Author: James Kwak

Dueling Federal Reserve Banks!

A few weeks ago, three economists at the Federal Reserve Bank of Minneapolis set off a debate among Internet-addicted economists by claiming that, in essence, lending to the real economy was just fine and anyone who said there was a credit crisis was wrong. (See my initial reaction, as well as links to the original paper and several perspectives.) Now we have been treated by four economists at the Federal Reserve Bank of Boston, who argue that there was, in fact, a credit crisis. In particular, they say:

  • “the aggregate figures in [the original paper] do not reveal the weakening in new lending”
  • lumping together AA and A2/P2 commercial paper hides the problems for A2/P2 issuers
  • lumping together all durations hides the fact that commercial paper shifted from longer durations to shorter durations
  • even though most corporate lending is via bonds, not direct bank lending, households and small businesses rely heavily on banks

and similar points. Take a look; some of the charts are fascinating.

419,000 Jobs Vanish

240,000 jobs lost in October; September revised from 159,000 to 284,000; August from 73,000 to 127,000. That’s 419,000 jobs less than we thought we had a month ago. It’s 651,000 less than there were three months ago. And because we need 140,000 new jobs each month just to keep place with population growth, that’s over 1 million fewer jobs than the economy would need to maintain unemployment where it was three months ago. Unfortunately, everyone expects this quarter and next quarter to be worse than last quarter. On top of that, unemployment is a lagging indicator: because of the transaction costs in firing and hiring workers, companies exhaust their other cost-cutting opportunities before laying people off, and they don’t hire again until they are certain that the economy is growing again.

More than 22% of the unemployed have been out of work more than six months, which is usually when unemployment benefits expire. For this and other reasons, only 32% of the unemployed were receiving state benefits in October. These are more reasons to expand unemployment benefits in multiple directions, at the very least for a limited time period. Alan Krueger has described the other ways our unemployment insurance system is broken.

Unfortunately, there is fear that President Bush (remember him?) will veto the stimulus package, including extended unemployment benefits, that the Democrats want to pass in November, thereby accomplishing nothing except delaying it by two months. Sigh.

Recession in Silicon Valley

Silicon Valley is often touted as an example of what is best about American capitalism – entrepreneurial, risk-taking, innovative, hard-working, and sometimes fabulously successful. Of course, it is also periodically criticized as a land of con men and get-rich-quick schemes.

Sequoia Capital, perhaps the most venerated VC firm in the Valley, held a “secret meeting” in October to discuss the impact of the credit crisis and economic downturn on the technology industry and startup companies. The slides have been leaked, beginning with a tombstone with the words “R. I. P. Good Times.” (By the way, those of you not from the business world – particularly those with academic backgrounds – may find the presentation amusing for the way it combines large amounts of incommensurate data with an extreme scarcity of verbs, thereby avoiding the need for a coherent argument. My favorite is slide 42. But believe me, this is far better than most business presentations.)

One of the first employees of my company has a much more original and intelligent perspective on what the recession means for Silicon Valley.

AIG, Credit Default Swaps, and “Risk Management”

Since the Lehman credit default swaps settled without the sky falling, there has been a small wavelet of support for the once-obscure financial instruments that are widely blamed for amplifying the effects of the financial crisis, including a Forbes.com op-ed entitled “Credit Default Swaps Are Good for You.” I happen to agree that CDS can play a useful role in enabling bond investors to hedge against the risk of default, and thereby make it easier for some institutions to get credit. But it’s a bit premature to proclaim that all is well and good in swapland.

Most obviously, there is the troubling matter of AIG, which has recently received additional scrutiny from the likes of the New York Times and the Wall Street Journal (subscription required). AIG has already burned through most of its initial $85 billion loan from the government, has drawn down half of a separate $38 billion loan for its securities lending business, and recently got permission to sell up to $20 billion of commercial paper to the Fed. (And remember, when negotiations over the AIG bailout began around September 12, the company was saying it only needed $20 billion.)

Continue reading “AIG, Credit Default Swaps, and “Risk Management”” →

More Interest Rate Cuts

Having woken up to the fact that inflation is not the thing to be worrying about, the UK, Eurozone (European Central Bank), and Switzerland all cut interest rates, the Bank of England by a completely unexpected 1.5 percentage points to 3.0%. Disappointingly, the ECB only cut rates from 3.75% to 3.25% (we earlier recommended an immediate cut to 2.0%), although Jean-Claude Trichet did leave open the possibility of further cuts in the future.

