Friday, August 31, 2007

My Conversation with Ben Bernanke

Between 2003 and 2004 I worked as an international economist with the U.S. Department of Treasury. While there, I had the privilege of meeting Ben Bernanke. No, Ben and I did not sit down and have a one-on-one discussion on the economic issues of day. Afterall, I was a mere desk officer in international affaris and he was a Fed board governor at the time. However, I did get to escort Ben Bernanke from the entrance of Treasury to a meeting room and I took advantage of this opportunity by engaging him in a conversation. You can imgaine how excited I was to be hanging (all of 5 minutes) with someone whose work I had studied extensively in graduate school and who was now a Fed governor. I did not wash my Bernanke-handshaked hand for weeks.

This experience emboldened me to follow up by shooting him an email. In this email I asked Ben Bernanke--who was also the AER editor at the time--why there was not more research being done on productivity-driven deflation, given that it seemed a reasonable way to interpet the low inflation of 2003. To my surprise, Ben actually replied with a most interesting response. First, he said there was some work being done on this issue and pointed me toward Michael Bordo and Angela Redish's deflation paper. Then--and this was the shocker to me--he proceeded to justify the extreme lowering of the Federal Funds rate by noting the low capacity utilization rate and how it supercedded any productivity-driven deflation considerations. In other words, he acknowledged the possibility that benign deflationary pressures could be at work, but fell back on the low capacity utilization interpretation of the low inflation in 2003. Ben Bernanke believed most, if not all, of the low inflation of this time was due to a weakening of aggregate demand not a strengthening of aggregate supply. In his 2003 speech, "An Unwelcome Fall in Inflation?" he makes the same connection between low capacity utilization and low inflation:

"Although (according to the National Bureau of Economic Research) the U.S. economy is technically in a recovery, job losses have remained significant this year, and capacity utilization in the industrial sector (the only sector for which estimates are available) is still low, suggesting that resource utilization for the economy as a whole is well below normal... [this] persistent slack might result in continuing disinflation..."

There are, however, theoretical reason why capacity utilization may not be closely tied to inflation and there is empirical evidence showing this metric to be a poor forecaster of inflation. On the first point, some argue that globalization has made domestic capacity constraints less meaningful. Other observers note that the link between capacity utilization and inflation is premised on demand being the main driver of inflationary pressures, when in fact supply shocks can also be important. I find this second argument the most compelling because it was during this very time (2002-2004) that produtivity growth was increasing (see my productivity graph). One the second point, I direct you to a Dallas Fed study showing the capacity utilization and inflation relationship breaksdown after 1983. Also check out the Stephen Cecchetti and friends study that shows capacity utlization to be one of the worse inflation predictors. In fact, this study shows that capacity utilization relative to an autoregrssion actually reduces the accruacy of forecasting inflation.

Why am I sharing all of this with you? Because it is germaine to question of whether the deflation scare of 2oo3 was mishandled by the Federal Reserve. Now Ben Bernanke was only a governor at the time, but his view is probably a good representation of what the Fed was thinking: low inflation => low aggregate demand => low interest rates needed. As I have stated elsewhere on this blog, what they should have been thinking is low inflation low inflation => robust productivity growth => no need to cut rates (maybe even raise them).

I went ahead and did some preliminary analysis of my own on the relationship among inflation, capacity utilization, and productivity. Specifically, I ran a distributed-lag regression with the q/q CPI inflation rate as the dependent variable and regressed on it the industrial capacity utilization rate and the q/q non-farm business sector productivity growth rate for the years 1967:Q1 -2007:Q2 (all data is from the FRED database). The regression included 8 lags plus the contemporaneous value of each right-hand side variable in the regression. The distributed-lag regression was run such that dynamic cumulative multipliers were estimated. Next, I applied one standard deviation of each right hand side variable to its cumulative multipliers and come up with the graph to the right. Here, the cumulative response of inflation over time to both series receiving a a one-standard deviation shock is portrayed. Confidence bands of 95% are marked by the dashed lines. Note that the effect of a productivity shock is far larger than the capacity utilization shock. The productivity shock causes a permanent decline in inflation of about 0.9%, while the capacity shock effect is teetering around a 0.1% increase. Moreover, the capacity utilization shock for the most part creates a response not significantly different than zero. The q/q inflation rate averaged 1.1% over the period of this sample, so the statistically significant 0.9% decline of inflation to productivity is a non-trivial response.

These results are preliminary and show only the typical response over the sample, but at a minimum they should give pause to consider that just maybe the low inflation of 2003 was due to the robust productivity growth rather than the low capacity utilization rate.

