Study: Recession Not Game Changer for International Politics

Economists aren’t the only ones scrambling to predict what the world will look like after the recession. Political pundits are also squinting too see into the future — their question: Will the global economic meltdown change the game in international politics?

The recession may be having a smaller impact on geopolitics than some predicted. (Getty Images)

“Not much,” says a new RAND Corp. study. The U.S. will continue to be the world’s superpower and policeman, capitalism the most popular economic recipe, and, as the rhetorical squabbles born in the heat of the crisis quiet down, old friends will stay friends and foes remain foes, argued Robert D. Blackwill.

Blackwill, a former U.S. ambassador to India and presidential envoy to Iraq under the Bush administration, dismissed what he called “a flood of recent articles” predicting the recession’s “destructive consequences for the international system.” If the economy recovers by the first half of 2010, as most analysts predict, wrote Blackwill, the face of international politics isn’t likely to change in any fundamental way in the next five years.

The report politely contradicts the Cassandras who have been warning about the international political fallout of the global economic slump, among them Director of National Intelligence Dennis Blair, who in February called the economic crisis “the primary near-term security concern of the United States” during testimony before the Senate Select Committee on Intelligence.

Sure, wrote Blackwill, the plunging world economy has already created its fare share of political trouble, with government crises in Iceland, Latvia, the Czech Republic, Hungary and Estonia, and street protests erupting in countries ranging from Greece to Russia. And more trouble may come in the near future, he noted, in the form of “more poverty, more disease, more crime, more migration, and more Third World military conflict.”

But, maintained the author, the economic crisis doesn’t seem to be moving the fundamental pieces of the international political puzzle. Popular discontent over the recession didn’t send Mexico teetering on the verge of anarchy and it didn’t trip Pakistan into loosing control of its nuclear weapons or starting another war with India, as some feared. In Iran, the closest approximation to a revolution the country has seen since 1979 was a result of election fraud, not falling oil prices amidst a global slump in demand.

The downturn, argued Blackwill, just isn’t enough to destabilize a Chinese Communist Party that survived self-made economic disasters of the size of the Great Leap Forward and the Cultural Revolution. And a staggering pile of public debt doesn’t seem to be pushing the U.S. to cut on its foreign policy agenda and commitments.

Blackwill’s paper is a sobering response to many of the doomsday scenarios circulating a few months ago, though predicting a rosier future must be easier now that talk is all about green shoots and China, for example, is back to 8% growth in the second quarter.

Burman Departs Tax Policy Center

There are some changes in the pipeline for one of the economic blogs that the Journal listed in its top 30.

Len Burman, director of the Tax Policy Center and contributor to the nonpartisan group’s TaxVox blog, is leaving the Urban Institute in Washington for the Maxwell School of Syracuse University.

Burman wasn’t the only contributor to TaxVox, and the blog will continue to provide content with contributions from the Tax Policy Center’s staffers. But Burman’s indispensable analysis will be missed. Perhaps readers can encourage him to start his own blog from the halls of academia.

For an example of his work, check out today’s post on taxing health-care plans.

Stimulus Can’t Take Credit for Slower GDP Contraction

Beware of politicians and economists who credit fiscal stimulus for slowing the pace of recession in the second quarter.

As has already been widely reported, gross domestic product shrank at a much slower pace in the first quarter — 1% — than in the two previous quarters. It is true that government spending grew at a 5.6% annual rate for the quarter, moderating the contraction in gross domestic product.

But most of that increase came from the defense sector, not the nondefense sectors targeted by the American Recovery and Reinvestment Act. Defense spending grew at a 13.3% annual rate, in part a rebound from a 4.3 first quarter contraction. Nondefense spending grew at a 6% annual rate, contributing 0.15 percentage points to overall growth. The economy can use all of the help it can get, but it’s too soon to declare that federal spending is effectively making its way into the system.

Economists React: ‘Hopefully Bottom of Recession’

Economists and others weigh in on the 1% contraction in second-quarter GDP.

