Further Evidence that the Future Belongs to Statisticians

From The Economist:

EIGHTEEN months ago, Li & Fung, a firm that manages supply chains for retailers, saw 100 gigabytes of information flow through its network each day. Now the amount has increased tenfold. During 2009, American drone aircraft flying over Iraq and Afghanistan sent back around 24 years’ worth of video footage. New models being deployed this year will produce ten times as many data streams as their predecessors, and those in 2011 will produce 30 times as many. Everywhere you look, the quantity of information in the world is soaring. According to one estimate, mankind created 150 exabytes (billion gigabytes) of data in 2005. This year, it will create 1,200 exabytes. Merely keeping up with this flood, and storing the bits that might be useful, is difficult enough. Analysing it, to spot patterns and extract useful information, is harder still.

This is why Hal Varian is right when he says the sexy job in the next decade will be a statistician.

A Fat-Tail Event for U.S. Government Financing?

I recently argued that those observers who only see long-term structural budgetary problems, fail to consider the potential for a fat-tail event adversely affecting U.S. government financing in the near term. Clive Crook considers this possibility by asking whether the U.S. government might soon face a crisis of confidence like that of Greece:

It depends on what you mean by "soon." At the moment, the United States is borrowing with no great sign of stress. Far from coming under pressure, the dollar is still strong, and the cost of U.S. government borrowing (the interest rate on Treasury bonds) shows no sign of spiking. Greece, to be sure, has some problems all its own. Where it leads, the United States need not follow. Yet one should not dismiss the parallel too blithely. Sentiment in financial markets can change abruptly, and the differences between Greece's financial condition and America's are not as vast as one would wish.

Read the rest here.

Revenge of the Balance Sheets

The U.S. economic crisis has been called by some observers a balance sheet recession given the deterioration of the balance sheets in the banking system and the household sector. The U.S. banking system's balance sheets certainly took a beating during the crisis, but some progress has been made in repairing them. The IMF, for example, shows in its latest Global Financial Stability Report (chapter 1, pp. 7-9) that 60% of needed writedowns of U.S. bank assets had already occurred by late 2009. The November 2009 OECD Economic Outlook notes similar improvements, including sizable capital injections. Of course, there are still more writedowns to do, bank lending is still anemic, and much of the banking system's balance sheet problems have only been transferred to the Fed's balance sheet. Still, there has been some meaningful repair to banking system's balance sheet and that is more than can be said for the household balance sheet. This can be seen by examining the flow of funds data for the households, specially household net worth (i.e. household assets minus household liabilities). The figure below graphs this series as a percent of disposable income (click on figure to enlarge):



Note that household net worth as a percent of disposable income reached its lowest point during the crisis in 2009:Q1 with a value of about 450%. At this point, household net worth was put back to where it was in late 1985! For the latest observation of 2009:Q3 household net worth is about 485%, which is approximately where it was on average for the entire 1987:Q1-1993:Q1 period. The bottom line is that household balance sheets have been put back almost two decades. This is both amazing and alarming.

Now repairing household balance sheets will not be an easy task. Here are the options: First, reduce household liabilities by (1) writing down claims against households and/or (2) wide-scale household bankruptcy. Second, increase household assets through (3) a new asset boom cycle and/or (4) increased household saving. Options (1) and (2) are undesirable since they would add further disruptions to an already weakened financial system. Option (3) seems unlikely unless there is some truly new innovation (e.g. green energy) that takes off. That leaves option (4) which is already happening as the U.S. personal saving (and overall private saving) rate has increased since the downturn. This approach to improving household balance sheets , however, creates its own set of problems. First, it is not a quick fix. It may take years this way to fully repair household balance sheets that have been put back two decades. Second, as noted by Martin Wolf, the higher household saving means a drop in total spending and ultimately broader economic activity. As a result, government spending has stepped in to fill the aggregate demand gap by running budget deficits. However, given that the decline in spending by households may last years the aggregate demand gap spending by government may also last years. This , in turn, raises the specter of sovereign bankruptcy. In short, in the absence of another asset boom the U.S. economy faces the possibility of wide-scale private sector bankruptcy or public sector bankruptcy. Martin Wolf agrees as does Paul Krugman. You can run but you cannot hide from the problems with household balance sheets.

Update:To be clear, U.S. sovereign bankruptcy may mean inflating away some of its debt. There need not be an explicit default.

Assorted Musings

Here are some assorted musings:

(1) Menzie Chinn does a one-year anniversary review of the evidence on Obama's fiscal stimulus and concludes that 1.6 to 2.5 million jobs were created. Given the poor state of the economy this conclusion is based on counterfactual analysis (i.e How much worse would the economy have been had there been no stimulus?). John Taylor says these results are built into the models that make them. Arnold Kling agrees and explains why from a Bayesian perspective:

In Bayesian terms, the weight of the modeler's priors is very, very high, and the weight of the data is close to zero. The data are essentially there just to calibrate the model to the modeler's priors.

This debate will not be settled anytime soon. It also ignores another important question that requires counterfactual analysis: how many jobs would have been saved or created had monetary policy been more aggressive? Recall that monetary policy does not lose its efficacy just because its policy rate hits zero: unconventional monetary policy can still affect aggregate demand in a meaningful way by altering inflation or price level expectations. If you are not convinced just ask Michael Woodford, Paul Krugman, or Scott Sumner for starters.