Thursday, August 30, 2007

How Deflation Orthodoxy Got Us Here

In a previous posting I claimed that that one of the reasons for current financial quagmire is that the Federal Reserve's response to the deflationary pressures of 2003 failed to account for the possibility of benign deflation. Rather, the Federal Reserve assumed the deflation was of the malign or harmful form and pushed the real federal funds rate into negative territory. What I want to do now is (1) discuss more fully the differences between malign and benign deflation and (2) then consider why this distinction matters for macroeconomic stability. (Some of this material I have borrowed from my recent article, The Postbellum Deflation and Its Lessons for Today. )

Malign Deflation
Most observers view deflationary pressures as a threat to macroeconomic stability. This understanding of deflation is often justified by noting several important channels through which deflation can adversely affect an economy. First, given relatively rigid nominal input prices, an unexpected decline in the price level will increase real input prices, lower firms’ profit margins, and as a result reduce production and employment levels. Second, the nominal interest rate may be pulled down by deflation to its lower bound of zero and thereby eliminate the possibility of additional monetary stimulus through the policy rate. Third, the financial system will become beset with unplanned increases in real debt burdens as the price level falls as well as unanticipated decreases in collateral values as the economy deteriorates. As a result, delinquencies and defaults will increase and the balance sheets of financial institutions will weaken. In turn, financial intermediation will suffer and create and additional drag on the economy. Collectively, these events may reinforce each other in a ‘deflationary spiral’ where expectations of more deflation and additional economic weakness lead to a further fall in aggregate demand pushes the economy into a prolonged economic slump.

Benign Deflation
This conventional view of deflation, however, assumes deflation is the result of negative shocks to aggregate demand and fails to consider that deflation may also arise from positive shocks to aggregate supply that are not fully accommodated by monetary policy easing. This benign form of deflation occurs as the result of productivity advances that lowers per unit costs of production and in conjunction with competitive forces, puts downward pressure on output prices [1]. Profit margins are likely to remain stable under this form of deflation even if relatively rigid nominal input prices, such as wages, are present since the decline in output prices is matched by the decline in per unit costs of production. The productivity gains also mean an increase in the natural rate of output and the real interest rate. In turn, the higher real interest rate should counter the downward pressure on the nominal interest rate from the deflationary pressures and minimize the chance of hitting the lower nominal interest rate bound. Financial intermediation should not be adversely affected either, since the burden of any unanticipated increase in the stock of real debt arising from benign deflation should be offset by a corresponding unanticipated increase in real income, while collateral values should not decline but increase given expectations of higher future earnings from the productivity growth. Deflation, therefore, can be consistent with economic growth and should not always be feared.

([1] Aggregate supply induced-deflation can also arise as the result of positive factor input shocks with many of the same implications as noted above.)

Why the Malign-Benign Deflation Distinction Matters
Imagine the U.S. economy is buffeted with a series of positive productivity shocks that increases aggregate supply. This development would put downward pressure on the price level and set off the deflation red alert sign at the Federal Reserve. Now, in order to keep the price level from falling, the Federal Reserve must act to increase nominal spending. If this change in monetary policy were unexpected, or if there were significant nominal rigidities (i.e upward sloping Short-run aggregate supply curve), the nominal spending increase that stabilizes the price level would also push actual output beyond its natural rate level. Hence, there would be both a sustainable component—the productivity gains—and a non-sustainable component—the monetary stimulus—to the subsequent increase in real output. Moreover, the unsustainable pickup in actual output would occur without any alarming increases in the price level making the real economic gains appear macroeconomically sound. The increase in nominal spending could thus create a boom-bust cycle in real economic activity without any of the standard inflationary signs of overheating.... sound familiar?

These developments could also be viewed from an interest rate perspective. Here, the Wicksellian view that the actual real rate of interest can deviate from the natural rate of interest in the short run is invoked. The natural rate of interest is the real interest rate justified by non-monetary fundamentals, specifically the productivity of capital, the labor supply, and individuals’ time preferences and is the real interest rate consistent with the natural rate level of output. Recall that an increase in the growth rate of productivity should be matched by a similar increase in the natural rate of interest. If, however, monetary authorities attempt to offset the productivity-generated deflationary pressures by lowering the policy interest rate, they may force the actual real interest rate below the natural interest rate. This response can create an unsustainable credit boom. The resulting macroeconomic disequilibrium will be manifested in unwarranted capital accumulation, excessive leverage, speculative investments, and inordinate asset prices...again, sound familiar?

Here is a figure from an earlier posting on this topic. Given the above discussion, it should be evident from this figure that the Federal Reserve's response to the 2003 deflation scare was hugely distortionary. Had the Federal Reserve not been a slave to the deflation orthodoxy and considered the possibility of benign deflation where would we be today?