  • Hopefully the bottom of the recession is here. The worst recession since the Great Depression is likely coming to an end. Economic growth beginning second half of the year will be made possible by a number of factors. Easy comparisons against last year, inventory buildup, the end of the drag from residential real estate, increased spending coming from the federal government and exports should be the key components. –Sung Won Sohn, Smith School of Business and Economics
  • Downside surprises in consumer spending and inventories more than offset surprises to the upside, primarily in net exports. The latter showed a smaller drop in exports in the second quarter than we expected while the drop in imports was in line with expectations. Inventories were the biggest surprise, subtracting about 1.5% from measured growth. Over the last two quarters, real inventories have declined by more than $250 billion, by far the biggest two quarter drop on record. However, these deep cuts should set the stage for increased production, beginning in the third quarter in our view. –Nomura Global Economics
  • To the extent that anything in these data yield insight into the third quarter, I would argue that the even-faster-than-expected pace of inventory liquidation … points to a larger positive contribution from inventories to GDP growth [in the second half], as inventory shedding slows down. Just to put the scope of this issue into perspective, if inventories were flat in [the third quarter], this component would push real GDP growth higher by more than 5 percentage points! Look for this adjustment, however, to take place over at least 2 or 3 quarters. Still, this should provide a powerful tailwind to GDP in the second half of the year, as firms bring production back up to a pace that is more consistent with demand. Indeed, this is the main reason that we expect [third-quarter] GDP to return to positive territory. –Stephen Stanley, RBS
  • The dramatic fall-off in the pace of U.S. economic decline is clearly a welcomed sign that the intense economic recession may be nearing its end. More importantly, with final sales relatively flat during the quarter, following three consecutive quarters of sharp declines, there is some hope that economic activity may rebound in short order –Millan L. B. Mulraine, TD Securities
  • First impressions: well that wasn’t so bad. Second impression: maybe it is… While the headline decline in output wasn’t particularly troubling, the sources of the decline–namely greater fundamental consumer weakness, continued poor residential and non-residential investment, and very little inflation adjustment–are somewhat concerning. In that sense, the second quarter didn’t mark so much the beginning to the end, but rather a further transition from a technically-driven economic weakness to a fundamentally-driven one. It’s now two years since we first warned that the housing unwind would be devastating for consumer balance sheets, and that assessment is playing out far worse and for far longer than we would have hoped. –Guy LeBas, Janney Montgomery Scott
  • Consumption fell 1.2% in [the second quarter] which was more than most expected and revealed that consumers decided to save the Federal stimulus programs income supports rather than spend them. Nevertheless, government did provide the key support to the economy in Q2 minimizing the contraction. It contributed 1.12% to growth. Such Federal support cannot continue to support future growth. –Brian Fabbri, BNP Paribas
  • The consumer will be in rough shape for a while owing to balance sheet problems, constrained income growth, and tight credit. However, the very successful “cash for clunkers” program will give spending a big lift in July and possible for longer if the program is extended. However, with fundamentals away from government giveaways still very negative, this will provide only a temporary boost, with much of the demand probably borrowing from future sales once the program ends for good. –Joshua Shapiro, MFR Inc.
  • This report provides further support to our view that the recession ended in the second quarter. The decline in real GDP was smaller than consensus expectations but, surprisingly given the monthly data, inventories were liquidated at a more rapid pace than expected, which subtracted 0.8 percentage points from growth. Real final sales, which is GDP less inventory investment, only fell at a 0.2% rate as trade added to growth (domestic final sales fell by 1.5%). The small final sales decline and rapid inventory liquidation sets us up either for a positive revision to second-quarter growth or a faster growth rate of real GDP in the third quarter than previously expected, as a slower rate of inventory liquidation boosts output. –RDQ Economics
  • We do not look for [expected stronger growth rates in the third quarter] to be sustained. As far as inventory restocking, those advancing this argument would do well to look at inventory-to-sales ratios, which remain quite elevated — while inventories have plunged, they have not kept pace with the decline in final sales, and barring a more robust rebound in domestic spending than we anticipate, the incentive to restock will be limited. Of course, this will be an industry-specific adjustment, for instance, auto production will be ramped up, but other manufacturing industries will see less of an increase in production. Moreover, even to the extent we see this restocking effect, it is a transitory phase and not a sustainable driver of growth. As for consumer spending, … while disposable personal income rose during the year’s first half, this was chiefly a function of government stimulus efforts and lower income tax withholding, the effects of which will fade in terms of income growth. With job losses moderating but continuing into 2010, there is little reason to expect meaningful support for consumer spending from the labor market over coming quarters. As long as this remains the case, real GDP growth will remain below trend. –Richard F. Moody, Forward Capital

Compiled by Phil Izzo

Offer your reactions in the comments section.

Dig into an interactive summary of economists’ forecasts for the coming year from the latest survey.

GDP Revisions: Deeper 2008-09 Contraction, Milder 2001 Recession

The latest recession, it turns out, is even worse than previously reported. And the 2001 downturn that plagued the job market for years? It now barely registers as a sustained contraction in economic output.

Alongside the second-quarter report on gross domestic product, the Commerce Department’s Bureau of Economic Analysis today released revised estimates of economic data going back to 1929. The BEA’s comprehensive revision to its National Income and Product Accounts shows an average annual growth rate of 3.4%, 0.1 percentage point higher than previously published estimates. From 1997 to 2008, the economy is shown growing at a 2.8% rate, also 0.1 percentage point above its earlier figure.

The update could make the current recession a challenger to the late-1950s downturn as the worst (in GDP terms) since the Great Depression. (Of course, the 2009 data could be revised next summer so you can’t say for sure.) The BEA now says inflation-adjusted GDP increased just 0.4% in 2008. Earlier estimates had put the growth at 1.1%. GDP is now shown dropping in last year’s first quarter (reported earlier as a gain), posting a smaller gain in the second quarter than shown earlier, a larger drop in the third quarter and a slightly-less-large tumble in the fourth quarter. From the fourth quarter of 2007 to fourth quarter of 2008, real GDP is shown dropping at a 1.9% annual rate compared with the earlier estimate of 0.8%.

The first quarter of 2009, which last month had been estimated as declining at a 5.5% annual rate, now shows an even worse 6.4% decline due to the benchmark revisions. That matches the first-quarter 1982 decline, but is still slightly better than the 7.9% drop in the second quarter of 1980.

The government’s comprehensive revisions are carried out every five years to update the NIPA accounts with new data from government agencies (such as the Census Bureau and IRS) and outside sources. This year, as we told you earlier, the BEA is changing some of its definitions and moving items around on the NIPA tables

The 2001 recession registers as even less of a contraction when measured over the full course of the downturn. From the fourth quarter of 2000 to the third quarter of 2001, real GDP increased by 0.1% under the revised figures due to a smaller contraction in investment spending. The earlier estimate showed it dropping 0.2%. Both are essentially flat, but the new figures should renew debate about the conventional GDP measure of a recession (versus the broader look at other data by the National Bureau of Economic Research). The first quarter of 2001 declined at a 1.3% annual rate, followed by a 2.6% gain in the second quarter, a 1.1% decline in the third quarter and a 1.4% gain in the fourth quarter.

The BEA says earlier business cycles show little revision.

Guest Contribution: Back to the Good Times on Wall Street

Lucian Bebchuk and Alma Cohen, professor of law, economics, and finance and visiting professor of law and economics at Harvard Law School, respectively, write that postcrisis executive compensation policies appear even more lucrative than prior to the meltdown.

New York State Attorney General Andrew Cuomo released yesterday a report on compensation and income at nine major banks during 2003-2009. An assessment of these figures raises serious concerns from the perspective of both investors and taxpayers.

The Cuomo report focuses on nine large financial institutions that received substantial TARP support from the government. Below we focus on the compensation decisions these firms made during the first half of 2009. Assuming that these decisions are a sign of things to come, the firms’ post-crisis pay policies appear to be, in the aggregate, even more lucrative to the firms’ employees than precrisis policies.

From shareholders’ perspective, it is useful to examine what may be labeled “Earnings before Compensation (“EBC”), which are equal to the sum of net income and compensation expenses. A financial firm’s ECB in any given year represents the total pie to be divided between the two groups crucial for the firm’s existence and operations — the firm’s employees and the shareholders providing the firm’s capital. Firms’ compensation decisions determine what fraction of ECB goes to employees rather than left in firms’ coffers (or distributed as dividends) to shareholders.

