Friday, February 29, 2008

LA Times Gets Real on Trade

This past Wednesday night Barack Obama came to campus. He held a rally near the river on campus--Texas State University is blessed to have spring-fed river that originates on campus--and about 12,000 people showed up. This came right after the debate in Ohio, which for many economists was a little disconcerting given all the NAFTA bashing. I was curious to see if Obama's anti-NAFTA rhetoric would carry over into this rally in Texas. Well, surprise, surprise, he said absolutely nothing about NAFTA. This absence makes political sense, but it is frustrating to watch. What does the real Obama think about trade? Are we just seeing primary season pandering or is this the real deal? As Greg Mankiw said over at his blog "will the real Obamanomics please stand up?"

Mark Thoma provides some links to different commentators who on balance suggest to me Obama is less protectionist than is indicated by his rhetoric. Nonetheless, the Financial Times reports Canada and Mexico, our NAFTA partners, are not pleased with all the anti-trade rhetoric coming out of the Obama camp. So, as Daniel Drezner points outs, "Democrats cannot simultaneously talk about improving America's standing abroad while acting like a belligerent unilateralist when it comes to trade policy" (hat tip Greg Mankiw). This point becomes even more salient if we look beyond Mexico and Canada and consider all the developing economies who are dying to penetrate the U.S. market (or desire to have the U.S. cut its distortionary subsidies to U.S. firms). What are they thinking when they hear such anti-trade talk?

The LA Times had an editorial yesterday that touches on some of these issues and is worth the read.

Deal with the Trade-Offs

The 14-year-old North American Free Trade Agreement has become a hot issue in this year's Democratic presidential campaign -- in Ohio, at least. When Sens. Hillary Rodham Clinton and Barack Obama hit the hustings in the Buckeye State, they compete to be NAFTA’s biggest critic. But when they jet to Texas, which is also holding its primary Tuesday, the candidates have little or nothing to say about the pact

The disparity illustrates two truths about major trade deals: They're a magnet for pandering, and they produce both winners and losers. Ohio, like other states in the Rust Belt, is stinging from the loss of manufacturing jobs in the years since NAFTA took effect. In Texas, however, communities near the border have blossomed with an influx of investment, jobs and workers

And the differences haven't just been regional. The trade deals signed since 1980 have helped spur job growth for some types of workers while decreasing jobs for others. Men at the high and low ends of the career ladder have benefited, but those in the middle have suffered, while the opposite holds true for women, according to a recent study by economist Stephen Rose at the Progressive Policy Institute.

The president's job is to take the long view of what's best for the country as a whole. Although it's hard to pinpoint jobs lost or created because of NAFTA, U.S. employment has grown far beyond even pessimistic estimates of the trade deal's costs. You wouldn't know that listening to Obama, who declared in a recent speech that "trade deals like NAFTA ship jobs overseas and force parents to compete with their teenagers to work for minimum wage." His stance is echoed by Clinton, who scolded Obama's campaign for distributing a flier that said she had called NAFTA a "boon" to the economy.

The centerpiece of both candidates' positions on trade is that future deals must include "good" or "strong" labor and environmental standards. That's vaguely comforting and feel-good-ish, but it's also misleading. Higher standards won't protect jobs and bottle up capital in the U.S. over the long term.

That's why the best course is to embrace free trade and fight for lower tariffs and other barriers to U.S. goods and services overseas. Protecting U.S. workers means giving them the education, training and, if necessary, retraining needed to compete for the higher-paying jobs that result from open markets. The capital and jobs that leave can help U.S. workers too by fostering stronger economies in the rest of the world and thus creating markets in which we can sell our products.

The increasingly global nature of business causes pain, but it's better to adapt to the competition than shake your fist at it.

Thursday, February 28, 2008

Where Goes the Oil?

As oil hovers near $100 a barrel, here are some interesting figures to mull over from a BBC report.