For those interested in more readings on this topic, I point you to William White's "Is Price Stability Enough?" and George Selgin's monograph "Less than Zero: the Case for a Falling Price Level in a Growing Economy." See also George Selgin's article "A Plea for (Mild) Deflation" as well as Michael Bordo and Andrew Filardo's "Deflation in Historical Perspective."

Wednesday, August 29, 2007

The Yield Curve and the Flight to Safety

A new paper by Glenn Rudebusch and John Williams shows that the yield curve spread is a better predictor of recessions than are professional forecasters. This fact may explain why yield curve is not used as much one would expect by the professional forecastors--they are loathe to promote a simple metric that renders them obsolete.

Given this papers timing, it is interesting to consider what impact the flight to safety in treasury bills (and out of asset-backed commerical paper) over the past few weeks has had on the current yield curve. This first figure (from the FT) highlights this drop using the 3-month treasury bill yield. Here the drop appears to be part of a downward trend even as the federal funds rate, the anchor of the short term interest rates, is stable. Note how the federal funds rate and the 3-month treasury yield track each other closley up through the middle of 2007. Thereafter, the series break, presumably because of the flight to safety (see the oppossite response in the asset-backed commerical paper). So what does this all mean for the yield curve? Does this flight to safety add noise to the yield curve's predictive ability?

This next figure shows the journey of the treasury yield curve since the Federal Reserve started tightening in the summer of 2004--beginning a slow ascent from the bottomed-out 1% federal fund rate--and takes us to the beginning of August 2007. During this time the yield curve is flattening--the long end is not proportionally moving up, if at all, with the short end. One famous observer called these developments a a 'conundrum'. Others simply viewed these developments as the yield curve beginning to point to a slowing of growth or a recession. Based on the expectation theory (and assuming a stable term premium), the long rates should simply be an average of expected short rates and thus, the long rates should be a reflection of where short rates are expected to be going. If market participants expect slower growth ahead and in turn expect the Federal Reserve to respond by cutting its policy rate, then the long-term rates will decline. Consequently, the recent flattening of the yield curve, and its slight inversion at times, can reasonably be interepreted as an economic slowdown is looming.

Given where we are--slow real growth, housing recession, credit crunch, etc.--the yield curve's predictions appear to have been on the money. So now, I want to see what impact, if any, the flight to safety has had on the yield curve--has it added any noise? This next graph reproduces the treasury yield curve at the begnning of August 2007 as well as two subsequent days in this month: August 2oth, when the 1-month treasury yield hit is lowest value of the month, and August 28, the latest data point available as of this posting. What this figure shows is that the noise from the flight to safety appears to only to have had a temporary effect on the overall flatness of the yield curve. Yes, there was a drop in the short end of the yield curve as seen on August 20, but by August 28 the shape of the yield was almost identical to what it had been at the beginning of the month. The yield curve, then, appears capable of withstanding the occasional noise of a marekt panic. More importantly, however, is that the current, flat yield curve indicates we are not out of the woods yet.. hang in there!

Monday, August 27, 2007

James Grant on the the Fed's Past Monetary Profligacy

Barry Ritholtz at the Big Picture directs us to an article in the NY Times by James Grant of Grant's Interest Rate Observer. Many excellent points are made in this piece, but I would like to call special attention to the following paragraph that highlights how the Fed's misguided fear of deflation in 2003 contributed to the mess we are in today:

... Under Mr. Greenspan, the Fed set its face against falling prices everywhere. As it intervened to save the financial markets in 1998, so it printed money in 2002 and 2003 to rescue the economy. From what? From the peril of everyday lower prices — “deflation,” the economists styled it. In this mission, at least, the Fed succeeded. Prices, especially housing prices, soared. Knowing that the Fed would do its best to engineer rising prices, people responded rationally. They borrowed lots of money at the Fed’s ultralow interest rates.

Now comes the bill for that binge and, with it, cries for even greater federal oversight and protection. Ben S. Bernanke, Mr. Greenspan’s successor at the Fed (and his loyal supporter during the antideflation hysteria), is said to be resisting the demand for broadly lower interest rates. Maybe he is seeing the light that capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich... Jiggling its interest rate, the Fed can impose the appearance of stability today, but only at the cost of instability tomorrow. By the looks of things, tomorrow is upon us already.

Sunday, August 26, 2007

Global Economic Imbalances Primer

For those readers who need a primer on the global economic imbalances debate see my article,
"A World Out of Balance: How A Spending Addition in the Developed World and a Saving Glut in the Developing World Undermines Global Economic Stability". I wrote this piece for the alumni magazine at my former employer, Andrews University (this is the version before the editor's cuts). If you want an article that gets more into the nuances of the debate check out Barry Eichengreen's article or this piece by Miranda Xafa.

