Author: James Kwak

Causes: Econbrowser Speaks

Other posts in this occasional series.

As you might imagine, I read (or skim) a lot of economics blogs. One of my favorites is Econbrowser, written by James Hamilton and Menzie Chinn. Whereas many blogs tell me good ideas that I didn’t think of but that theoretically I might have come up with (given infinite time and mental alertness), Econbrowser almost invariably teaches me something I absolutely couldn’t have known beforehand.

In the last week, both Hamilton and Chinn have written about the causes of the current economic crisis.

Menzie Chinn

For Chinn, the current situation was created by a “toxic mixture” of:

  • Monetary policy
  • Deregulation
  • Criminal activity and regulatory disarmament
  • Tax cuts and fiscal profligacy
  • Tax policy

He thinks that lax monetary policy was not particularly significant (or, more specifically, the policy was not lax given the information available at the time). He says that some examples of deregulation were more significant than others (repealing Glass-Steagall OK, the Commodity Futures Modernization Act not so much, which is the distinction I also made in an earlier post). Deregulation bleeds into the third point – the abandonment of regulatory agencies of their policing functions, along with examples where regulators committed actual fraud to aid the companies they were supposedly regulating (IndyMac being the prime example).

But the last two points are the ones you don’t hear a lot about. The Bush tax cuts fueled the asset price bubble, especially the second one (in 2003), which came long after the recession had ended and when housing prices were on the steep part of their climb. Under tax policy, Chinn takes aim at the tax deductibility of second homes; combined with tax cuts that largely favored the rich, this increased demand for second homes, and therefore the prices of homes. Right now many people are calling for tax cuts as a way to stimulate the economy, and while you can debate whether tax cuts are more effective than increased spending, that is a reasonable debate to have. In retrospect, the error Chinn is pointing to is cutting taxes – providing a fiscal stimulus, in other words – when it wasn’t needed, at the same time that interest rates were low. Since the Reagan administration, the argument for tax cuts has been to shrink the size of government, increase the incentive to work, and return money to people who know how to spend it better than the government. Only this time, we’ve reached a point where (almost) everyone agrees we need a fiscal stimulus, and the need is so pressing we’re going to ignore the fiscal handcuffs created by the Bush tax cuts, which makes no one happy.

James Hamilton

In a November 2008 lecture, current IMF chief economist Olivier Blanchard discusses the boom in oil prices in a footnote:

How could the very large increase in oil prices from the early 2000s to mid-2008 have such a small apparent impact on economic activity? After all, similar increases are typically blamed for the very deep recessions of
the 1970s and early 1980s.

Hamilton takes almost the opposite approach: maybe it was high oil prices that tipped the global economy into recession. While this may sound preposterous (everyone knows it was housing, right?), remember that the U.S. housing bubble has been front-page news since at least early 2007, yet the peak of financial panic didn’t occur until September-October 2008. Was there really a lot of new information about the subprime mortgage market that appeared during that time? Christopher Dodd was already holding hearings on the subprime meltdown in March 2007 (thanks to Michael Lewis’s book Panic! for reminding me of that.) Or was it something else?

Hamilton takes a 2007 model created by Lutz Kilian and Paul Edelstein of how changes in energy prices affect personal consumption. (Summary: an increase in energy prices that would require a 1% reduction in other purchases to buy the same amount of energy actually leads to a 2.2% decrease in consumption over 15 months.) He then applies the model to actual energy prices since the middle of 2007 and (according to my eyeballing the chart) shows that about half of the falloff in consumption over the period is due to increased energy prices.

The (possible) implication is that if oil had remained at its early 2007 prices, the decline in housing prices that was already clearly visible would not have been enough to cripple the financial system and bring the global economy to its knees. In the process, of course, we ended up with oil in the $30s, but the damage has clearly been done. Hamilton promises to continue this topic in a future post, and I’ll be watching out for it.