During the first half of 2009, with the exception of State Street, the banks in the group have enjoyed substantial ECB levels. The bar graph below displays the fraction of the banks’ aggregate EBC levels paid out as compensation to employees during the precrisis years as well as during the first half of 2009.

As the bar graph shows, during each of the years 2003-2006, this fraction was in the 52%-62% range. In contrast, during the first half of 2009, this fraction was about 74%. To the extent that employees were not under-compensated during 2003-2006, investors have a reason to wonder: might financial firms be letting employees eat part of the investors’ lunch?

Defenders of firms’ compensation decisions argue that firms are paying what is necessary to retain able employees and to prevent the flight of talent. The aggregate figures of pay and compensation can also be useful in considering this argument.

In 2006, aggregate ECB for the banks in the group equaled (in 2009 dollars) $244 billion and the banks’ total compensation expenses were $143 billion. By contrast, assuming that ECB and compensation in the second half of 2009 will be the same as in the first half, the firms will pay an aggregate $156 billion even though they will generate an aggregate EBC of only $211. Assuming that the behavior of these firms is representative of the financial sector, investors might wonder why financial firms need in the aggregate to spend more on compensation even though they generate less value.

We now turn from the perspective of investors to that of the government (two perspectives that somewhat overlap as the government owns shares in some of these banks). We believe that government policy toward compensation in banks should focus on the incentives produced by pay structures, not on compensation amounts. But the above compensation figures should be of interest to public officials for two reasons.

First, during the financial crisis, taxpayers have expended substantial resources to shore up the firms’ capital, with the firms covered by the report receiving a total of $165 billions in TARP funding. The compensation amounts taken by employees out of the firms — $156 billion in 2009 alone assuming the second half of the year is the same as the first — are sufficiently large to have a meaningful impact on the firms’ capital.

Second, during the past two decades, compensation in finance has increased relative to other parts of the economy, and the financial sector has attracted an ever-increasing share of the country’s best and brightest. Following the financial crisis, there is widespread recognition that, in the post-crisis world, finance should command a smaller share of these best and brightest. To the extent that relative pay in the financial sector remains at or above its lofty precrisis levels, the desirable adjustment in the allocation of talent will be impeded or delayed.

Assessing the compensation figures for the first half of 2009 indicates that the good days of compensation are clearly rolling again. Investors and taxpayers should closely watch how these figures evolve during the remainder of 2009 and beyond.

Economists React: Push and Pull on Euro-Zone Jobs and Prices

The annual contraction in euro-zone consumer prices accelerated in July, with the annual CPI falling 0.6% in July from a year earlier. Meanwhile, June euro-zone unemployment rate rose to 9.4%, the highest level in a decade. Below, economists and others react.

People enter a government job center in Madrid in June.

July’s drop in euro-zone inflation was largely due to temporary factors and is good news for real consumer spending in the near term. But June’s rise in unemployment adds to the risk of a more damaging and sustained period of deflation in future. – Jennifer McKeown, Capital Economics Ltd

The yearly [CPI] change is by far the lowest ever recorded in the series. However, it is important to note that from August the base effect on the energy component (due to the sharp declines in oil prices last year) will exert upward pressure on the yearly rate of inflation. It seems very likely that Euro area inflation has therefore touched the bottom. — Marta Bastoni, J.P. Morgan

Overall, unemployment in the euro area is rising less than the steep economic contraction would otherwise suggest. This is partly due to extensive government aid – indeed, there are now an estimated 1.3 million to 1.4 million people working on short-time in Germany alone. Going forward the next challenge will be to unwind these measures in a timely manner in order for the economy to adjust to the new post-recession realities. Expect unemployment to rise further well into 2010. – Jörg Radeke, Centre for Economics and Business Research

Of particular concern to us is that the surge in eurozone unemployment since last summer has occurred without much upward adjustment in German unemployment as yet. [T]his partly reflects government support for businesses who have cut working hours but not headcount. … [O]n the basis of our assessment of the labour market at least, underlying inflationary pressures are likely to remain muted for some time to come. The adjustment in the US labour market is much further advanced than that in the eurozone and note the comments in the latest Fed Beige Book: to quote “the weakness of labour markets has virtually eliminated upward wage pressure”. We suspect that the eurozone will go much the same way, but it will take time. – Ken Wattret, BNP Paribas

The labor market has reacted surprisingly quickly to the diminishing declines in economic activity, and even if unemployment is likely to rise somewhat more quickly in coming months, the pace of deterioration is expected to remain well below that observed in Q1. That has of course favorable implications for consumer sentiment and demand. – James Nixon, Societe Generale

[The CPI] data should not have too much of an impact [on monetary policy] given the ECB has been braced for a period of negative inflation around the middle of this year. The key uncertainty, however, is whether this bout of negative price growth may turn into a more sustained deflationary trend. – Richard McGuire, RBC Capital Markets

The larger-than-expected drop in inflation and the unrelenting rise in unemployment should serve as a stark reminder to the ECB that medium-term inflation risks in the Eurozone are tilted to the downside – as opposed to “broadly balanced”. - Martin van Vliet, ING Bank

A V-Shaped Recovery: Maybe It’s Not Different This Time

Is there any phrase more likely to get a forecaster in trouble than “It’s different this time”?

Soaring home prices unsustainable? “It’s different this time.” Tech stocks’ P/E ratios look insane? “It’s different this time.”

But here’s one we’ve heard a lot recently: A V-shaped recovery due to a deep recession? “No way, it’s different this time.”

Will signs like this one be more popular than most people expect? (Getty Images)

The Great Recession has been so deep, so painful and so destructive that most economists remain highly skeptical of anything but a tepid recovery. Although in the past most sharp downturns have been followed by swift, V-shaped recoveries, the majority of forecasters right now shake their heads at such a prospect, claiming it’s going to be different — that growth will be much less likely to rebound swiftly this time.

Just yesterday, New York Fed President William Dudley echoed the consensus. “There are a number of factors which suggest that the pace of recovery will be considerably slower than usual,” he said in a speech.

But a few observers are noting how much the consensus breaks with recent history.