Global Economic Imbalances: a 'Saving Glut', a 'Liquidty Glut', or Both?

Although there have been many takes on the current imbalances in the world economy, I believe they can all be broadly put into two camps. The first view is that there is excess saving (over domestic investment) in Asia and oil-exporting countries that has to go somewhere, so it ends up coming to consumption-addicted United States. The story goes that many of these excess-saving countries experienced severe financial crises in the 1990s that led to a sudden and devastating outflow of capital. As a consequence, these countries are building up "war chests" of foreign reserves to protect themselves (i.e. saving up for the next big financial crisis). Another story is the surge in oil prices for the oil-exporting countries is creating an excess of income over spending. There also might be institutional reasons for the saving glut such as the lack of a good social safety net prompting household to save excessively.

This 'saving glut' view was first put forth by Ben Bernanke in his now famous 2005 speech, "The Global Saving Glut and the U.S. Current Account Deficit." Here the United States is a hero, coming to the rescue of world economy in need of spending. According to this view, if it were not for the courageous saving-rate reduction and consumption spending increase of the United States there would be all of this excess saving sitting around idly doing nothing--we would have a global recession, or at least weaker global growth due to restrained spending. As I noted in my last posting, this is what Martin Wolf is appealing to when he calls on the Federal Reserve to keep the party going.

I believe there is some truth to this argument. Parts of the world are saving an inordinate amount of their income, and this may be due to the past financial crises, institutional factors, and high oil prices. But is this the whole story? I think not. Rather, like Mark Thoma I believe the 'liquidity glut' view has merit too and provides a complementary perspective. One big proponent of the 'liquidity glut' view is Stephen Roach of Morgan Stanley as seen in his classic "Original Sin" and his more recent "The Great Unraveling" . Daniel Gross and friends at the Centre for European Policy Studies also have some goods things to say about the 'liquidity glut view'. So what is the 'liquidity glut' view? I already touched on it in my previous posting, but here is Martin Wolf's description of this view (taken from his column titled "Villains and Victims of Global Capital Flows"):

"In the [liquidity-glut view]. . . the world’s savers are passive victims, profligate Americans are villains and the Federal Reserve is an anti-hero. In this world the US central bank is a serial bubble-blower, has distorted asset markets and visited excess monetary emission on trading partners around the world, above all, on those who seek monetary stability through pegged exchange rates... The argument is that US monetary excess causes low nominal and, given subdued inflationary expectations, real interest rates. This causes rapid credit growth to consumers and a collapse in household savings. The excess spending floods across the frontiers, generating a huge trade deficit and a corresponding outflow of dollars. The outflow weakens the dollar. Floating currencies are forced up to uncompetitive levels. But pegged currencies are kept down by open-ended foreign currency intervention. This leads to a massive accumulation of foreign currency reserves (up $3,445bn between January 2000 and March of this year). It also creates difficulties with sterilising the impact on money supply and inflation.

In this view of the world economy, savings are not a driving force, as in the savings-glut hypothesis, but a passive result of excess money creation by the system’s hegemonic power. Profits (and so measured corporate savings) rise simply because of increased exports and output under economies of scale. Governments of countries that possess the huge trade surpluses then follow the fiscal and monetary policies that sustain the excess savings needed to curb excessive demand and inflation."

Unfortunately, most of the world seems to be subscribing solely to the 'saving glut' view, at least that is my impression. If anyone out there knows of studies have estimated what portion of the global economic imbalances can be attributed to the past monetary profligacy please let me know.

Friday, August 24, 2007

Martin Wolf Drinks the 'Saving Glut' Kool-Aid

Martin Wolf is one of the best columnists in the financial press and I have always looked forward to reading his column in the Financial Times (FT). His columns bring fresh insight and reason to many of the big issues facing the world. So you can understand my utter shock when I opened Wednesday's FT and saw this title hanging over his column: Why the Federal Reserve has to Keep the Party Going.

After coming to from my initial state of shock, I sat down to read what Martin Wolf had to say. I was hoping his title was just some clever way to get readers attention, but alas it was not. Poor Martin Wolf apparently has had one-too-many drinks of the 'saving glut' kool-aid. It is one thing to argue for the 'saving glut' theory as a way to interpret the current global imbalances facing the world, but it is absurd to invoke it as a reason for the Federal Reserve to cut its policy rate to 'keep the party going'. His main point is that given the current global 'saving glut', the Federal Reserve must do its part to ensure that the U.S. economy, the demand engine of the world economy, keeps running. Consequently, to the extent the current financial crisis causes this important engine to sputter, the Federal Reserve should act aggressively.