Some Questions about GMAC

I’m a little late to the GMAC bailout story, but after reading all the newspapers and blogs I usually read, there are still some things I don’t understand. I’m particularly confused about the announcement that GMAC will start lending to anyone with a credit score above 620, down from their previous minimum of 700. (The median credit score in the U.S. is 723.)

1. What is the relationship between GM and GMAC? I know that Cerberus owns 51% of GMAC and GM owns the other 49%. I also know that, in order to become a bank holding company, both were forced to reduce their ownership stakes. In any case, GMAC is an independent company that should not be run for the benefit of GM. Its obvious that GM benefits if GMAC reduces its lending standards. But how does GMAC benefit?

2. If a loan to someone with a credit score of 621 was a bad idea on Monday, why was it a good idea on Tuesday? The only theory I can think of under which this makes sense is that GMAC thinks that loans to people with credit scores of 621 are profitable, but they couldn’t get the capital cheaply enough until they got their government bailout money.

3. Who is going to pay the bill when these loans go bad? It looks to me like GMAC is making a big gamble by trying to pump up its lending volume with higher-risk borrowers, right in the middle of the worst recession since . . . 1981? the 1930s? (In any case, it won’t be able to get anything like the lending volume it used to have, simply because fewer people are buying cars.) Isn’t this a situation where a company is choosing a high-risk strategy because its only option is to watch its revenues shrink away to nothing because the demand for credit has plummeted? But if that’s the case, how smart is it to go chasing after high-risk borrowers because the low-risk ones are suddenly saving their money? And now that GMAC has gotten the Henry Paulson seal of approval (remember, TARP money was not supposed to go to unhealthy “banks”), I think there’s a fair chance they are counting on Treasury to bail them out of their next round of bad loans.

Of course, it could be said in GMAC’s defense that they are just doing what Congress wants them to do: take TARP money and use it to make loans more available to consumers. But this goes back to the fundamental schizophrenia of TARP: it was conceived to keep banks from failing, but most people think its purpose should be to increase credit. And in this case I suspect GMAC’s taxpayer money is being used to sell GM cars that people wouldn’t buy otherwise, and when it runs out GMAC will be back for more.

IMF Speaks

On Monday, the IMF released a new research “note” entitled “Fiscal Policy for the Crisis,” which sets out recommendations for fiscal policy to address the global economic downturn. The premises of the note are, first, that the financial system must be fixed before it is possible to increase demand and, second, that there is limited scope for monetary policy, leaving fiscal policy as the main weapon. The executive summary provides the main recommendation in short form:

The optimal fiscal package should be timely, large, lasting, diversified, contingent, collective, and sustainable: timely, because the need for action is immediate; large, because the current and expected decrease in private demand is exceptionally large; lasting because the downturn will last for some time; diversified because of the unusual degree of uncertainty associated with any single measure; contingent, because the need to reduce the perceived probability of another “Great Depression” requires a commitment to do more, if needed; collective, since each country that has fiscal space should contribute; and sustainable, so as not to lead to a debt explosion and adverse reactions of financial markets.

Continue reading “IMF Speaks” →

Human Nature

Or, why human beings are bad investors.

Free Exchange has Anthony Gottlieb’s recollections of interviewing Bernie Madoff about financial regulation:

at the time he came across merely as calm, strikingly rational, devoid of ego, and the last person you would expect to make your wealth vanish. I certainly would have trusted him with my money. I cannot say the same of other financial superstars I interviewed. . . . Perhaps it is the most confidence-inspiring ones that you have to look out for.

I couldn’t agree more. We human beings have this completely misplaced confidence in our ability to judge people by “looking them in the eye.” I recall reading about one study (sorry, I don’t remember anything else about it) which showed that hiring managers were more likely to make good hires by selecting solely on the basis of resumes than by interviewing people – because using resumes is completely objective, while interviews allow you to interject your own erroneous beliefs. (I do believe that if you use interviews well – that is, to obtain factual information, like how well someone can actually write a computer program – you can do better than just using resumes; but maybe I’m just fooling myself.)