In the US, the low Fed funds rate (currently 1.0%) limits the potential benefit of further rate cuts. Europe still has a ways to go; so far, with the UK and the Eurozone set to contract in 2009, there’s no evidence that they couldn’t go further.

Update: What he said. (He, in this case, being James Surowiecki of The New Yorker.)

The Race for Treasury Secretary

For those of us following the current economic crisis, Barack Obama’s most important cabinet choice will be his Treasury Secretary pick. Although nothing to be sneezed it, the position has historically been less prominent than the portfolios of State and Defense, but the news of the last six weeks and the urgency created by the current recession make it critical at this moment. The names being floated in a variety of articles on the Internet are, in rough order of likelihood:

  • Tim Geithner, head of the Federal Reserve Bank of New York and a key player in every government action involving Wall Street so far
  • Larry Summers, President Clinton’s last Treasury Secretary and a prominent academic economist
  • Jon Corzine, former head of Goldman, former senator, and now governor of New Jersey
  • Paul Volcker, former chairman of the Federal Reserve
  • Sheila Bair, head of the FDIC
  • Robert Rubin, also a Clinton Treasury Secretary, also a former head of Goldman, and currently board member of Citigroup

Less likely names floated include Warren Buffett, billionaire investor; Jamie Dimon, CEO of JPMorgan Chase; and Paul Krugman, 2008 Nobel Prize winner in economics and an outspoken liberal columnist and Bush administration critic.

The main thing all of the leading candidates have in common is that they are centrists and pragmatists (not a socialist among them, as far as I can tell). There is no reason to believe any of them would reverse the major steps taken by Henry Paulson so far, although several would likely move more aggressively for mortgage relief and broad-based economic stimulus. This is generally a good thing. While Paulson can be accused of some major missteps, and of so far failing to unblock lending to the real economy, his one achievement has been to restore some confidence to the banking sector, and the impact of a wholesale change in policy direction could be highly unpredictable.

My personal opinion, based on nothing, is that the Wall Street connection rules out Corzine and Rubin, and his comments about women while president of Harvard rule out Summers, so I would bet on Geithner, who has knowledge of Wall Street but does not have the political taint of having made a fortune on Wall Street.

Economic Priorities

Even as we celebrate tonight, we know the challenges that tomorrow will bring are the greatest of our lifetime — two wars, a planet in peril, the worst financial crisis in a century. Even as we stand here tonight, we know there are brave Americans waking up in the deserts of Iraq and the mountains of Afghanistan to risk their lives for us. There are mothers and fathers who will lie awake after the children fall asleep and wonder how they’ll make the mortgage or pay their doctors’ bills or save enough for their child’s college education. There’s new energy to harness, new jobs to be created, new schools to build, and threats to meet, alliances to repair.

The road ahead will be long. Our climb will be steep.

Full transcript here.

We’ve been talking for a while now about the short-term economic priorities facing the United States: financial system stabilization, economic stimulus, mortgage restructuring, and re-regulation of the financial system (domestic and international). But even before the current economic crisis, our country was also facing some major challenges that the Obama administration will have to tackle.

In my personal opinion, the top four long-term challenges facing our country are, in order:

  1. Global warming: We know with a high degree of certainty that the world is getting warmer, and that this could have catastrophic effects that we can only partially foresee today. Moving our economy from carbon to sustainable energy sources will require a transformation of large parts of the economy.
  2. Terrorism and nuclear proliferation: While the probability of a nuclear attack by terrorists is extremely low, at present that probability is only going up. This is not particularly an economic issue.
  3. Retirement savings: Despite all the attention Social Security has received, it is dwarfed by the looming Medicare deficit. In addition, there is evidence that private sector sources of retirement income will not fill the gap that they are expected to fill. First, many defined-benefit pension plans (both private and public) may not be sufficiently funded, because of accounting regulations that allow them to assume optimistic rates of return. (The events of the last six weeks, of course, did not help.) Second, many people’s individual retirement savings are sorely insufficient. I’ve seen estimates of the average retirement savings balances of people in their 50s ranging from $50,000 to $140,000 – and that was before the recent stock market crash, which probably took 15-20% off the average portfolio. And even for people with houses, the housing crash has constrained their ability to live off of them.
  4. Health care: Approximately 50 million Americans are uninsured today, and the number will only go up as people are laid off and companies cut health care costs during the recession. In addition, objective indicators show that health outcomes in the US are worse than in most of the developed world.

These challenges will be tougher to solve than the immediate challenges of fixing the financial system and restarting economic growth. Let’s hope that the Obama administration can start solving them.