“What is interesting though is not that this view [that the recovery will be muted] is generally accepted, but rather how unusual it is,” said Dan Greenhaus of Miller Tabak in a research note. “Our economy has suffered downturns before although the majority of post WWII recessions have not been quite as deep, or caused by the same factors, as the current recession. As a result, there are no real parallels in terms of judging how our economy may emerge. In light of this, economists that are attempting to gauge the strength of a recovery have tossed aside a previous relationship that has suggested the depth of any given recession is related to the strength of the recovery.”

Tim Bond at Barclays Capital, meanwhile, wrote in the Financial Times about the potential of a stronger than expected recovery in the U.S. He argues that the steep drop in payrolls was likely triggered by panicky managers who over-reacted. As the economy recovers, they may find themselves having to restaff faster than expected. Meanwhile, he argues that the effect of household deleveraging has been overemphasized.

“The standard cyclical timing of a U.S. economic turning point tells us pessimistic expectations are likely to collide with the economic reality of a strong recovery,” Bond wrote.

James Paulsen of Wells Capital Management also has made the argument that panic has made forecasters overly pessimistic. “The complete collapse of economic activity can only be explained by healthy consumers and businesses which were ‘frozen with fears’ about the second coming of the Great Depression and simply stopped all economic behaviors for a time. Once the depression scenario was widely dismissed, healthy players regained some confidence and began spending and hiring again,” he wrote in a research note earlier this month. “As fears recede further, healthy players will contribute even more to the recovery.”

He says that multiple factors could contribute to a stronger than expected recovery. Among them are the massive stimulus in the pipeline, a smaller burn rate from housing and autos and a rising savings rate being partially offset by improving net exports.

And there’s also Michael Darda, chief economist at MKM Partners, who says the intense narrowing in high-yield debt spreads of late points to a 4% growth rate in GDP next year — twice the consensus forecast. “Consensus forecasts, which were far too optimistic a year ago at this time, are now likely far too pessimistic about year-ahead prospects,” he said in a research note today.

The pessimists make the case that the massive effect of the bursting of the credit bubble on the consumer can’t be understated. “Since consumers make up over 70% of the economy, if they are not a driving factor of the recovery — which we believe will begin later this year — then the speed of the recovery will likely be impaired,” said Joseph LaVorgna at Deutsche Bank. “Household spending has played a substantial role in virtually every economic recovery in the post-WWII era.”

Maybe it’s different this time.

Paul Krugman: Health Care Realities

When it comes to health care, "government involvement is the only reason our system works at all":

Health Care Realities, by Paul Krugman, Commentary, NY Times: At a recent town hall meeting, a man stood up and told Representative Bob Inglis to “keep your government hands off my Medicare.” The congressman, a Republican from South Carolina, tried to explain that Medicare is already a government program — but the voter, Mr. Inglis said, “wasn’t having any of it.”

It’s a funny story — but it illustrates the extent to which health reform must climb a wall of misinformation. It’s not just that many Americans don’t understand what President Obama is proposing; many people don’t understand the way American health care works right now. They don’t understand, in particular, that getting the government involved in health care wouldn’t be a radical step: the government is already deeply involved, even in private insurance.

And that government involvement is the only reason our system works at all.

The key thing you need to know about health care is that it depends crucially on insurance. You don’t know when or whether you’ll need treatment — but if you do, treatment can be extremely expensive, well beyond what most people can pay... Triple coronary bypasses, not routine doctor’s visits, are where the real money is, so insurance is essential.

Yet private markets for health insurance, left to their own devices, work very badly: insurers deny as many claims as possible, and they also try to avoid covering people who are likely to need care. Horror stories are legion...

And in their efforts to avoid ... paying medical bills, insurers spend much of the money taken in through premiums ... on “underwriting” — screening out people likely to make insurance claims. In the individual insurance market,... so much money goes into underwriting and other expenses that only around 70 cents of each premium dollar actually goes to care.

Still, most Americans do have health insurance, and are reasonably satisfied... How is that possible, when insurance markets work so badly? The answer is government intervention.

Most obviously, the government directly provides insurance via Medicare and other programs. ... Medicare — which is ... one of those “single payer” systems conservatives love to demonize — covers everyone 65 and older. And surveys show that Medicare recipients are much more satisfied with their coverage than Americans with private insurance.

Still, most Americans under 65 do have some form of private insurance. The vast majority, however, don’t buy it directly: they get it through their employers. There’s a big tax advantage to doing it that way... But to get that tax advantage employers have to follow a number of rules; roughly speaking, they can’t discriminate based on pre-existing medical conditions or restrict benefits to highly paid employees.

And it’s thanks to these rules that employment-based insurance more or less works, at least in the sense that horror stories are a lot less common than they are in the individual insurance market.

So here’s the bottom line: if you currently have decent health insurance, thank the government. ...

Which brings us to the current debate over reform.

Right-wing opponents of reform would have you believe that President Obama is a wild-eyed socialist, attacking the free market. But unregulated markets don’t work for health care — never have, never will. To the extent we have a working health care system at all right now it’s only because the government covers the elderly, while a combination of regulation and tax subsidies makes it possible for many, but not all, nonelderly Americans to get decent private coverage.

Now Mr. Obama basically proposes using additional regulation and subsidies to make decent insurance available to all of us. That’s not radical; it’s as American as, well, Medicare.

The Courage to Click

Brad DeLong asks Do I Dare Click Through on This article by Jonah Goldberg? He then answers "No. I do not. I will remain forever ignorant..."

I dared to click through. Next time, I won't bother, and let me save you the trouble. The argument is that we don't spend enough to fight the threat of asteroids, so we must be spending too much fighting global warming, but one doesn't follow from the other. I see now why I can't remember the last time I read an article by Goldberg.

Maybe this sudden bout of timidity from Brad DeLong is my fault (though there is a sign he is recovering). Last night, I was the one who didn't dare click through on an article, so I sent the link to Brad saying "I just couldn’t read this. Maybe tomorrow." Looks like that may have sent him over the edge:

Someone Is Saying Something Wrong on the Internet in the Pages of the Wall Street Journal, by Brad DeLong: Someone Is Saying Something Wrong on the Internet in the Pages of the Wall Street Journal!