There are a couple of ways to look at this phenomenon. One is to think about motivations. There are people who are trying to rip you off and people who aren’t. The latter have no motivation to try to seem trustworthy, so they don’t bother. The former do have that motivation, so they try. Some are bad at it; some, however, are very good at it.

More broadly, what does it mean to appear trustworthy? “Trustworthiness” is just a set of signifiers that are generated by one person and that enter the brain of another person, like a firm handshake or a steady gaze. It’s like those luxury car manufacturers who expend effort and cost engineering the sound of the car door closing, because that sound is a signifier for quality. There is some evolutionary process whereby these signifiers got attached to the concept of trustworthiness in our brain over the history of the species, and maybe the connection was valid at some point. But now that people can reverse-engineer the connection and replicate the signifiers whether or not they are actually trustworthy, our instincts aren’t much use anymore.

The only way not to be fooled by your instincts is to rely solely on objective facts. Now, in the Bernie Madoff case, one can object that the only visible “facts” were themselves cooked, and that is true. But that just means we need better policing of things that are presented as facts. And I think the overall point still holds.

What You Can Do

On one level, recessions are about numbers, like the post I just wrote about the November statistics. On another level, recessions cause enormous hardship and misery to real families. I know most of us have less wealth than we did a year ago, since two major sources of household wealth – stocks and housing – have fallen steeply in value this year. But even if you don’t feel like you can afford to donate as much as usual to charities, there is still something you can do.

Most middle- and upper-income American households have lots of stuff. Many of us, particularly adults, have lots of clothes and other things we rarely or no longer use. You can think of this either as a behavioral phenomenon (people don’t like to get rid of things, even if they cause more disutility by taking up closet space than any utility they will ever provide) or as a market failure (it’s too much of a hassle to get rid of things, so we keep them). But if you just take a day, identify the things you will never use again, put them in bags, and drive them to a local shelter, you can help allocate those goods to the people who value them most. Or, as non-economists put it, you can help people. And, of course, you can get a tax deduction (the shelter in my town recommends using the Salvation Army valuation guidelines), which is itself probably worth more to you than those clothes you will never wear again.

Silver Linings?

We got one of our last batches of economic data for this calendar year today, and there may have been a glimmer of good news in there. In the news stories about the November data, I read that personal income went down, but real personal consumption went up, and the savings rate went up, which I found confusing, so I looked directly at the Bureau of Economic Analysis news release.

To summarize (all numbers are November’s change from October), personal income went down by 0.2%, and disposable personal income (after taxes) went down 0.1%, but in real terms (after adjusting for inflation, or deflation in this case), disposable personal income went up by 1.0%, which is huge (remember, that’s month over month). This was entirely due to falls in food and energy prices (mainly gasoline), since the core price deflator (excluding food and energy) was flat. Of that 1.0% increase in real disposable personal income, 0.6% turned into increased consumption, and 0.4% turned into increased saving, raising the savings rate from 2.4% to 2.8%.

Continue reading “Silver Linings?” →

All Financial History for Beginners

I was really hoping I could recommend The Ascent of Money by Niall Ferguson as a kind of catch-all Beginners book, in the spirit of my Beginners articles. Its subtitle is “A Financial History of the World,” after all. But I have to say it fell short of my expectations, although it would still make a nice gift. And although it has 360 pages, the spacing is wide and the margins are big, so you could buy it in the morning, read it in the afternoon, and still wrap it up in time for Christmas.