The Economics of Elections

In honor of Election Day, we bring you a slight change from our usual programming.

There has been a lot of talk about the use of futures markets to predict elections. The granddaddy of election markets (in the US) is the Iowa Electronic Market. The one that gets the most attention these days is Intrade. I used to trade on the IEM during the primaries and made a decent return in just a few weeks, mainly by betting that people would overreact to news. (For example, when Huckabee (remember him?) spiked – I believe he was in the lead on IEM at one point – it was a pretty easy bet that at some point before the convention he would come down to zero.) But then I did a bet on the general election and forgot to close it out at the right time, so on balance I lost a few bucks. (The maximum you can put into IEM is $500, so we’re not talking big sums here.)

FiveThirtyEight.com takes a different approach: they take polling data as inputs, and then run multiple simulations of who will win each state election. A given survey has a midpoint (say, Obama 47 – McCain 45) and an error distribution around that midpoint. By doing repeated simulations, you estimate how often each person would win that election, based on expected variance around the midpoint. If you do this for all states at once, you get an estimate of what the electoral vote tally will be. I don’t know if they account for correlations in the error across different states – the fact that if McCain does 2 points better than expected in Pennsylvania, he is likely to do better than expected in Ohio, too (the two are not independent outcomes). They should take this into account. (I don’t know because I haven’t read the website other than the predictions.)

The problem with both of these approaches is that they take polling data as their inputs – so if there is a problem with the polls (the Bradley effect, for example), they will produce inaccurate results. Polling markets partially compensate for this, because they incorporate people’s expectations of how accurate the polls are. But given the prominence of the polls, I doubt they can correct for polling inaccuracy.

Not surprisingly, economists have developed predictive models for presidential elections based on economic conditions. Mark Thoma provides an excerpt of one (and a link to the whole paper) here. These are statistical models that compare election outcomes to various economic variables at the time of the election. The problem with these models is that presidential elections are overdetermined: the sample size is small enough that you can find many different series of data that seem to predict outcomes accurately, like the Washington Redskins predictor. All of these cute predictive models are based on the same fallacy: with hundreds of sports teams to choose from, and the thousands of ways you can slice the data, it would be remarkable if you didn’t find one that seemed to be a perfect predictor of presidential elections. Economic models are better (though not perfect), because they are based on variables that you would expect should have an impact on election results.

Happy Election Day.

Help the Doggies!

Massachusetts ballot question 3, the Greyhound Protection Act, will end greyhound racing, a “sport” that rests on systematic cruelty to animals. Greyhounds are confined in tiny cages for 20 or more hours per day, and over 800 dogs have been injured in the last six years. We can do better.

If you live in Massachusetts, please vote yes on 3. If you care about animal cruelty and know people who live in Massachusetts, please ask them to vote yes on 3. For more information, see the Yes on 3 website.

Thanks,

James

Financial Crises and Democracy, Part Two

We have several times emphasized the need for a large economic stimulus package to limit the extent and damage of the recession that we are almost certainly in already – a need recognized by economists from Nouriel Roubini to Larry Summers to Martin Feldstein. More recently, I speculated on the relationship between democratic politics and economic policy in a time of crisis. Well, as just about everyone in the world knows, things are coming to a head.

Whether we get a large economic stimulus package in the US – the economy whose health affects, for better or worse, just about everyone in the world – could very well depend on who is elected on Tuesday. For a summary of their short-term economic proposals, see here.

If Barack Obama is elected, we are likely to see a large stimulus package. It would probably include the measures that many economists are favoring, including extended unemployment benefits (and suspension of tax on those benefits), immediate cash aid to state governments, increased home heating cost aid, and infrastructure spending. These measures will have a direct impact on the economy by increasing spending now, while increasing it in ways that are necessary (keeping poor people alive) or that are productive long-term investments (infrastructure). Some of his other suggestions will have a more limited impact on the economy, such as a cash tax rebate, or are more or less irrelevant to the economy, such as relaxing the minimum distribution requirements for retirees.

With John McCain, we are not likely to see a stimulus package – or, more accurately, the package we see will be built around tax cuts that are not likely to have a direct economic impact. His proposals include: reducing taxes on retirement account withdrawals; increasing capital loss write-offs; reducing long-term capital gains tax rates; exempting unemployment benefits from taxes; also relaxing minimum distribution requirements; extending all of the Bush tax cuts; and reducing corporate tax rates. Except for the tax cut on unemployment benefits, these proposals suffer from the basic problem that undermined the last stimulus package this spring: in tough economic times, people take their tax rebates (or tax cuts, or cash you give them in any form) and stuff it under their mattresses, or pay down debt. McCain’s plan also includes the famous (or infamous) proposal for the government to buy up and refinance mortgages directly. (Obama favors increased loan modifications and legislation to eliminate some of the legal barriers to modifications.) But while that could potentially help homeowners and lenders, it doesn’t increase economic activity any.