My friend Mark Thoma is trying to diminish my quality of life by emailing me links to Donald Luskin writing in the Wall Street Journal:

Luskin: President Barack Obama proposed last month that the Fed act as an overall “systemic risk” regulator, with consolidated supervisory responsibility over “large, interconnected firms whose failure could threaten the stability of the system.” Now William C. Dudley, the ex-Goldman Sachs economist just appointed president of the New York Federal Reserve, has upped the ante.... Mr. Dudley is effectively asking for the power to control asset prices...




The Federal Reserve is not "asking for the power to control asset prices." It already has the power to control--or, rather, profoundly influence--asset prices already. When the Federal Reserve carries out an expansionary open-market operation, the whole point of the exercise is that it boosts bond and stock prices. The Federal Reserve buys bonds for cash. There are then fewer bonds out there for the private sector to hold. By supply and demand, the prices of those bonds goes up, and their yields--the interest rates quoted in the financial press--go down. Also by supply and demand, when bonds are yielding less investors are willing to pay more for substitute assets like equities and real estate, and their prices go up as well.

When the Federal Reserve carries out a contractionary open market operation, the same process works in reverse: the whole point of the exercise is that it lowers bond and stock prices. The Federal Reserve sells bonds for cash. There are then more bonds out there for the private sector to hold. By supply and demand, the prices of those bonds goes down, and their yields--the interest rates quoted in the financial press--go up. Also by supply and demand, when bonds are yielding more investors are willing to pay less for substitute assets like equities and real estate, and their prices go down as well.

For Luskin to claim that Dudley is asking for something new--that there is an extraordinary increase in the big, bad government's power to regulate financial markets contained in Dudley's "effectively asking for the power to control asset prices" is to demonstrate a degree of cluelessness that takes my breath away. The Federal Reserve already has the power to control asset prices. It has had this power since its founding in 1913. That's the point. That's what a central bank does. That's what it's for: it's an island of central planning power seated in the middle of the market economy.

If you don't like it, call for its abolition. But don't pretend that it isn't there--don't pretend that "Mr. Dudley... asking for the power to control asset prices" is some wild change in our current system.

Jeebus save us...

So what did Federal Reserve Bank of New York President William Dudley say at the 8th Annual BIS Conference in Basel last June 26?

He said:

  1. We had not understood that interconnection had breached the firewalls of the banking system--that it was no longer enough to guarantee the stability of the financial system that the FDIC guaranteed deposits and the Federal Reserve supervised commercial banks, as we saw when the disruption of the securitization marktes of the shadow banking system quickly transmitted itself to the entire financial sector and caused the biggest globl economic decline since the Great Depression. Thus "the U.S. Treasury is right in proposing a systemic risk regulator as part of their regulatory reform plan... we shouldn’t kid ourselves about how difficult this will be to execute.... It will take the right people, with the right skill sets, operating in a system with the right culture and legal framework. I don’t believe creating this oversight process will be an easy task"...

  2. We need to try to "engineer out of the financial system" destabilizing positive-feedback mechanisms like: (a) collateral tied to credit ratings; (b); collateral and haircuts; (c) compensation "tied to short-term revenue generation, rather than long-term profitability over the cycle"; (d) incentives for banks to fail to "raise sufficient capital to be able to withstand bad states of nature... many banks did not hold sufficient capital and market participants knew this"...

  3. Specifically, we need to add debt that automatically converts to equity on the downside

  4. And, specifically, we need CDOs and other securitized obligations that are easier to value, and we need more public reporting of exposures.

It's only after this that Dudley gets to monetary policy and asset bubbles, and his belief that we need "a critical reevaluation of the [Greenspanist] view that central banks cannot identify or prevent asset bubbles, they can only clean up after asset bubbles burst." There is an opportunity for the government to "lean against the wind" in real time, Dudley believes, and cites as an example that "the compressed nature of risk spreads and the increased leverage in the financial system was very well known going into 2007."

The problem with "leaning against the wind" to some degree to try to curb the growth of asset bubbles, Dudley says, is that the standard tool that the Federal Reserve uses to affect asset prices are open-market operations directed at the short end of the yield curve, and "the instrument of short-term interest rates... is not well-suited to deal with asset bubbles." The problem is that using short-term interest rates to manipulate asset prices raises or lowers all asset prices together, which means that one risks curbing the bubble by attacking the economy and causing the recession one wants to avoid. In a bubble the Federal Reserve does not want to lower all asset prices but, rather, just the prices of those risky assets that are affected by the bubble.

One way to think about it is that standard Fed tools allow it to affect the market rate of time preference and thus the level of asset prices, but that the configuration of asset prices is actually a two-dimensional animal in which both the rate of time preference and the premium on risk are important. The Fed then needs two different policy instruments to do its job. Open-market operations that affect the rate of time preference are one. And Dudley thinks that banking collateral regulatory policy--"we might give a systemic risk regulator the authority to establish overall leverage limits or collateral and collateral haircut requirements... limit leverage and more directly influence risk premia..."

But nobody should believe the Wall Street Journal when it tells us that Dudley wants to move us into a world in which for the first time the Federal Reserve "is effectively asking for the power to control asset prices." That's not what is going on at all.

Why oh why can't we have a better press corps?

“Savings Rate Could Stay High”

Andy Harless explains why he believes that much of the recent increase in the savings rate will be permanent, while Brad DeLong thinks "only a small part" will be permanent. My own view is somewhere between Andy's "much" and Brad's "small part": 

Savings Rate Could Stay High, by Andy Harless: Mark Thoma shows us a historical chart of the personal savings rate since 1960 and asks how much of the recent increase (from an average of about 0.5% from 2005 through 2007 to a peak of almost 7% in May of this year) is permanent? One must, of course, take the May figure with a grain of salt: the savings rate rose in May largely because tax withholding was reduced; unless that attempt at a stimulus is completely ineffective, we should expect the savings rate to decline as people start taking advantage of the new disposable income. But even before May the savings rate this year was running consistently above 4%, which is a dramatic change from a few years ago. Let’s use the April figure – 5.6% – as a guesstimate of what the “true” savings rate is right now and ask how much of that will be permanent.

Not much, thinks Brad DeLong:

I would guess that only a small part of the rise in the savings rate is permanent. Financial distress was and is much greater than in past post-WWII recessions, and financial distress is associated with transitory rises in the savings rate.