The book proceeds through a series of historical lessons, one for each major asset class – money (meaning primarily bank credit), bonds, stocks, insurance, real estate, and “international finance.” And there is certainly a lot of fascinating history to learn in there. For example, although I spent seven years dealing exclusively with insurance companies, and I knew about the usage of insurance in early Renaissance Italy, I had never read the story of the Scottish Widows’ Fund, the first true insurance fund designed to be self-financing in perpetuity. Nor did I know how Nathan Rothschild made a fortune betting that UK government bonds would rise in the years after Waterloo (because the government’s need for borrowing would decline). And the book does touch on many of the historical parallels you have probably been reading about during the past few months, from the Great Depression to the S&L crisis to Japan’s lost decade and the emerging markets crisis of 1997-98. Ferguson is also an excellent writer, and even your friends and relatives who are less excited by topics such as bond yields and the money supply will probably find most of it enjoyable going.

But the problem is that the book is just too short. Niall Ferguson made his reputation writing some very big books about considerably smaller topics. Reading this smallish book about an enormous topic, I got the feeling that he wasn’t allowing himself enough pages to deal with each topic in the depth he would have liked. This has two consequences. First, even though he is clearly writing for the general reader, there are places where he doesn’t take enough care to define his terms, and where he is bound to lose large parts of his audience. For example, describing the capital structure of what would become the Mississippi Company, which mixed new shareholder’s capital, billets d’etat issued by Louis XIV, and perpetual bonds, he lost me. So if you really want to understand the shift of European governments from confiscatory taxation to borrowing, you’ll need to look elsewhere.

Second, The Ascent of Money necessarily treats in just a few pages topics on which entire books – and quite long ones, sometimes – have been written, and if you’ve read those books, you’ll find the summaries here pale by comparison. For example, Ferguson makes Enron (on which see The Smartest Guys in the Room) into an emblematic bubble company (“the Mississippi Company all over again”), the bubble this time inflated by cheap money, courtesy of the Federal Reserve. I think calling Enron a bubble company is a only part of the story, since much of what it did – dating back to the early 1990s – was accounting fraud that needed no bubble to exist (although the bubble certainly magnified the scale of the take); Pets.com would be more of a pure bubble company. Similarly, Ferguson’s account of Long-Term Capital Management emphasizes the quantitative arbitrage premise of the fund; but the big bet that killed LTCM was not arbitrage by any means, but a one-sided bet against volatility – a bet that was informed by quantitative analysis (volatility was high, so LTCM thought it would go down) but was ultimately a gambler’s bet, as described in When Genius Failed.

As for the current crisis, Ferguson had the fortune or misfortune of finalizing the book in May, and so missed out on the events of the last few months. At the time he was writing, it still seemed like the crisis would only hasten the day when China would overtake the U.S. as the world’s largest economy (“at the time of writing Asia seems scarcely affected by the credit crunch in the U.S.”). Which, of course, only shows how unpredictable the events of the last four months have been, that China is now facing its most serious labor unrest of the last ten years. Hey, I didn’t see it coming, either. As a historian, the narrative he wants to tell is one of a shift in the balance of economic power from the U.S. to China. Of course, it still may happen – we just won’t know for a couple of decades, at least.

Thanks, But We Can Take Care of Ourselves

Every once in a while, someone leaves a snarky comment on this blog along the lines of “Well, have you ever started your own company?” I usually leave them alone, although occasionally I can’t resist responding. In general, I just think that my experience co-founding one company in one industry does not really qualify me to say anything that knowledge and logic wouldn’t qualify me to say anyway. In particular, having been through the experience, I can say that the amount of luck you need dwarfs any other attributes you bring to the table, so starting a company is not a particularly useful filter.

But now Michael Malone has managed to aggravate me with an op-ed in the Wall Street Journal called “Washington Is Killing Silicon Valley.” And Silicon Valley being one of the parts of our economy I know particularly well, I feel compelled to respond.

Continue reading “Thanks, But We Can Take Care of Ourselves” →

The Perils of Exports

The steep decline in U.S. consumer spending is clearly taking its toll on the U.S. economy. But still, the U.S. has one advantage over many of its trading partners. Theoretically at least, our government has the tools it needs to boost domestic demand and thereby increase production. This is not true of the many countries who depend on exports for a large share of their economic growth.