Allan Meltzer Goes for the Fed Jugular

Allan Meltzer gets shrill in this Wall Street Journal article. He argues (1) the Fed is becoming more politicized and, as result, (2) is making some decisions that will be very costly in the future. What is really causing Allan all this angst is the specter of 1970s-style stagflation. He experienced this stagflation firsthand and the subsequent 'cleansing' Paul Volker's Fed had to undertake to bring back macroeconomic order. Melzter does not want to see it happen again.

That '70s Show
Is the Federal Reserve an independent monetary authority or a handmaiden beholden to political and market players? Has it reverted to its mistaken behavior in the 1970s? Recent actions and public commitments, including Fed Chairman Ben Bernanke's testimony to Congress yesterday -- where he warned of a steeper decline and suggested that more rate cuts lie ahead -- leave little doubt on both counts

... In the 1970s and again now, Federal Reserve officials repeatedly promised themselves and each other that they would lower inflation. But as soon as the unemployment rate ticked up a bit, the promises were forgotten... People soon recognized that avoiding possible recession overwhelmed any concern about inflation. Many concluded that inflation would increase over time and that the Fed would do little more than talk. Prices and wages fell very little in recessions. The result was inflation and stagnant growth: stagflation.

... One lesson of the inflationary 1970s: A country that will not accept the possibility of a small recession will end up having a big one when the politicians at last respond to the public's complaints about inflation. Instead of paying the relatively small cost of a possible recession, the public pays the much larger cost of sustained inflation and a deeper recession. And enduring the deeper recession is the only way to convince the public that the Fed has at last decided to slow inflation.

... The freezing up of short-term financial markets called for more borrowing... But the rush to bring real short-term interest rates to negative values is an unseemly and dangerous response to pressures from Wall Street, Congress and the administration. The Federal Reserve became "independent" in 1913 so that it could resist pressures of that kind.

... The Fed's recent behavior is in sharp contrast to the European Central Bank. The ECB keeps its eye on both objectives, growth and low inflation. It doesn't shift back and forth from one to the other. The Fed should do the same.

Wednesday, February 27, 2008

How Low Will Home Prices Go?

This is a question I keep asking myself, not as an economist but as a potential homebuyer. As I have discussed previously on this blog, I recently moved to Texas from Michigan and am now looking to buy a home. A few weeks ago my wife and I aided and abetted the housing recession. Yes, we are guilty as charged of withdrawing an offer we had on a home under the assumption that the housing market has not hit bottom (there were some other factors as well). It is almost surreal to think I am a part of a downward deflationary spiral in the housing market where expectations play an important role. Of course, the Texas housing market is not the same as the Michigan housing market--where I had to bring money to the table to sale my home--and so I need to be careful in assessing how far home prices will fall here.

Still, I ask how far will home prices fall? The S&P/Case-Shiller house price index for select metropolitan areas and the OFHEO national house price index just came out for the end of 2007 and both show on-going declines across the nation. Below is a graph of the these two (nominal) series in year-on-year growth rate form through the end of 2007.

While this graph is interesting, it does not really provide any insight into my question of how low will house prices go. If we look at the series in the levels we get the following graph:

This figure shows in nominal terms that the home prices reached a peak in late 2006 (Case-Shiller) or early 2007 (OFHEO). The figure also indicates there is much more correction needed for nominal house prices to return to pre-2003 trend levels. This simple 'eyeball' analysis is consistent with what Calculated Risk has reported about futures data on housing prices:

... futures data is forecasting a price drop of 11% over the next year, and close to 25% over the next 3 years for the 25 largest MSAs.

As a home buyer, though, I am also sensitive to mortgage rates and recently they have been going up (see this picture over at the Big Picture). The Wall Street Journal explains why this is happening despite ongoing policy rat cuts:

There are two reasons mortgage rates haven't responded more to the Fed's rate cuts. One is that long-term Treasury yields, which are the benchmark for most mortgage rates, have risen recently, perhaps because of increased concern about inflation as the prices of oil and other commodities soar. The other is that the spread between mortgage rates and Treasury rates has widened as investors and banks become increasingly reluctant to make home loans.