There are several problems with his view. First, he ignores the 'liquidity glut' view of the current global imbalances that says at least some of the excess saving coming out of the periphery countries of the world has been due to the excessively accommodative monetary policy in United States. The story is that with U.S. monetary policy set on super easy between 2001 and 2005 and putting downward pressure on the dollar, these periphery countries who depend on a export-driven growth strategy for development had to buy massive amounts of foreign reserves to maintain both their peg to the dollar and their external competitiveness. Excess saving emerged as the result of these countries currency interventions--which again, were set off and driven by the loose monetary policy in the United States--that effectively increased the price and reduced the quantity of domestic consumption. Of course, the periphery countries could have chosen not to intervene in currency markets, but given that they did one clear implication is that the excess saving to some extent is a consequence of a policy choice made in Washington D.C. Asking the Federal Reserve to keep 'the party going' then is asking it to perpetuate it share of the global imbalances.

A second, related problem are the implications of his recommendation. As Catherine Mann notes in her response to this column, Martin Wolf essentially is prescribing more U.S. household indebtedness to maintain domestic demand and keep the global economy going. But is that not one of the very reasons we are in this financial quagmire now? Is not an overextended household sector one of the real economic distortions that has to be worked out? As Catherine Mann points out, "[i]t seems to me that continued unsustainable increases in household indebtedness should not be the outcome of Federal Reserve policy, no matter how important consumer spending is to the overall performance of the US economy." Why would we want more more asset bubbles and leverage when these very things put us where we are today.

Martin, it is time to put down the 'saving glut' kool-aid

Another Liquidity Addict?

Jim Cramer has found a new friend in Alan Mulally, the CEO of Ford. According the Financial Times, Mulally has come out calling for another liquidity binge to help get the U.S. economy through it current financial hangover. Alan needs to read the latest Economics Focus section in the Economist (discussed in my previous posting).

From the Financial Times:

Ford chief calls for Fed push on growth
The chief executive of Ford has joined calls for the Federal Reserve to stimulate the economy, saying the housing crisis and credit turmoil has made sustaining economic growth a ‘priority’. In an indication of the growing pressure on the Fed to cut rates, Alan Mulally said economic and credit conditions were a “big headwind” to his plan to turn round the carmaker, which last year lost $12.65bn.

“Something we are all concerned about is the macro-economy,” he said. “Especially right now in the US with subprime and [higher] fuel prices.”

Asked whether he backed a rate cut, Mr Mulally said: “It is a really important job to manage inflation and economic growth [but] focusing on economic growth appears to be a really important priority now.”

Thursday, August 23, 2007

The Economist Magazine Asks a Troubling Question

The Economist magazine asks a troubling question: does America need a recession? The answer may at first seem an obvious 'No!', but looking back to the example of former Federal Reserve chairman Paul Volker tempers this conclusion. As chariman, Paul Volker in the early 1980s successfully engineered two sharp recessions that are credited with creating the stable macroeconomic environment important to the subsequent 20+ years of U.S. prosperity. Back during Volker's time the recessions were used to lick inflation, today the argument for a recession rests on removing the real economic distortions (e.g. housing glut) created during the 2001-2005 monetary binge.

From the Economist:

Does America need a recession?
"...But should a central bank always try to avoid recessions? Some economists argue that this could create a much wider form of moral hazard. If long periods of uninterrupted expansions lead people to believe that the Fed can prevent any future recession, consumers, firms, investors and borrowers will be encouraged to take bigger risks, borrowing more and saving less. During the past quarter century the American economy has been in recession for only 5% of the time, compared with 22% of the previous 25 years. Partly this is due to welcome structural changes that have made the economy more stable. But what if it is due to repeated injections of adrenaline every time the economy slows?

Many of America's current financial troubles can be blamed on the mildness of the 2001 recession after the dotcom bubble burst. After its longest unbroken expansion in history, GDP did not even fall for two consecutive quarters, the traditional definition of a recession. It is popularly argued that the tameness of the downturn was the benign result of the American economy's increased flexibility, better inventory control and the Fed's firmer grip on inflation. But the economy also received the biggest monetary and fiscal boost in its history. By slashing interest rates... the Fed encouraged a house-price boom which offset equity losses and allowed households to take out bigger mortgages to prop up their spending. And by sheer luck, tax cuts, planned when the economy was still strong, inflated demand at exactly the right time.