I was taking a tour of the world’s news today and came across the following (courtesy of the FT):

  • Japanese exports fell 27% year-over-year in November, the largest fall ever; remember, exports were a major reason Japan finally emerged from its decade-long slump a few years ago.
  • Thai exports fell 19% year-over-year in November, the first decline since 2002 – and exports make up 70% of GDP. The numbers may have been artificially reduced by political conflict in late November, but political conflict is hardly a good thing in itself.
  • China is looking less and less like the big winner of the global recession and more and more like a significant loser. 10 million migrant workers have lost their jobs by the end of November. In response, “the State Council, China’s highest governing body, issued a decree to local governments over the weekend ordering them to create jobs for migrant workers who had returned to their home towns.” Prime Minister Wen Jiabao went as far as saying that a government priority is to “make sure all graduates have somewhere constructive to direct their energy” – somewhere other than social protest, that is.

One of the challenges of an export-driven economy is that when your consumers (Americans and Europeans) stop buying, you have few direct tools to get them buying again. There has been speculation that China could take the opportunity to stimulate domestic consumption and shift its economy away from reliance on exports, but that clearly can’t happen fast enough. Another trick exporters can use is to devalue their currencies, but that will crimp domestic purchasing power and potentially lead to a round of competitive devaluations, with wealthy countries printing money in an effort to stave off deflation and thereby devaluing their own currencies. In the meantime, everyone will be watching the Obama stimulus plan carefully.

Japan for Beginners

For a full list of Beginners articles, see the Financial Crisis for Beginners page.

The most common point of comparison for our current economic crisis is, far and away, the Great Depression. The Depression is most often bracketed with some version of the phrase, “but we’re unlikely to see a depression, just a recession,” whatever that’s supposed to mean. And, fortunately for us, with the addition of Christina Romer, we now have two scholars of the Great Depression on our nation’s economic policymaking team.

But in many ways, a more relevant comparison may be the Japanese “lost decade” of the 1990s, when the collapse of a bubble in real estate and stock prices led to over a decade of deflation and slow growth. This is the Nikkei 225 index from 1980 to the present.

Nikkei

Continue reading “Japan for Beginners” →

We Have a Winner?

After seeing dozens of mortgage proposals emerge over the past several months, there are news stories that Larry Summers and the Obama economic team are converging on an unlikely candidate: the proposal by Glenn Hubbard and Christopher Mayer first launched on the op-ed page of the Wall Street Journal on October 2. Hubbard and Mayer published a summary of the plan in the WSJ last week; a longer version of the op-ed is available from their web site; and you can also download the full paper, with all the models.

Continue reading “We Have a Winner?” →

When Consumers Get Depressed

The Return of Depression Economics, by Paul Krugman, is certain to be one of the most gifted books this holiday season; that’s what happens when you combine a Nobel Prize with a massive economic crisis and book with the word “depression” in the title. Here’s another reason to buy it for someone, as I found out: it’s so short you can read it in a couple of hours before wrapping it up.

The title of the book refers broadly to the recurrence of a need to deal with Depression-style economic threats, a theme that originally (in the 1999 edition) referred to the emerging markets crisis of 1997-98 and and the stagnation in Japan caused by the collapse of their housing bubble at the beginning of the 1990s. More particularly, however, it refers to the problems brought on by a collapse in economic demand – “insufficient private spending to make use of the available productive capacity,” as Krugman puts it. And it seems clear that that’s where we are today. The Case-Shiller index of housing prices reached its peak in real terms sometime in 2006, but the economy continued to grow until the end of 2007, even as housing prices fell significantly. Although the negative wealth effect of falling housing must have had some effect, people still wanted to spend. When the severe phase of the crisis began in September 2008, it was widely described as a credit crunch, meaning that reductions in the supply of credit were making it difficult for borrowers to get the money they needed, either for investment or consumption. Today, however, as Simon has said before, falling demand for credit may be just as big a problem. People just don’t want to borrow money any more, and if that’s the case, then increasing the supply of credit (by funneling cash into banks) will have only a limited effect, as we’ve seen. This is what Krugman finds most worrying about the current situation: the “loss of policy traction,” in which even dramatic moves by the Fed have only a limited impact ont he real economy.