(For an explanation of why different programs have different marginal impacts on GDP, see Menzie Chinn’s post.)

That said, given the way legislation is passed in Washington, the final package is likely to differ from either person’s proposals, whoever is elected. But the next major step that our government takes to combat the financial and economic crisis will depend directly on the outcome of Tuesday’s election.

Should the Government Bail Out the Auto Industry?

Over in the real economy, perhaps the biggest story is the impending and highly likely merger of GM and Chrysler, in which GM would swap its 49% stake in GMAC, its consumer finance company, to Cerberus (which owns the other 51%), in exchange for Chrysler, which is currently owned by Cerberus. It seems that the deal may hinge on financial assistance from the government, at least according to six governors attempting to pressure the dynamic duo of Paulson and Bernanke to help out. Until Thursday, GM was seeking $10 billion from the Treasury Department’s $700 billion bailout fund – yes, the same one that has been used to recapitalize banks – but Paulson’s preference is that GM tap a $25 billion low-interest loan program set up by the Energy Department in September.

It’s easy to argue for bailing out the auto industry, with its hundreds of thousands of factory workers, as opposed to the financial sector and its Wall Street bonus babies. (It’s less easy to argue for bailing out Cerberus, which is a private equity firm.) But I want to point out one difference.

Continue reading “Should the Government Bail Out the Auto Industry?” →

JPMorgan Joins Mortgage Restructuring Party

JPMorgan recently announced a program to offer loan modifications to 400,000 homeowners with a total of $70 billion in mortgages. The program is roughly similar to one announced by Bank of America as part of a settlement with state attorneys general of investigations into Countrywide (acquired by B of A): JPMorgan is offering to convert option ARM mortgages, one of the most poorly-conceived and worst-performing products of the housing boom, into fixed-rate mortgages at lower rates and potentially with lower loan balances. From the WSJ article:

The mortgages affected by J.P. Morgan’s program represent 4.7% of the home loans it owns or that are serviced by one of the bank’s units, EMC Mortgage Corp. While the program to give these mortgages easier terms is likely to cost J.P. Morgan billions of dollars in interest payments and loan fees, it is also likely to save the bank from the costly and lengthy process of foreclosing homes and selling them.

This is more evidence that banks see mortgage restructuring as being in their own economic interests, for reasons I’ve described earlier. (As an aside, Yves Smith wonders why banks are only offering modification programs now, when it seems like the government is about to act.) Unfortunately, it’s also more evidence that modifying whole mortgages owned by one bank is easier than modifying securitized mortgages owned by many parties who may have competing interests; this program is only aimed at mortgages owned by JPMorgan, which are a tiny fraction of the volume serviced by that bank.

Given the small scope of the program, government action is still almost certainly necessary. But private action has at least one advantage over government programs. When the government acts to encourage loan modifications for delinquent mortgage holders, millions of “responsible” homeowners who are not delinquent on their mortgages will scream. No one expects private sector banks to do anything other than act in their own interests, and so they don’t have to worry about being seen as fair.

To Buy or Not To Buy …

Judging by the traffic on the Planet Money blog, many people are wondering if now is the time to be spending money. On the one hand, we hear that the economy is crashing because of a decline in consumer spending. On the other hand, we hear that the economy is crashing, which frightens us to consuming less and saving more for the rainy days ahead. Real economists worry about these things, too – see Paul Krugman and Tyler Cowen, for example. But at the end of the day, all economists can do is speculate and watch what happens, because aggregate consumption is just the sum of hundreds of millions of individuals making their own purchasing decisions.

I’m not a personal financial advisor, but I think this can be broken down logically. Let’s assume that, before the current downturn, you chose with your level of spending (and, by implication, your level of saving) rationally. Then there are three main reasons why you might want to reduce spending today: (1) you don’t have the purchasing power you need to maintain your spending; (2) you are going to lose your job (I know there’s a problem with that statement, and I’ll come back to it); or (3) the assets you are counting on for retirement have fallen enough that you need to increase savings in order to replenish them.

Continue reading “To Buy or Not To Buy …” →