Many hope that the Fed will now repeat the trick. Slashing interest rates would help to prop up house prices and encourage households to keep borrowing and spending. But after such a long binge, might the economy not benefit from a cold shower? Contrary to popular wisdom, it is not a central bank's job to prevent recession at any cost. Its task is to keep inflation down (helping smooth out the economic cycle), to protect the financial system, and to prevent a recession turning into a deep slump.

The economic and social costs of recession are painful... [b]ut there are also some purported benefits... [o]nly by allowing the “winds of creative destruction” to blow freely [can] capital be released from dying firms to new industries. Some evidence from cross-country studies suggests that economies with higher output volatility tend to have slightly faster productivity growth. Japan's zero interest rates allowed “zombie” companies to survive in the 1990s. This depressed Japan's productivity growth, and the excess capacity undercut the profits of other firms.

Another “benefit” of a recession is that it purges the excesses of the previous boom, leaving the economy in a healthier state. The Fed's massive easing after the dotcom bubble burst delayed this cleansing process and simply replaced one bubble with another, leaving America's imbalances (inadequate saving, excessive debt and a huge current-account deficit) in place. A recession now would reduce America's trade gap as consumers would at last be forced to trim their spending. Delaying the correction of past excesses by pumping in more money and encouraging more borrowing is likely to make the eventual correction more painful. The policy dilemma facing the Fed may not be a choice of recession or no recession. It may be a choice between a mild recession now and a nastier one later.
Mark Thoma comments on this piece and receives a lot of interesting comments

A Picture is Worth a Thousand Words

From Kevin Kallaugher at the Economist.

An Brief Empirical Look at the 'Past Monetary Profligacy' View

A common refrain found in the ongoing discussions surrounding the current market volatility is that we are bearing the consequences today of past monetary profligacy. Dropping the federal funds rate to 1% and holding it down for so long over the past few years has been cited by many observers as being distortionary, particulary in the housing sector. Although some observers such as Mark Gertler of NYU--a longtime buddy of Ben Bernanke--discount these claims, I believe there is enough evidence to take these claims seriously.

One bit of evidence for past monetary profligacy often cited by the Economist is that during this alleged time of profligacy the nominal federal funds rate was below the nominal growth rate of the U.S. economy. In other words, the rate of return of investing in America Inc. exceeded the cost of borrowing. Consequently, it was a no brainer that there would be excessive leverage. The above graph examines this claim. This graph plots the year-on-year growth rate of nominal GDP minus the nominal federal funds from 1975 through early 2007--the policy rate gap for short. By this metric, the alleged period of monetary profligacy is evident by the inordinately-sized spike in this series that looks like an inverted V for the years 2001-2007. The large size of the policy rate gap during this time does suggest monetary policy may have been too easy. Also plotted on this graph is the year-on-year growth rate of the OFHEO housing price index adjusted for inflation and lagged by 1.5 years. Interestingly, the surge in real home prices of the last few years appears to have been related to the surge in the policy rate gap between 2001 and 2005.

The next graph takes the policy rate gap and the real housing price growth rate and plots them against each other in a scatter plot. This graph indicates there is indeed something systematic occurring between these two series. Running a regression produces a relationship that is statistically significant (p-value of 0.000) with a R-squared of 30%. A non-trivial amount of the variability in the real housing price growth rate then can be explained by the policy rate gap. This analysis indicates the Economist was on to something after all and that there does appear to have been monetary profligacy.

Another point made by many observers, including myself, is that the deflation scare of 2003 that prompted the Federal Reserve to lower rates all the way down to 1% appears in retrospect to have been particularly distortionary. A standard result in most growth models is that the natural rate of interest is determined by the productivity growth rate, individuals intertemporal preferences, and the population growth rate. If the latter two factors are relatively stable, then changes in productivity should be reflected in similar changes in the interest rate in order to avoid the formation of financial imbalances. For example, if the productivity growth rate increases then there should be some nudging up of the real interest rate as well. However, if monetary authorities step in and push the real interest rate beneath the productivity growth rate they have set the stage for a classic Wicksellian disequilbria. The above graph provides evidence the Federal Reserves response during the deflation scare of 2003 was indeed creating just such a distortion. Part of the problem was that the Federal Reserve failed to account for the possibility that the deflationary pressures of this time could have come from the robust productivity growth depicted in this graph. This suggest the Federal Reserve needs to hone up on its ability to distinguish between malign and benign deflationary pressures (see William White's article "Is Price Stability Enough" for a good primer on these distinctions).

Although brief, the evidence posted here does lend support to the view that we are paying the price today of past monetary profligacy. My hope is we learn from these experiences moving forward.