The only way for long-term rates to fall now is for there to be more bad economic news. That would help with the inflation concerns, but it would not eliminate the mortgage-Treasury spread. If the Nouriel Roubini's of the world are correct, and if the mortgage-Treasury spread does not dramatically change, then lower mortgage rates await me in the near future.

So, patiently I wait for further housing price declines and more bad economic news.

James Hamilton discusses the latest housing price data over at Econbrowser.

Thursday, February 21, 2008

The Next Big Bubble?

We live in interesting times. Oil and other commodity prices continue to rise even as global demand is presumably slowing down. Normally, one would expect commodity prices to slow down with a weakening global economy. What explains these developments? As The Economist notes, it cannot be supply conditions since they have not dramatically worsened recently. James Hamilton believes these developments may indicate the economy will be improving in the near future. The uptick in commodity prices is simply a reflection of their role as a leading economic indicator. Maybe he is correct, or maybe we are seeing the beginning of the next big monetary policy-generated bubble.

Jeffrey Frankel of Harvard University has shown there is an important negative relationship between real interest rates and real commodity prices, with causality running from the former to the latter. Here is one illustrative graph from his work:

One story Frankel tells is that as monetary policy lowers interest rates speculators shift out of treasury bills into commodity contracts. Hence, the recent rate cuts by the Fed are generating a movement of liquidity into commodities. This story gets even more traction when we consider that the other big asset markets--stocks and housing--that would normally attract this liquidity have already been bubbled and popped. Lquidity, then, is looking for a new home to make a bubble and commodities seem to fit the billing this time around.

While this view is only one interpretation of the recent surge in commodity prices, it strikes me as reasonable. If time shows it to be true, the Fed will have unwittingly lived up to its reputation as a serial bubble blower.

Monday, February 18, 2008

Why Trade is Good

From this BBC article comes this striking figure on productivity in the auto industry:

Imagine where productivity in the U.S. auto industry would be if there were no Toyota, Honda, or Nissan. Certainly, the dislocations from trade can be painful, but this graph suggests there are meaningful dyanmic gains from trade.

Recession at the State Level

The Economist recently did an interesting article that examined where the U.S. economy was getting hit the hardest. The article found that economic "misery has been concentrated... in two set of states: the industrial Midwest and those states that was the biggest housing bubble, particularly California, Nevada, Arizona, and Florida." Much of the analysis, however, appears to have been based on unemployment rates in each state. While this is a useful metric, it may not be capturing the full extent of the economic distress given its known shortcomings. Consequently, I went to see what the Philadelphia Fed's state coincident indicator series are saying about regional economic activity. The data is on a monthly basis and the available observations run through December 2007. The fist bit of analysis I did was to simply look at the annualized growth rate for each state in December:

The above table reveals 27 states were contracting, while 23 were expanding. Next, I took the data and plugged it into some mapping software to get the following figure, where black = decline of 3% or greater, dark grey = decline of less than 3%, and light grey = expansion. In short, the darker the shading the greater the economic distress:

A few observations are in order. First, the hardest hit states are not the ones were the housing boom was the most pronounced. Thus, California, Nevada, Arizona, and Florida while experiencing a contraction in their economies are not being hammered as hard as the states in black. Second, while The Economist article showed the Northern Plain states to be doing relatively well, these information indicates otherwise--they are contracting. Third, Wyoming is doing so well relative to the other states and I assume it is because of higher commodity prices. If so, then why why is Kansas and Idaho dosing so poorly?

It will be interesting to see if January's data will show similar patterns.

Sunday, February 17, 2008

Lessons Learned from the Greenspan Era

The Financial Times has an editorial comment looking at the lessons learned from the Greenspan era. I have posted the piece below with my comments in brackets.

Learning from the Greenspan Legacy

The subprime crisis is Alan Greenspan’s fault, or so we are increasingly told: he offered bankers too much monetary candy and should have put them on a monetary diet instead. Is this criticism justified? And what does it imply for the future behaviour of central banks?