I’m inclined to disagree. Undoubtedly the savings rate will fall somewhat as the degree of financial distress declines, but I think there’s a good case to be made that much of the increase is permanent.

For one thing, from the point of view of households, “financial distress” may be extremely slow to lift. If the Japanese experience is any guide, it is a very slow process to get a severely distressed banking system to start lending normally again, and it’s not clear that things are going to be any easier for the US. Meanwhile, most forecasts expect the unemployment rate to remain quite high for several years. It could take 3 years, or 5 years, or 10 years, or 20 years before the financial distress lifts.

Granted, even 20 years is not forever, and 3 years is certainly not forever, but it’s long enough to stop thinking about household behavior as being continuous over time. We can reasonably surmise that, even without so much financial distress, the savings rate would have trended upward over time. Presumably households would gradually have come to recognize that they weren’t saving enough. (Can zero be anywhere near enough?) And as baby boomers’ children settle into their own careers, they would cease to be a drag on their parents’ savings, and at the same time those parents would have to start worrying seriously about retirement. The financial distress messed up this scenario (or maybe just speeded it up), but the underlying trend should still be going on “beneath the surface.” By the time the distress lifts, there will be other reasons for the savings rate to be higher than it was in 2006.

That argument is rather speculative, I admit, but there are more solid reasons to expect the savings rate to remain high.

While the current, comparatively high savings rate may reflect the effects of financial distress, the low savings rates of the 2005-2007 period did not merely represent the absence of financial distress. What is the opposite of financial distress? Financial ease? The degree of financial ease during that period (which was the culmination of a process that had been building on and off for a couple of decades) was well beyond normal, and well beyond what we can expect in the coming years, even if recent sources of distress are resolved fairly quickly. Consumption was supported (and aggregate saving accordingly reduced) by a fountain of credit that will not re-emerge with such force unless people in Washington and on Wall Street make some big mistakes.

The ready availability of credit to consumers was in large part the result of lax regulation, careless investing, and the assumption that home prices would never decline significantly on a nationwide basis. With respect to regulation, the pendulum is clearly swinging in the other direction now. Careless investors have learned their lesson for a generation. And housing prices have disproven the earlier assumption.

After the collapse of housing prices, not only will lenders be more cautious: borrowers also won’t have as much collateral. It will be quite a while before typical homeowners have as much equity as they did in 2006.

Moreover, the meltdown may have shaken confidence in the concept of securitization to the point where it will take a decade or more to restore even healthy securitization markets (if they can be restored at all), let alone the severely intoxicated ones that we were seeing in 2006. It won’t be easy for households to borrow money for consumption in the coming years. The ones that had negative savings rates will be much less common, while the ones that had positive savings rates will still be there. I expect we’ll be seeing savings rates noticeably higher than zero for years to come.

Why Wasn’t an RTC-like Institution Set up for TARP?

Where are the technocratic institutions?:

Why wasn't an RTC-like institution set up for TARP?, by Economics of Contempt: Brad DeLong asks...:

I do have one big question. The US government especially, but other governments as well, have gotten themselves deeply involved in industrial and financial policy during this crisis. They have done this without constructing technocratic institutions like the 1930’s Reconstruction Finance Corporation and the 1990’s RTC, which played major roles in allowing earlier episodes of extraordinary government intervention into the industrial and financial guts of the economy to turn out relatively well, without an overwhelming degree of corruption and rent seeking. ...

So I wonder: why didn’t the US Congress follow the RFC/RTC model when authorising George W. Bush’s and Barack Obama’s industrial and financial policies?

...I think it's an interesting question..., so I'll take this chance to offer my response. With regard to TARP, I think Congress didn't set up an RTC-like institution because the feeling was that there simply wasn't enough time. Neither the RTC nor the RFC were set up during market panics. By the time the RTC was set up in 1989, the S&L crisis had been raging for several years, and the 1987 stock market crash had come and gone. Similarly, the RFC was created in January 1932—over 2 years after the stock market crash of '29.

Time was of the essence back in September, and in order to respond with the necessary speed and force, more discretion had to be given to the executive branch. The RTC, for example, was run by a board of directors and a separate oversight board. In a crisis, policy-by-committee doesn't work. The market had to be confident that help was coming soon, and wouldn't be held up by internal government bickering (think Sheila Bair).

Why wasn't an RTC-like institution created once the financial markets more or less stabilized, and time was no longer of the essence? That's easy: because Congress already gave the executive branch the money. In the administration's view (which I largely share), there's no real benefit from creating a separate "technocratic" institution to administer TARP. Treasury is a highly "technocratic" institution itself, as DeLong no doubt knows, having worked in the Clinton Treasury. I have great confidence in Tim Geithner's competence—in fact, I don't think there's anyone I'd rather have in charge of TARP.

links for 2009-07-31

What Caused Foreclosures?

Richard Green:

Michael Lacour-Little says it's all about the refinances, by Rickard Green : He points me to:

Why are so many homeowners underwater on their mortgages?

In crafting programs to prevent foreclosures, policymakers have assumed that the primary reason homeowners owe more on their home than it is worth is that they bought at the top of the market. In other words, they’ve lost equity primarily through forces beyond their control.

A new study challenges this premise and finds that excessive borrowing may have played as great a role.

Michael LaCour-Little, a finance professor at California State University at Fullerton, looked at 4,000 foreclosures in Southern California from 2006-08. He found that, at least in Southern California, borrowers who defaulted on their mortgages didn’t purchase their homes at the top of the market. Instead, the average acquisition was made in 2002 and many homes lost to foreclosure were bought in the 1990s. More than half of all borrowers who lost their homes had already refinanced at least once, and four out of five had a second mortgage.

The original loan-to-value ratio for these borrowers stood at a reasonable 84%, but second and third liens left homeowners with a combined loan-to-value ratio of about 150% by the time of the foreclosure sale date.

Borrowers, meanwhile, took out around $2 billion in equity from their homes, or nearly eight times the $262 million that they put into their homes. Lenders lost around four times as much as borrowers, seeing $1 billion in losses.

“[W]hile house price declines were important in explaining the incidence of negative equity, its magnitude was more strongly influenced by increased debt usage,” writes Mr. LaCour-Little. “Hence, borrower behavior, rather than housing market forces, is the predominant factor affecting outcomes.”