Bill Gross on Adding More Liquidity

Bill Gross of PIMCO has just posted his latest investment outlook. These reports are always interesting and filled with colorful imagery (recall his comparing the new sexy credit derivatives to hookers with six-inch heels). In this latest report, Bill Gross examines the recent market turmoil and considers the implications of injecting more liquidity to the markets:

"Housing prices could probably be supported by substantial cuts in short-term interest rates, but even cuts of 200-300 basis points by the Fed would not avert a built-in upward adjustment of ARM interest rates, nor would it guarantee that the private mortgage market – flush with fears of depreciating collateral – would follow the Fed down in terms of 15-30 year mortgage yields and relaxed lending standards. Additionally, cuts of such magnitude would almost guarantee a resurgence of speculative investment via hedge funds and levered conduits which have proved to be the Achilles heel of the current crisis. Secretary Paulson might also have a bone to pick with this “Bernanke housing put” since it more than likely would weaken the dollar – even produce a run – which would threaten the long-term reserve status of greenbacks and the ongoing prosperity of the U.S. hegemon."

These points are essentially identical to the ones I made in my previous post: (1) this is an insolvency crisis not a liquidity crisis: there are real painful adjustments that have to be made in the housing sector, (2) injecting more liquidity will only led to more of the financial imbalances that got us here in the first place, and (3) there may long-term implications to monetary accommodation today, such as increased moral hazard and a weakening dollar.

Paying the Price of Alan's Profligacy

Tito Boeri and Luigi Guiso (hat tip Mark Thoma) do a terrific job explaining the subprime mess. They show three factors got us into this financial quagmire:

(1) The low financial literacy of US households
(2) The financial innovation that has resulted in the massive securitisation of illiquid assets
(3) The low interest rate policy followed by Alan Greenspan’s Fed from 2001 to 2004.

The authors believe, however, that one of these factors was by far the most important: the incredibly easy monetary policy of the Fed.

From their piece:

Low interest rates

The first two factors aren't new. Without the third factor – the legacy of the “central banker of the century” – the crisis probably would have never occurred. The monetary policy of low interest rates – introduced by Alan Greenspan in response to the post-9/11 recession and the collapse of the new economy “bubble” – injected an enormous amount of liquidity into the global monetary system. This reduced short-term interest rates to 1% – their lowest level in 50 years. What’s more, Greenspan spent the next two years maintaining interest rates at levels significantly below equilibrium. Interest rates were kept at low levels for a long time, and were often negative in inflation-adjusted terms. The result was no surprise. Low returns on traditional investments pushed investors and lenders to take bigger risks to get better returns. Financial intermediaries, in search of profits, extended credit to families and companies with limited financial strength. Investors with varying degrees of expertise duly reallocated their portfolios towards more lucrative but riskier assets in an attempt to increase their wealth and preserve its purchasing power. The low borrowing rates for both short and long-term maturity attracted throngs of borrowers – families above all who were seduced by the possibility of acquiring assets that for had always been beyond their means. At the same time, house prices soared, ultimately encouraging the additional extension of credit; the value of real estate seemed almost guaranteed. . .Thanks Alan! Today we’re paying the cost of your overreaction to the 2001 recession.

More on the Liquidity Addicts

In my previous post I spelled out a few reasons why the Jim Cramers of the world are liquidity addicts. Regarding these folks, I would be remiss not to point you to Dean Baker's posting, Wall Street Welfare Wimps Keep Whining, and the posting by Macro Man, 1-800-Bailout . Although the middle-of-roaders on this issue such as Mark Thoma and the Economist make good points about preventing contagion, I suspect that even they squirm uncomfortably when hearing the rants of liquidityholics.

Sound Policy or Liquidity Addicts?

What is the appropriate role of the Federal Reserve at this time? Most views on this question fall into one of three camps: (1) the 'inject much more liquidity now' view, (2) the 'inject some liquidy now to prevent contagion' view, (3) and the 'exercise monetary restraint now' view. What to make of these competing views? I want to focus in this posting on the 'inject more liquidity now' view. This group represents the Jim Cramers of the world who never tire of calling for more monetary easing whenver a finanical storm besets the markets. Below is an Op-Ed piece I wrote that addresses this very group.

Sound Policy or Liquidity Addicts?