Few now have as much confidence in the self-restraint of the financial children as Mr Greenspan was wont to. No less certainly, Mr Greenspan’s reputation is sinking. Once hailed as a maestro, he is condemned by many as profligate. The truth is more complex. He was never the genius he was held to be. Nor is he the dunce some now allege. He was merely fallible. As such, he made good and bad calls.

Four features of the global economy – low inflation, the global “savings glut”, globalisation and the US productivity upsurge – have made managing monetary policy seductively difficult. It was difficult because the combination of low interest rates with fast economic growth proved the breeding ground for a succession of asset bubbles, most recently in housing. It was seductive because the bubbles were so popular, at least at the time.

[I concur--rapid real economic growth fueled by productivity gains and accompanied by historically low real interest rates is a Wicksellian no-no. The Fed cannot push the actual real interest rate below the neutral one and expect all will be well. Below is a graph from an earlier post that illustrates these developments (see here for larger picture).]

Even if one grants the difficulty, the US Federal Reserve might have erred: its monetary policy might have been too loose after 2000, particularly when its target interest rate sank to 1 per cent in 2003; it might also have remained loose for too long; it might have been asymmetric, with more attention being paid to downside than upside risks; and it might have paid too little attention to asset prices. Furthermore, under Mr Greenspan, the Fed might have assumed too readily that the financial system was self-policing.

Of these charges, the first is least plausible. After the stock market bubble burst, the case for insurance against deflation was overwhelming. But the argument that policy was loose for rather too long looks convincing, in hindsight. The asymmetric response to asset price movements is also, alas, compelling: in practice, the Fed has responded to asset price declines with greater urgency than to rises.

[Regarding the first charge, the case against deflation was not overwhelming. As suggested by the above figure and as I have made clear elsewhere, there is enough evidence to doubt the deflationary pressures of 2003 were of a malign nature. Rather, it is more reasonable to conclude they were the product of rapid productivity gains. I will concede the evidence is mixed for 2002, but by 2003 the deflationary pressures appear to have been largely benign. The Fed simply misread the deflationary tea leaves in 2003 and thus set a monetary policy in play that was distortionary. A few observers recognized this possibility of misreading the deflatoinary pressures back then and the potential consequences that could follow. Others are now vindicating this view.]

Yet the last charges seem the most important. The Fed’s view is that central bankers should respond to asset price bubbles only after they burst. But the bursting of a bubble associated with a credit surge is almost always highly destabilising. Taking at least some preventive action surely makes sense. Finally, the view that financial markets are self-policing is, alas, rather less credible than it was. A year can be a long time in economic policy.

[George Selgin has suggested a monetary policy rule that would address some of these problems. It is a nominal income targeting rule that would allow productivity movements to be more readily reflected in the price level. Selgin calls this the 'Productivity Norm' rule. See here for more about this rule or check out his book "Less than Zero."]

So central bankers have to learn lessons. Yes, the bankers were responsible for bingeing on the cheap money provided. But central banks bear responsibility for providing the feast and need to be more frugal in future. So Ben Bernanke, the Fed chairman, should take note. Using a new supply of candy to cure indigestion might cause even sharper pains tomorrow.

Thursday, February 14, 2008

Another Look at the Policy Rate Gap

So we now know that Big Ben is not upbeat about the economy. He testified before the Senate today that the ``outlook for the economy has worsened in recent months, and the downside risks to growth have increased.'' His grim assessment gave me a good excuse to spend some time today looking at a metric I call the policy rate gap. As I have discussed before on this blog, this metric is is an easy-to-use measure of the stance of monetary policy that in conjunction with the yield curve spread does a decent job predicting NBER recessions. It is calculated by subtracting the average fedreal funds rate from the growth rate of nominal GDP for each quarter. This metric is based on the Wicksellian-like idea that if the cost of borrowing is too low relative to the growth rate of the American economy, then excessive leverage and investment is encouraged and vice versa. Using this metric, a neutral monetary policy would be one where the federal funds rate never wondered too far from the nominal GDP growth rate.