(2) Tyler Cowen makes the case for the value added tax (VAT) and then asks for good arguments against it. Here is a big one: the VAT does not allow the public to fully internalize the true cost of the federal government. This problem would be particularly pronounced now if the VAT were enacted since about half the the U.S. population pay no federal taxes. If we want voters to make informed decisions about government programs they need to know the true costs and benefits of those programs. While the VAT might widen the tax base and help shrink the deficit in the near term it would also serve to only further externalize the true cost of government spending. In turn, this may eventually lead to a further widening of the budget deficit.

(3) Nick Rowe addresses some of the problems with the Post Keynesian/Chartalist theory of money. As someone who was their poster boy of what is wrong with mainstream macro over the past weekend in the comment section of this post , it is refreshing to see Nick Rowe assess some of their views. Among other things, we learn that they lack a theory of the price level. (We also learned from the earlier post that the money supply and the monetary base are completely and always endogenous. Robert Mugabe, therefore, is a victim not the perpetrator of Zimbabwe's hyperinflation!)

(4) I am a parent of young children and am an economist. Here I learn that I can be a better parent by utilizing my skills as an economist! My wife will love this one.

(5) Who says brain drain in the developing world is a bad thing? Laura Freschi says brain drain has unfairly received a bad rap.

Martin Wolf, Niall Ferguson, James Kwak, and Fat Tail Events

Martin Wolf today gave Niall Ferguson a true smackdown on the U.S. budget deficit issue:

Niall Ferguson is not given to understatement. So I was not surprised by the claim last week that the US will face a Greek crisis. I promptly dismissed this as hysteria. Like many other high-income countries, the US is indeed walking a fiscal tightrope. But the dangers are excessive looseness in the long run and excessive tightness in the short run. It is a dilemma of which Prof Ferguson seems unaware.

Ouch, that has to hurt. Martin Wolf, however, is making a fair point that currently the real U.S. government solvency issue is a long-run one given the projected runaway growth of entitlement programs such as Medicare. As is well known, soaring health care costs are behind these projections and thus, one of the motivations for health care reform is a desire to maintain long-term U.S. government solvency. James Kwak has been making this point recently and like Wolf has been on the warpath to scalp those poor souls who fail to see the long-term issues here. His victims include Robert Samuelson and Greg Mankiw. While I agree with what Martin Wolf, Jame Kwak, and other observers like them are saying on the long-term problems, I believe they underestimate the potential for a fat-tail event in the short-run. As we learned from the emerging market crisis of the late 1990s and early 2000s, market moods can unexpectedly swing and create havoc for sovereign debt. There may even be no fundamental reason for the market mood swing; it could be a random event or series of random events that triggers a reevaluation of a government's creditworthiness. Imagine for example, the other rating agencies follow Moody's recent warning about the U.S. AAA rating with their own warnings, news reports say China and other major holders are selling off a sizable portion of their U.S. securities, and bond investor suddenly began questioning the ability of the U.S. political system to address the unfunded liabilities of the U.S. government. In such a scenario,the Obama deficits suddenly become terrifying to the market and the U.S. government gets hammered with much higher financing costs. This in turn leads to fears of contractionary fiscal retrenchment or a monetizing of the debt. Welcome to the U.S. banana republic. Okay, this scenario is far fetched, but if there is anything we learned from this crisis it is that we should not ignore the potential for such fat tail events.

Update I: One thing Martin Wolf gets very wrong in his article is that monetary policy was tapped out and there was nothing more it could do. Hence, expansionary fiscal policy was needed. This is incorrect. There was and is much monetary policy can do even when its policy rate hits zero. Primarily, if the Fed would permanently change inflationary expectations (or the expectation of the future price level or better yet, the future path of nominal GDP) it could significantly affect current aggregate demand. See this Michael Woodford paper or Scott Sumner's blog for more.

Update II: On a related note, The Economist discusses sovereign debt domino theories. This is another reason we should be mindful of fat tail events.

More on the Eurozone Challenges

Ambrose Evans-Pritchard reports on the latest challenge in the Greek bailout:

The EU has issued a political pledge to rescue Greece – and by precedent, all Club Med – without first securing a mandate from the parliaments of creditor nations.

Holland's Tweede Kamer has passed a motion backed by all parties prohibiting the use of Dutch taxpayer money to bail out Greece, either through bilateral aid or EU bodies. "Not one cent for Greece," was the headline in Trouw. The right-wing PVV proposed "chucking Greece out of EU altogether".

Germany's Bundestag has drafted an opinion deeming aid to Greece illegal. State bodies may not purchase the debt of another state, in whatever guise.The EU is entering turbulent waters by defying these irascible and sovereign bodies...

This is why a common treasury is essential to any currency union. Imagine Texas refusing to allow its tax revenues to flow to the union-laced Michigan economy. Or the state of New York not allowing its taxes to support the bigoted folks in certain parts of the country. The dollar currency union would be in trouble too. Fortunately, there is a federal treasury. In Europe they are not so fortunate. Here is Evans-Pritchard:

The last two weeks have cruelly exposed the Original Sin of monetary union: that EMU was launched without an EU treasury or debt union. This will be tested again and again by bond vigilantes until such a mechanism is created.

I have my doubts about a EU Treasury being created. It is possible, though, that this crisis could be the catalyst that makes it happen. Finally, here he is explaining why the Eurozone is not an optimal currency area:

Europe's leaders still refuse to face the awful truth: that monetary union is unworkable as constructed. That different labour markets, different sensitivities to interest rates, different economic structures, have caused the gap between North and South to grow ever wider...

Sometimes a one-size-fits-all monetary policy does not work.

Global Debt Hangover

From Barrons:

There are credit-default swaps on 50 countries, and all but three have seen widening spreads, notes James Bianco, CEO of Bianco Research. "The whole planet's ability to pay its debt is being questioned," he says.

What a great thought with which to start the week.