rather than Washington, especially with the US current account deficit now falling and the budget deficit for fiscal 2007 at a mere 1.2 percent of GDP. Even if the euro were to rise a bit more against the dollar, large appreciations from the Asian countries and oil exporters would limit or even negate any further increase in its trade-weighted average and thus in the eurozone’s global competitiveness.

Rather mysteriously, Europe has been largely absent from efforts to address global imbalances over the past three years, in spite of warnings that it had the biggest stake in a geographically diversified outcome. The obvious places to start are effective implementation of IMF rules against competitive currency undervaluation and “prolonged, large-scale one-way intervention,” and the World Trade Organization rules against “frustrating the intent (of the Articles) by exchange action” and export subsidies, as Ben Bernanke, Federal Reserve chairman, has labeled China’s currency practices. Perhaps a euro at $1.50 or $1.60 will focus European minds on these imperatives.

Friday, October 19, 2007

House prices and the stance of monetary policy

A new paper provides further evidence on a view (see here, here, and here) promoted by this blog: past monetary profligacy contributed to the U.S. housing boom-bust cycle. Marek Jarociński and Frank Smets of the European Central Bank in a conference paper titled House Prices and the Stance of Monetary Policy find the following:

In this paper, we have examined the role of housing investment and house prices in US business cycles since the second half of the 1980s using an identified Bayesian VAR... There is also evidence that monetary policy has significant effects on residential investment and house prices and that easy monetary policy designed to stave off perceived risks of deflation in 2002 to 2004 has contributed to the boom in the housing market in 2004 and 2005.

I wrote a similar note on U.S. monetary policy and the U.S. housing boom. In my note, though, I use a different measure of monetary policy than the paper above and discuss the issue from a more Wicksellian perspective. Nonetheless, the conclusions are essentially the same: the Fed was too accommodative during the "deflation scare" 2002-2003 and was slow to return to normalcy thereafter.

The Business Cycle and Religiosity

Does economic distress increase religiosity and vice versa? This is a question that first intrigued me back in 2001, during the last U.S. recession. I was visiting my sister in Atlanta, Georgia and attended her church. During a part of the church service a microphone was passed around to individuals who then shared with the rest of the congregation what was going on in their life. Almost everyone who participated during this open mike time had just lost their job and were asking God to find a new one for them. As the right side of my brain sympathized with these suffering individuals, the left side of the brain got excited and started thinking about the econometric possibilities. I wondered, might this experience be reflecting a much broader, systematic relationship between church attendance and the business cycle? If so, were would I get data to test for such a relationship? And would this relationship be different for different denominations? I was curious and wanted to find out more.

I was a graduate student back in 2001 and had other pressings issues that put this interesting question on hold. I recently started looking at this issue again and now have a working paper titled "Praying for a Recession: The Business Cycle and Church Growth." I will be presenting this paper at the annual meetings for the Association for the Study of Religions, Economics, and Culture (ASREC) in November. My abstract reads as follows:

Some observers believe the business cycle influences religiosity. This possibility is empirically explored in this paper by examining the relationship between macroeconomic conditions and Protestant religiosity in the United States. The findings of this paper suggest there is a strong countercyclical component to religiosity for evangelical Protestants while for mainline Protestants there is both a weak countercyclical component and a strong procyclical component.

This paper is preliminary and I would appreciate any comments on it.

Tuesday, October 16, 2007

The Bubble Man Song

Via the Big Picture ,we have a great song from Scott Pettersen about the bubble man. Sit back, relax, and enjoy some great music.

The Fall of the Dollar

Above is the trade weighted value of the dollar against major currencies (major currency index includes the Euro Area, Canada, Japan, United Kingdom, Switzerland, Australia, and Sweden). Although the figure shows the dollar to have fallen significantly against the major currencies since 2002, many observers believe it has not hit bottom yet given the large U.S. current account deficits. Take a look at this graph to get a better sense of why a further fall in the dollar may be needed. The ongoing fall of the dollar is attracting much attention. Below are some interesting articles on this development.