If other housing markets across the country offer similar findings, then the study argues that current “policies aimed at protecting homeowners from foreclosure are misguided” because lenders, and not borrowers, have born the lion’s share of economic losses.

Borrowers that bought homes without ever putting any or little equity in their homes could have seen huge returns on investment simply by extracting cash through refinancing. “Why such borrowers should enjoy any special government benefits such as waiver of the income taxation on debt forgiveness or subsidized loan modifications to reduce their borrowing costs is at best unclear,” the authors write.


is a co-author of mine (and was a student at Wisconsin while I taught there), and has a gift for slicing up mortgage data. On the policy question, we might think about treating the half who did not refinance differently, as they were drowned by the flood.

A Look Inside Fed’s Balance Sheet – 7/30/09 Update

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The Fed’s balance sheet shrunk again in the latest week falling back below $2 trillion. Direct-bank lending rose slightly, but remained under $300 billion. The makeup of the balance sheet continued to shift out of emergency facilities and into debt holdings. Treasurys and agency debt continued their upward march, though holdings of mortgage-backed securities fell more than $2.5 billion. The Fed started a program in March to ramp up such acquisitions in order to push down long-term interest rates low. Central-bank liquidity swaps declined again, but by far the largest drop came from the commercial paper and money market facilities, which dropped by nearly $44 billion. Some securities in the commercial paper facility reached expiration and companies likely decided take their funds out and tap investors directly as sentiment in the market improved.

In an effort to track the Fed’s actions, Real Time Economics has created an interactive graphic that will mark the expansion of the central bank’s balance sheet. Every Thursday afternoon, the chart will be updated with the latest data released by the Fed.

In an effort to simplify the composition of the balance sheet, some elements have been consolidated. Portfolios holding assets from the Bear Stearns and AIG rescues have been put into one category, as have facilities aimed at supporting commercial paper and money markets. The direct bank lending group includes term auction credit, as well as loans extended through the discount window and similar programs.

Central bank liquidity swaps refer to Fed programs with foreign central banks that allow the institutions to lend out foreign currency to their local banks. Repurchase agreements are short-term temporary purchases of securities from banks, which are looking for liquidity and agree to repurchase them on a specified date at a specified price.

Click and drag your mouse to zoom in on the chart. Clicking the check mark on categories can add or remove elements from the balance sheet.

To Page this Person, Press Five Now…

From my son Paul:

Take Back the Beep Campaign, Pogue's Posts: ...I’ve been ranting about one particularly blatant money-grab by U.S. cellphone carriers: the mandatory 15-second voicemail instructions.

Suppose you call my cell to leave me a message. First you hear my own voice: “Hi, it’s David Pogue. Leave a message, and I’ll get back to you”–and THEN you hear a 15-second canned carrier message.

  • Sprint: “[Phone number] is not available right now. Please leave a detailed message after the tone. When you have finished recording, you may hang up, or press pound for more options.”
  • Verizon: “At the tone, please record your message. When you have finished recording, you may hang up, or press 1 for more options. To leave a callback number, press 5. (Beep)”
  • AT&T: “To page this person, press five now. At the tone, please record your message. When you are finished, you may hang up, or press one for more options.”
  • T-Mobile: “Record your message after the tone. To send a numeric page, press five. When you are finished recording, hang up, or for delivery options, press pound.”

(You hear a similar message when you call in to hear your own messages...)...

[UPDATE: iPhone owners' voicemail doesn't have these instructions--Apple insisted that AT&T remove them. And Sprint already DOES let you turn off the instructions message, although it's a buried, multi-step procedure...]

These messages are outrageous for two reasons. First, they waste your time. Good heavens: it’s 2009. WE KNOW WHAT TO DO AT THE BEEP.

Do we really need to be told to hang up when we’re finished!? Would anyone, ever, want to “send a numeric page?” Who still carries a pager, for heaven’s sake? Or what about “leave a callback number?” We can SEE the callback number right on our phones!

Second, we’re PAYING for these messages. These little 15-second waits add up–bigtime. If Verizon’s 70 million customers leave or check messages twice a weekday, Verizon rakes in about $620 million a year. That’s your money. And your time: three hours of your time a year, just sitting there listening to the same message over and over again every year.

In 2007, I spoke at an international cellular conference in Italy. The big buzzword was ARPU–Average Revenue Per User. The seminars all had titles like, “Maximizing ARPU In a Digital Age.” And yes, several attendees (cell executives) admitted to me, point-blank, that the voicemail instructions exist primarily to make you use up airtime, thereby maximizing ARPU.

Right now, the carriers continue to enjoy their billion-dollar scam only because we’re not organized enough to do anything about it. But it doesn’t have to be this way. ... Let’s push back... Send them a complaint, politely but firmly. Together, we’ll send them a LOT of complaints. [List of addresses for complaints in full post.] If enough of us make our unhappiness known, I’ll bet they’ll change. ... I have a feeling that the volume of complaints will be too big for them to ignore. ...

Home ATM: Low on Cash, but Not Totally Tapped Out

Using a home-equity loan for extra cash was popular during the housing boom, and while fewer people are taking advantage of the home ATM, a new Freddie Mac report indicates that it still has some cash left.

Some are still able to pull extra cash out of their homes through refinancing. (Getty Images)

In a report on mortgage refinancing, Freddie said that 38% of those who refinanced in the second quarter wrapped a second-lien loan such as home-equity financing into the new mortgage. That rate is at a six-year low, and is down from 43% in the first quarter. But it indicates that despite tighter credit, people are still pulling cash out of their homes.

What people are doing with that money is an open question. Some economists have argued that consumption was propped up on the back of such “cash-out” mortgages, and that less availability has helped spur the jump in the saving rate and drops in consumer spending.

Those who are still able to get cash-out loans may be using the money to make home improvements or spend on other big-ticket purchases, which would be a boon to the economy. Or they could be using the money to pay down credit-card debt or car loans, which would be less beneficial in the short-term.