The figure below shows the policy rate gap calculated up through 2007:Q4 using two different approaches. The first approach, indicated by the red line, takes difference between the year-on-year growth rate of nominal GDP and the average federal funds. The second approach, marked by the blue line, uses the annualized quater-on-quarter growth rate of nominal GDP. Both approaches show that policy rate gap turns sharply negative during NBER recessions. The figure also shows a neutral-to-slightly easing monetary policy stance by end of last year. This figure suggests that if the U.S. is in a recession this quarter and if the past is any guide to proper monetary policy, then it is appropriate for further policy rate cuts. (Click here for larger picture)

Plugging this metric along with the yield curve spread (10year-3month) into a probit model, where the dependent variable is a NBER-recession dummy variable, creates a simple but powerful tool for predicting recessions. The model specifically was designed to predict one quarter ahead. The figure below shows the results from this model up through 2008:Q1. The red and blue lines again come from what policy rate gap was used. (click here for larger picture)

This figure shows the probability of a recession this quarter is at most about 40%, down from a high of abour 60% a few quarters back. These numbers are surprising given the considerably higher probability numbers on the recession contract at (65% today). What I conclude from this brief analysis is (1) either my model is misspecified (a very good chance!) or (2) Big Ben should not be as worried as he is about the economy. Time to recheck the model!


I reestimated the above model, but this time included the spread between Moody's Aaa and Baa bond yield. Now, the model's recession probability for 2008:Q1 is about 60%, much closer to the 65% Intrade value. Including all three explanatory variables--the poilcy rate gap, the yield curve spread, and the corporate spread--improves the fit of the model (pseudo R2 of 63%) and produces a probability more in line with conventional wisdom. (Click here for larger picture)

Wednesday, February 13, 2008

There is a New Business Cycle on the Loose...

according to Thomas Polley and Paul Krugman. Thomas tells us that a new business cycle emerged in the 1980s and is defined by "large trade deficits, manufacturing job loss, asset price inflation, rising debt-to-income ratios, and detachment of wages from productivity growth." He also notes that the new business cycle "embeds a monetary policy that... tacitly puts a floor under asset prices." Paul takes a slightly different look at this new business cycle by focusing on its expansionary and contractionary stages. He notes that unlike pre-1983 recessions, the contractionary stage--which he calls a "postmodern recession"--is now more endogenous in nature and occurs as a result of the natural unwinding of economic imbalances. Simply put, these recessions are not being engineered by the Federal Reserve. Paul also notes that while these postmodern recessions are less painful than before, they seem to be more protracted.

I think Thomas and Paul are definitely on to something. However, rather than calling it a new business cycle, I would say it is the same business cycle responding to developments that were not around prior to the 1980s. These developments are (1) widespread financial liberalization, (2) credible anti-inflation regimes, and (e) globalization of the real economy. Claudio Borio and his colleagues at the Bank for International Settlements (BIS) have been writing about these developments for some time. A key message they have been consistently making is that monetary policy and prudential policy as usual are not going to cut it in this new era.

In their "Whither Monetary and Financial Stability? The Implications of Evolving Policy Regimes", Claudio Borio and William White summarize the nature of this new era:

Like a good novel, each phase in economic history has its villains, heroes and defining moments. Often, it is only with hindsight that we can identify them. There is little doubt now that the great villain during much of the postwar period has been inflation… The defining moment, perhaps, was the end of the 1970s, when monetary policy in the leading economy of the globe, the United States, purposefully sought to break the enemy’s back, thereby fostering a more favourable environment for similar battles elsewhere.

At the same time, since the 1980s a new concern, financial instability, has risen to the top of national and international policy agendas. It is as if one villain had gradually left the stage only to be replaced by another… Why has the full “peace dividend” of the war against inflation ostensibly failed to materialise?