A more competitive dollar is good for America, by Martin Feldstein, Commentary, Financial Times: The dollar has finally begun its long overdue correction. The dollar’s decline in recent weeks is just a prelude to the much more substantial fall needed to shrink the US current account deficit, running at a nearly $800bn annual rate, about 6 per cent of gross domestic product. If the dollar remained at its current level, the US trade deficit would continue to expand because Americans respond to rising incomes by increasing imports more rapidly than foreign buyers raise their imports from the US. Although a faster growth rate in the rest of the world would raise US exports and reduce the US trade deficit, experience shows that even substantially faster foreign growth would have only a very small impact. A lower dollar has to do most of the work of reducing the global trade imbalance. (Read the rest)

Triangular Trouble: the Euro, the Dollar and the Renminbi , by Thomas I. Palley: For the last several years the euro has been appreciating steadily against the U.S. dollar. Given the Chinese renminbi and other East Asian currencies are pegged to the dollar that means the euro has been appreciating steadily against all. This spells trouble for Euroland, and it suggests European policymakers should join with the U.S. to address the global problem of under-valued currencies. (Read the rest and see related article at the Economist: A Worker's Manifesto for China)

Is the United States headed for double bubble trouble?, by Richard Baldwin, Vox EU: In the minds of most mainstream international economists, there is never much doubt that the dollar must eventually decline significantly.[1] A trade deficit this big cannot persist indefinitely. Many analysts hope that the necessary real depreciation of the dollar might be gradual. After all, isn't the avoidance of such jumps one of the reasons we abandoned the Bretton Woods fixed-exchange system for a floating regime? So why are there modern fears of a sudden discrete drop in the dollar?

Here is the basic idea underlying dollar 'plunge scenarios.' Foreign investors have long demonstrated an increased appetite for US assets, moving a greater share of their portfolios into dollars and thus generating large capital flow into the US. But the capital flows needed to maintain an increased dollar share are much smaller than those needed to achieve it. Thus, when investors reach their desired holdings, there will be a drop off in capital flows into the United States, leading to an abrupt decline in both the current account deficit and the value of the dollar. (Read the Rest)

Why These Historical Patterns?

A number of blogs have pointed to some interesting patterns in the history of financial markets: the month of October (1929, 1987, 1997) and years ending in 7 (1837, 1847, 1907,1987,1997, 2007) seem prone to financial crises. These patterns may be purely coincidental or they may reflect some real economic phenomenon yet to be discovered. In any event, below are two blogs commenting on these patterns.
As experts look back at 20th anniversary of the stock market’s Black Monday crash, some questions remain about why October has been a common month for major declines. The reasons aren’t clear, but Federal Reserve Chairman Ben Bernanke has offered one possible explanation.

In today’s
retrospective of the 1987 crash, the Journal’s E.S. Browning notes, “For reasons analysts don’t fully understand, October has been the month for market crashes and other sudden drops. It was in October that stocks crashed in 1929, falling 23% over two days. On Oct. 27, 1997, within a day of the anniversary of the 1929 crash, the Dow Jones Industrial Average fell 7.2%, for a drop of 13% in two months.”

Mr. Bernanke commented on the phenomenon in a 2005 interview with Randall Parker, an economics professor at East Carolina University, about the Great Depression. “Classically, October has always been the month for financial problems,” Mr. Bernanke said. “If you look at the reasons for the Federal Reserve Act in the beginning, one reason was to provide an elastic currency. The main purpose of an elastic currency was to provide extra money as needed during periods of harvest or planting which in turn was intended to keep short-term interest rates more stable,” Mr. Bernanke said. “The high short-term interest rates during the fall and the spring created a shortage of liquidity and often provided the backdrop in which banking panics would take place.”