In the current environment, credit is extremely tight, but it’s also cheap. Mortgage rates remain low, and Freddie chief economist Frank Northaft anticipates more than half of mortgages the rest of the year to be refinances “as long as rates stay near their current levels of 5.25%.” Some borrowers could be taking the extra cash, and parking it in savings or elsewhere in hopes of generating a higher return in the future.

Secondary Sources: Next Bubble, Sluggish Wages, Peter and Doug

A roundup of economic news from around the Web.

  • The Next Bubble: Tim Duy of Fed Watch looks at the recipe for a new bubble. “Lacking a story that leads to strong wage growth in the near - or even medium - term, the Fed is almost certainly on hold at least through this year and likely well into 2010, allowing the size of the balance sheet to adjust according to the needs of the financial markets while keeping interest rates at rock bottom levels. That doesn’t mean all that easy money will not show up somewhere - technical analysts are looking for US equities to explode on the basis of recent market action. But will the Fed lean against such an explosion without clear and convincing evidence that the labor market is poised for strong, sustainable improvement? I doubt it - and for those looking for it, therein lies the ingredients for making the next big bubble.”
  • Sluggish Wages: On his Economist’s View blog, Mark Thoma notes that even when jobs start coming back, wages increases will likely take longer to show up. “There is a lot of expansion that can come from currently employed workers through expanded hours, reversing temporary shutdowns, eliminating forced furloughs, no longer allowing unpaid vacations, those sorts of things. These bring hours and other work conditions back to normal and hence do not place much if any upward pressure on wages. There is a lot of slack in hours alone that can be taken up before the existing workforce is fully utilized, and adding back hours that have been taken away does not require an increase in wages. (There are some cases where the wage rate was cut instead of hours, and even some cases where both happened, but because the proportion of firms that cut wages is relatively small, even if those wage cuts are reversed it would not have much of an effect on the overall wage rate, and it would be a one-time change in wages in any case, not continuous upward wage pressure)..”
  • Peter and Doug: Diane Lim Rogers of EconomistMom says that OMB Director Peter Orszag and CBO Director Douglas Elmendorf aren’t feuding despite signs of disagreement over CBO’s statements on health-care reform. “I honestly think Peter was just disappointed in/felt “stung” by CBO’s quantitative 10-year estimate (for savings of just $2 billion) and felt like getting defensive about it, and in the process he forgot halfway through his blog post that he was actually happy that Doug said that the IMAC concept had the potential to save significantly on health costs beyond the first ten years (and that Doug had even explained specific ways to structure IMAC to make those savings much more certain). I know people are getting bored because this health reform effort is stalling and it’s almost August recess, but sorry, these guys (Peter and Doug) aren’t the “drama kings” you might be hoping for.”

Compiled by Phil Izzo

Daily Show Gets Some Laughs Out of Geithner’s Home Troubles

Last night The Daily Show had some fun with the difficulty Treasury Secretary Timothy Geithner is having in selling his Larchmont, NY home, calling it a “toxic asset” and referring to his blue tile bathroom as “ghastly.” It also makes jokes that Mr. Geithner’s woes are the result of Fed policies “he helped to implement.”

Mr. Geithner, only a few months into his term, has already been through his share of late-night lampoonings, including this Saturday Night Live segment.

The Daily Show piece struck a little closer to home, literally. It starts by describing the thawing real estate market but noting a “tragic tale” about “a family forced to move when the father had to take a job in a different city, and now their well-appointed home remains unsold.” The house, of course, is Mr. Geithner’s.

The Daily Show interviews a real estate agent who says Mr. Geithner priced his house “way too high” but didn’t want to take a price reduction. According to the piece, Mr. Geithner bought his house during the 2004 peak for $1.6 million but, despite the subsequent falloff in prices, listed it for slightly more.

The Daily Show drags out Yale Economist Robert Shiller for a little perspective on the matter.

“Is it not like hiring a personal trainer who is morbidly obese?” Daily Show correspondent John Oliver asks Mr. Shiller, about hiring a Treasury secretary who can’t seem to navigate the real estate market.

“Its not that bad…but yes, it is bad,” Mr. Shiller says, in an interview where it’s not clear if he’s talking about the Treasury secretary or the broader real estate market.

And then it just gets silly, with Mr. Shiller critiquing the blue tile in Mr. Geithner’s bathroom and suggesting a piece of “accent furniture.”

Economists React: More Evidence U.K. Housing Has Bottomed

House prices have a “reasonable chance” of ending 2009 up for the year, the Nationwide Building Society said, as data showed U.K. prices rose for a third straight month. Nationwide said the average price rose increased 1.3% to £158,871 (about $260,000) following a revised 1.0% gain in June. Below, economists react.

Once again the report has attributed the increase in prices to lack of stocks of property for sale, consistent with reports from other housing indicators. Overall, [it is] yet further evidence that the housing market has bottomed, helping to remove some of the downside risks facing consumer spending. – Alan Clarke, BNP Paribas

While it looks increasingly likely that February marked the trough in house prices, we suspect that they will be prone to relapses over the coming months and we certainly do not think that a sharp sustained upward trend in house prices is in the process of developing. The average 7.5% rise in house prices since February means that affordability pressures are increasing anew at a time when the economic climate of recession, sharply rising unemployment and slowing wage growth is largely negative for the housing market. — Howard Archer, IHS Global Insight

It is fair to argue that the improvement in the level of prices recorded here partly reflects a low turnover market with a significant number of potential purchasers being rationed out of the ability to buy. Even so, it is impressive that prices have managed to generate some upward momentum despite that constraint on demand. As we wrote up in a [recent] note …, we have viewed the upswing in prices as in part payback for the sharp declines seen in the late part of next year, while expecting monthly prices to move back into modest declines over the rest of 2009. This first report of the July data challenges that view. — J.P. Morgan

We have changed our view on [Bank of England's quantitative easing] on the back of this morning’s Nationwide house price index…. This is the fourth rise in five months and according to this index, house prices are now 4.4% higher than they were at the trough in February. This does not necessarily mean that house prices are now on the way up in the medium term … . However from the point of view of short-term monetary policy decisions we feel that the run of better housing market data may well have an impact on the [monetary policy committee’s] collective thoughts. Accordingly we are now forecasting that the committee will leave the asset purchase target at £125bn at next Thursday’s meeting. – Philip Shaw, Investec Securities