Although the above paper answers this question, for the sake of variety I take you now to Claudio's article with Ilhyock Shim titled "What Can (Macro-)prudential Policy do to Support Monetary Policy?" to get answers and perspective on this question:

[These new] dynamics of the world economy [can be traced] back to the triad of forces mentioned at the outset[:] financial liberalisation, the establishment of credible anti-inflation regimes and the globalisation of the real-side of the economy...

Financial liberalisation may have made it more likely that financial factors in general, and booms and busts in credit and asset prices in particular, act as drivers of economic fluctuations. In particular, financial liberalisation has greatly facilitated the access to credit. It has therefore also increased the scope for perceptions of wealth and risk to drive the economy, more easily supported by external funding. More than just metaphorically, we have shifted from a cash-flow constrained to an asset-backed global economy. Such perceptions are highly procyclical, reinforcing expansions and contractions as they move in sync with the real economy. While these forces are essentially part of the “physiology” of the economic system – the oil that lubricates it – occasionally, they may go too far, and hence become part of its “pathology”...

At the same time, the establishment of a regime yielding low and stable inflation, underpinned by central bank credibility, may have made it less likely that signs of unsustainable economic expansion show up first in rising inflation and more likely that they emerge first as excessive increases in credit and asset prices (the “paradox of credibility”).

Finally, the globalisation of the real economy may have played a dual role. On the one hand, it may have represented a sequence of pervasive positive supply-side “shocks”. Such shocks would tend to raise world growth potential and help to keep inflation down while at the same time encouraging the asset price booms on the back of liquidity expansion…As history indicates, such supply-side-driven deflations are quite benign compared with their demand-driven counterparts. The risk is that, paradoxically, excessive resistance to “good deflations” can, over time, lead to “bad deflations”, if it supports the build-up of financial imbalances that eventually unwind.
[i.e. a point that I have repeatedly made on this blog... see here]

Finally, I send you to Claudio's piece with Philip Lowe titled "Asset Prices, Financial and Monetary Stability: Exploring the Nexus" for further insights:

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

We would like to make three points.

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

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

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

I hope influential observers like Thomas Polley Paul Krugman as well as policymakers take note of this work coming out of the BIS.

Wednesday, February 6, 2008

The Rise of Financial Populism

Although one can make reasonable arguments for the recent rate cuts by the Federal Reserve, there is the appearance that the Federal Reserve is simply responding to cries of help from Wall Street. Perception can often be more important than reality and if played out it can become reality. So even if the Federal Reserve was acting from an objective, fact-based perspective, its recent rate cut decisions may come to be seen as meaning the Federal Reserve has a new mandate to bail out Wall Street--it is simply too important to fail.

Some observers(here, here), however, take a even stronger position and assert that the recent rate cuts were not based on sound economic analysis, but rather on the Federal Reserve responding to panic-driven volatility in equity markets. Here, the Federal Reserve is consciously responding to the pleas of help from Wall Street. Both scenarios imply a troubling development. Robert Samuelson calls it 'financial populism' in a recent article. Some excerpts:

Jim Cramer -- the hyperactive, loud and opinionated host of CNBC's "Mad Money" -- is no fan of Federal Reserve chairman Ben Bernanke. If you'd tuned into "Mad Money" any time in recent months, you might have caught one of Cramer's outbursts against the ex-Princeton University economics professor. "Defend us from Uncle Ben Bernanke's relentless march to recession," went one rant. "You know what Bernanke is? He's the General Sherman of monetary policy. He's waging total war against the American economy."

Call this the rise of financial populism. Cramer is its biggest star and, in some ways, it has fundamentally altered the climate in which the Federal Reserve makes economic policy. Throughout its history, the Fed has rarely been popular (the peaceful period in the 1990s under Alan Greenspan was an exception). People often blame the Fed for recessions or high interest rates. But traditionally, politicians, business leaders and unions have been the most vocal critics.

No more. In recent months, the noisiest criticism of the Fed has come from Wall Street.