Although, it’s hard to understand why this should still be the case when agriculture has become such a smaller part of our economy. Perhaps, people just can’t let go of harvest traditions, whether they be jack-o-lanterns or banking panics.
A lot of people have compared the recent financial crisis to the crisis of 1907. It’s interesting that the time difference is exactly 100 years, but it’s easy to call that a coincidence. The modern economy hasn’t been around long enough, hasn’t provided enough data to say whether the 7th year of a century has been a more likely occasion for a financial crisis, and there’s no particular reason (that I know of) to think that it would be. But it’s vaguely interesting that both years end in 7: there are enough years ending in 7 that one could look for a correlation in the actual data if one thought there were any point in doing so.
The story gets more interesting in the light of a piece by financial historian Harold James (hat tip: Greg Mankiw). Without any apparent inclination to look specifically for sevens, he comes up with three years that he thinks are better parallels for 2007: they are 1837, 1847, and 1857. Since only 1 in 10 years end in 7, the chance of pulling 3 such years by random chance is 1 in 1000. That’s looking like statistical significance, considering that we already had an empirical basis for the hypothesis that there is something special about 7. Thinking back over the last two decades, I also recall that that the great Asian financial crisis began in 1997, and the US stock market crash happened in 1987.

Perhaps this is still all coincidence, but it seems that, if someone could think of a reason why financial crises are more likely in years ending with 7, it would make sense to listen to that reason

Thursday, October 11, 2007

How Bad Will It Get in the Housing Market?

Nouriel Roubini had a recent posting on his blog where he concluded he had been "Way Too Optimistic on the Housing Recession", this coming from someone known as one of the biggest bears on the housing market. He notes that his assessment of the housing market a few months, which many observers considered to be extreme, is now sounding very similar to the forecasts for the housing market coming from major investment banks on Wall Street. For example, Morgan Stanley is now calling for a cumulative decline in the number of housing starts to reach 56% while Goldman Sachs is saying housing prices will fall a further 15% on average before the dust settles sometime in 2008-2009. Robert Shiller is saying home prices will need to fall as much as 50% in some areas. So Nouriel was not too far off calling this the worst housing recession since the Great Depression.

The chief economist at Standard & Poors is now seconding this bleak outlook, as reported in the New York Post. (hat tip: NYC Housing Bubble). Some excerpts:

October 10,2007--A top economist predicted an even bleaker housing recession, saying it will last at least another two years, dragging down the American economy to trail the rest of the world. "Housing prices won't hit bottom until next summer and the losses won't peak for another two years, until 2009," said David Wyss, chief economist of Standard & Poor's. "We are not halfway through this crisis yet."

Although there has been an improved outlook for the economy overall, this housing sector analysis suggests we can look forward to deteriorating conditions in the housing market though 2009. Hang in there America.

Sudeep Reddy at the WSJ Real Time Economics blog reports on a AEI panel discussion today on the outlook for the housing market and its influence upon the broader economy. Here is some of what Sudeep reports:

But the recent interest-rate cut by the Federal Reserve, and a rallying stock market, aren’t swaying some economists from their expectation of a housing-induced recession. It was more a question of when, not if, during
a discussion today at the American Enterprise Institute about risks from the deflating mortgage and housing bubble.

"AEI visiting scholar John Makin said the recent performance of stocks suggests “financial markets are in a period of denial.” Housing downturns of today’s magnitude have always been followed by a recession, Mr. Makin says, calling the current environment a “textbook recession lead-up.”

“When you have a recession and the market doesn’t believe a recession [is coming], you get very radical changes in the financial markets,” he said. Credit instruments today “that are sort of hanging on by their fingernails…are not priced for a recession. I’m very concerned that we have a bit of a false dawn here, because that only delays the adjustment process.”

Desmond Lachman, a resident fellow at AEI, spelled out the key figures in case they’ve been forgotten: Previous housing booms featured a 20% inflation-adjusted appreciation in home prices. The current housing boom: an 80% increase in prices. House prices from 1979 to 2000 were 3.2 times people’s incomes; now they’re 4.5 times income. Mr. Lachman expects house prices to fall 15% to 30% from the peak to the ultimate trough. “This isn’t your regular kind of housing bust,” he said. “This is the worst housing bust that we’ve had in the post-war period.”

New York University economics professor Nouriel Roubini said housing starts would fall from the current annual rate of 1.3 million (a 12-year low) to 900,000 to clear the market glut, pushing down prices along the way. With a drop in business investment and consumer spending as well, that means a hard landing for the economy, he said. The stock market rallied in April and May of 2001 (just after a recession started) as the Fed eased interest rates. “The Fed cannot rescue neither the markets nor the economy,” he said."