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.