The rise of financial populism is certainly troubling. But if one makes the argument that the excesses from the past housing bubble and its related mess in credit markets needs to be sorted out, then financial populism becomes even more troubling since it aims to avoid the painful corrections needed. The always enertaining Daniel Gross raises this point in a recent article:

Wall Street traders are the infants and toddlers. They're the tykes who stage public tantrums, screaming and yelling and writhing on the floor until they get what they want. Since the markets began to buckle last summer, what traders want is interest-rate cuts and other government measures to bail out banks from reckless and disastrous lending and investment decisions. In response, Federal Reserve chairman Ben Bernanke has done what any exhausted parent does when a child screams for three hours straight: he gives in. In the past two weeks, the Fed cut interest rates sharply twice, taking the Federal Funds rate down from 4.25 percent to 3 percent.

Of course, "giving in to a tantruming child just reinforces the demand," says Dr. Wendy Mogel, a clinical psychologist in Los Angeles and author of the wildly popular parenting tome "The Blessing of a Skinned Knee." And each time you cave to a screaming child, it buys you less quiet. The Federal Reserve's latest attempt to calm the market's tantrums—the half-point interest-rate cut on Wednesday—bought about 90 minutes of market silence. Within hours, as poor economic news continued to materialize, the clamor for further rate cuts began to rise. Mogel puts it in starkly financial terms: "Indulge tantrums and you get short-term gains and long-term loss"...

The same might be said about Washington's current economic ministrations. The nation is now nursing a seriously skinned knee because of reckless behavior in housing and credit. But rather than force consumers, borrowers and bankers to face the consequences of their own actions, Washington is functioning as a helicopter parent. Harvard economist Ricardo Hausmann, who characterized America as "whiner of first resort," believes the rush to stimulus is being led more by a concern for Wall Street than a concern for Main Street. Rather than take their lumps after several years of exceptional returns, the banks are furiously lobbying for help. They're getting it.

The rise of financial populism suggests that Federal Reserve is becoming more politicized, even though it is designed to be independent from political pressures. Chalk one up for Jim Cramer and the other liquidity addicts of the world.

Sunday, February 3, 2008

Large Global Economic Imbalances Remain

Mark Thoma points us to an interesting article by Simon Johnson and Jonathan Ostryon of the IMF on global economic imbalances. Simon and Jonathon note the following:

The US dollar has depreciated in a way that helps global adjustment and fortunately does not disrupt the US government securities market; long-term rates are in fact down from July, so adjustment has been "orderly."

However, all is not well in the rest of the world.

[T]he pattern of exchange-rate movements in the rest of the world has been largely unrelated to existing current-account positions. In fact, currencies of surplus countries with heavily managed exchange rates have actually depreciated in real effective terms since the summer, creating inflationary pressure and frustrating global adjustment.

This has also shifted the burden of adjustment disproportionately onto countries with floating currencies, such as the euro and the Canadian and Australian dollar. The lack of adjustment of surplus countries with inflexible exchange rate-regimes means that as the US deficit falls, a counterbalancing deficit develops elsewhere in the world -- along with real effective exchange rate appreciation.

So in spite of the recent appreciation of the Chinese Renminbi against the dollar and the related (slight) improvement in the U.S. trade balance, the global economic imbalances tied to this part of the world are just being gradually shifted to Europe et al. as seen through their trade balances and exchange rates. And then there are the on-going current account surpluses coming out of oil exporting countries. The world, then, is still largely imbalanced, but just in a slightly different way. This story is not really new if you have been reading Brad Sester, but it drives home the point.

Here is a graph (click here for larger file) that illustrates this reality:

This figure pulled from the ECB web site shows the number of Renminbi per Euro since late 2005. The upward trend in the value of the Euro relative to the Renminbi is clear.

Below is another figure illustrating this shift of imbalances from the U.S. to the Europe. This figure shows each region's current account balance as a percent of world GDP. The data comes from the IMF and the data for 2007 is an estimate (including my own adjustments). So the last data point should be viewed with caution. Nonetheless, this picture indicates global imblances are far from being unwound.