He doesn’t quite come out and say it in so many words, but a lot of Krugman’s story has to do with what might be called psychology. He describes how economic crises may be the product of poor governmental policies and weak economic fundamentals – or they may be entirely the product of panics that have the very real effect of destroying wealth and setting countries back for years. Seen from this perspective, the scale of the current crisis may not have any proportional relationship to the fundamental flaws of our economy (or the global economy). It may simply reflect the fact that the scale, liquidity, and leverage of the global financial system have made it possible for panics to have much greater damage than they did in the past. (I know we’re still not dealing with anything on the scale of the Great Depression, but while the financial system was simpler then, it also had a simpler flaw – the lack of deposit insurance – and a simpler mistake – the failure to expand monetary policy in response to the downturn.)

The fact that you are reading this blog probably means that you would not learn a lot about the current crisis from Krugman’s book (especially if you’ve already read his article in The New York Review of Books), but you might learn something about the crisis of the 1990s, and the dynamics of currency crises. In 1997-98, multiple unrelated emerging market countries suffered panics and currency crises, and the response of “Washington” (the U.S. and the IMF) was to demand fiscal austerity – higher interest rates, lower government spending, higher taxes – in exchange for bailout loans. Now, of course, when large parts of wealthy country economies need to be bailed out, few people are calling for austerity; in the U.S., liberals and (most) conservatives differ only on whether the deficit should be increased through government spending or through tax cuts. Ten years ago, perhaps the austerity argument was defensible: in order for countries to gain credibility (and be able to pay back their loans), they needed to improve their government balance sheets. And at the time, the U.S. could be confident that reduced purchasing power in Thailand, South Korea, and Russia would have little effect on our economy. Today, however, the entire world is facing a steep downturn, and an economic stimulus will be most effective if it is roughly coordinated across countries, including emerging markets. So far the IMF appears to be using a gentler hand than last time, although so far most countries are attempting to steer clear unless absolutely necessary. The fact is that preventing an economic collapse in emerging markets will be an important of our recovery this time, both because of the importance of foreign trade and because of the amount of cross-border investment (think about the massive inflows into international stock funds in the past ten years).

In any case, it’s a quick read, and for those who are nervous about Krugman’s politics they make only a very brief entry near the end.

Managing Financial Innovation

Financial innovation tends to be a bit of a bad word these days. But while I and many other people are in favor of an overhaul of our regulatory system, that still leaves open the question of how the system should be managed.

A reader pointed me to a 2005 paper by Zvi Bodie and Robert Merton on the “Design of Financial Systems.” They argue that neoclassical finance theory – frictionless markets, rational agents, efficient outcomes – needs to be combined with two additional perspectives: an institutional approach that focus on the structural aspects of the financial system that introduce friction and may lead to non-efficient outcomes; and a behavioral approach that focuses on the ways in which and the conditions under which economic actors are not rational (see my post on bubbles, for example). The paper walks through examples of how to think about some real problems we face, such as the fact that households are increasingly being forced to make important decisions about retirement savings, but generally lack the knowledge and skills to make those decisions. One of their arguments is that while institutional design may not matter in a pure neoclassical world, it does matter in the world of irrational actors: deposit insurance to stop bank runs is an obvious example.

Some of the content may be tough going, but in general the paper offers one perspective on how to think about the relationships between markets, institutions, and individual behavior that make up our financial system.