"Ben Bernanke needs to open the discount window…He is being an academic! This is no time to be an academic. Open the darn discount window! ...My people have been in this game for 25 years. And they are losing their jobs and these firms are going to go out of business, and he's nuts! They're nuts! They know nothing! . . . The Fed is asleep…"
Jim Cramer on CNBC, August 3, 2007

Jim Cramer could not be happier. The Federal Reserve surprise discount rate cut of 50 basis points this past Friday spurred a brief recovery in markets and has created expectations of a Federal Funds rate cut in the September FOMC meeting. Jim Cramer and others like him who had been calling for an easing of monetary policy by the Federal Reserve surely feel vindicated by the market’s response on Friday and now are even more emboldened in their call for further interest rate cuts. But does this policy response make sense? Are these champions of interest rate cutting promoting sound policies that address the underlying problems or are they liquidity addicts simply begging for another shot of liquidity to get them through the hangover of the last monetary easing binge?

There are several compelling reasons to believe that these calls for the easing of monetary conditions are in fact nothing more than the cries of liquidity addicts hoping to avoid the needed correction in financial markets. First, the Jim Cramers of the world fail to recognize the difference between a liquidity crisis and an insolvency crisis. A liquidity crisis is when an individual, firm, or some sector of the economy is solvent but temporarily short of liquidity. For example, if an individual is unexpectedly hit with major medical expenses that he cannot pay out of pocket, but could pay once he sells some of his assets, such as land, then this individual is facing a liquidity crisis. However, if this same individual cannot pay out of pocket and has no assets to draw on then he is insolvent and facing an insolvency crisis. In the former case, extending credit or liquidity to this individual makes sense since he has assets to cover the new line of credit, but in the latter case extending credit would only postpone and maybe worsen the insolvency. This distinction is important because as Nouriel Roubini has shown the current turmoil in global markets is the result of an insolvency crisis not a liquidity crisis. Roubini notes in particular that this crisis stems from insolvencies and bankruptcies in mortgage-ladened households, mortgage lenders, home builders, and some hedge funds all of whom were driven by real economic distortions in the housing sector. These excesses in the housing sector simply cannot be waved away by some magical liquidity wand. This current insolvency crisis stands in stark contrast to a true liquidity crisis that emerged with the Long-Term Capital Management hedge fund debacle in 1998. Then, the Federal Reserve was able to successfully intervene and thwart a credit crunch, but it occurred in the context of a robust economy with no signs of broad insolvency. Believing that more monetary accommodation now will save the day misses this important distinction.

The Jim Cramers of the world also seem to forget what got us here in the first place: past monetary excesses. Following the recession of 2001 and the deflation scare of 2003, the Federal Reserve lowered it policy interest rates from a high of 6.5% in early 2001 to a low of 1% that was maintained through the summer of 2004. Although monetary policy began tightening in the second half of 2004, the federal funds rate was still lower than the year-on-year growth rate of nominal GDP through 2006. By keeping the interest rate below the growth rate of the economy for so long, there was every incentive for excessive leverage. Moreover, the lowering of interest rates in response to the deflation scare of 2003 looks to be particularly distortionary in retrospect. Rapid productivity gains appear to have been the source of the low inflation in 2003, but rapid productivity gains imply a higher policy interest rate, not a lower one, is needed for monetary policy to stabilize economic activity. It is no coincidence that these policy moves coincided with the housing boom and the related distortions in mortgage markets that are only now beginning to be worked out. The irony in all of this is that the Jim Cramers of the world are now calling for more of the same liquidity medicine that generated the financial imbalances in the first place—a surge sign of liquidity addiction.

Finally, the Jim Cramers of the world fail to grasp the implications of their policy prescriptions going forward. As has been discussed already on these pages, every time the Federal Reserve steps in to calm financial markets it creates less incentive for investors to be more careful next time. To the extent the Federal Reserve is setting a precedent in the mind of investors and creating moral hazard, it is perpetuating a culture of liquidity addiction. If the Federal Reserve continues to follow down this path of accommodating the markets, then we have not seen the last Jim Cramer rant against the Federal Reserve nor the last of the liquidity addicts. Another implication going forward of this policy prescription for more monetary easing is that it may put downward pressure on the dollar. To the extent the dollar has been overvalued this may be a good outcome, but ongoing interest rates cuts in the midst of market turmoil and could lead to an outright run on the dollar. Either the Jim Cramers of the world simply cannot see far foward enough to appreciate these dangers or they personally high discount rates.

The Jim Cramers of the world then are liquidity addicts who are prescribing the U.S. economy go on another Fed Spirits binge and put off the financial hangover until another day. The U.S. economy has been down this road before after the last asset bubble burst in the early 2000s. Here is hoping the Federal Reserve does not follow their policy recommendations, but allows the U.S. economy to finally sober up.

Wednesday, August 22, 2007

The Journey Begins...

This posting begins my blogging journey. I plan to regularly make postings here regarding all things macroeconomics and markets. These postings will include everything from research progress reports to news commentary to interesting links. Stay tuned, the fun is just beginning.