Note to self: holidaying in Greece will soon be cheap

Megan McArdle directs the world to this piece in the FT.  From the FT article:

The European Commission said on Tuesday it would endorse Athens’ plan to bring back under control the public sector deficit, which last year reached almost 13 per cent of gross domestic product.

Under a three-year plan, the Greek government seeks to cut the national budget deficit to less than 3 per cent of GDP by the end of 2012.

and:

In response to criticism that earlier plans had not included sufficient spending cuts, Mr Papandreou also announced an across-the-board freeze in public sector wages which, together with cuts in allowances, would reduce the public sector wage bill by 4 per cent. The government has also pledged to raise the retirement age.

If the Greek government can achieve this without massive, nation-wide strikes, I’ll be terrifically impressed.  Megan’s comments:

Everyone is expressing optimism. But while this sort of belt-tightening is necessary for Greece to stay in the EU, it’s going to come at a huge cost. Greece is already in recession–that’s why its budget problems loom so large–and the fiscal contraction will only make them deeper. Meanwhile, the EU will be setting its interest rates to meet the needs of larger, healthier members (and inflation-hawk bondholders). Tight fiscal and monetary policy means a long, painful period ahead for the Greeks.

This is the dilemma that faced Argentina with its monetary peg to the dollar; ultimately, it led to devaluation and default. We will see if Greece can whether [sic] it better.

I don’t think that this sort of belt-tightening is strictly necessary in the near term.  Germany will, again, fund a bail-out if it really comes down to it because, if nothing else, the loss to Germany of a member of the EU dropping the currency is greater than the loss to Germany of paying for Greece’s debt.

It’s clearly necessary in the long term that Greece get it’s fiscal house in order, but since they’re in such a severe recession, this isn’t really the time to do it (financial market pressure aside).  This is, in essence, the same debate that is gripping America, although there the pressure to address the deficit is coming from a successful political strategy of the opposition rather than, much as that same opposition might like, pressure from the markets.

Ultimately, what the EU needs is individual states to be long-term fiscally stable and to have pan-Europe automatic stabilisers so that areas with low unemployment essentially subsidise those with high unemployment.  Ideally it would avoid straight inter-government transfers and instead take the form of either encouraging businesses to locate themselves in the areas with high unemployment, or encouraging individuals to move to areas of low unemployment.  The latter is difficult in Europe with it’s multitude of languages, but not impossible.

In a perfect world where all regions of the EU currency zone were equally developed, this would simply replace the EU development grants.  But this isn’t a perfectly world …

More on the US bank tax

Further to my last post, Greg Mankiw — who is not a man to lightly advocate an increase in taxes on anything, but who understands very well the problems of negative externalities and implicit guarantees — has written a good post on the matter:

One thing we have learned over the past couple years is that Washington is not going to let large financial institutions fail. The bailouts of the past will surely lead people to expect bailouts in the future. Bailouts are a specific type of subsidy–a contingent subsidy, but a subsidy nonetheless.

In the presence of a government subsidy, firms tend to over-expand beyond the point of economic efficiency. In particular, the expectation of a bailout when things go wrong will lead large financial institutions to grow too much and take on too much risk.
[…]
What to do? We could promise never to bail out financial institutions again. Yet nobody would ever believe us. And when the next financial crisis hits, our past promises would not deter us from doing what seemed expedient at the time.

Alternatively, we can offset the effects of the subsidy with a tax. If well written, the new tax law would counteract the effects of the implicit subsidies from expected future bailouts.

My desire for a convex (i.e. increasing marginal rate of) tax derives from the fact that the larger financial institutions are on the receiving end of larger implicit guarantees, even after taking their size into account.

Update:  Megan McArdle writes, entirely sensibly (emphasis mine):

That implicit guarantee is very valuable, and the taxpayer should get something in return. But more important is making sure that the federal government is prepared for the possibility that we may have to make good on those guarantees. If we’re going to levy a special tax on TBTF banks, let it be a stiff one, and let it fund a really sizeable insurance pool that can be tapped in emergencies. Like the FDIC, the existance of such a pool would make runs less likely in the shadow banking system, but it would also protect taxpayers. Otherwise, with our mounting entitlement liabilities, we run the risk of offering guarantees we can’t really make good on.

I agree with the idea, but — unlike Megan — I would allow some of it to be collected directly as a tax now on the basis that the initial drawing-down of the pool came before any of the levies were collected (frustration at the political diversion of TARP funds to pay for the Detroit bailout aside).

The death throes of US newspapers?

Via Megan McArdle’s excellent commentary, I discovered the Mon-Fri daily circulation figures for the top 25 newspapers in the USA.  Megan’s words:

I think we’re witnessing the end of the newspaper business, full stop, not the end of the newspaper business as we know it. The economics just aren’t there. At some point, industries enter a death spiral: too few consumers raises their average costs, meaning they eventually have to pass price increases onto their customers. That drives more customers away. Rinse and repeat . . .

[…]

The numbers seem to confirm something I’ve thought for a while: we’re eventually going to end up with a few national papers, a la Britain, rather than local dailies. The Wall Street Journal, the Washington Post, and the New York Times (sorry, conservatives!) are weathering the downturn better than most, and it’s not surprising: business, politics, and national upper-middlebrow culture. But in 25 years, will any of them still be printing their product on the pulped up remains of dead trees? It doesn’t seem all that likely.

For those of you that like your information in pictoral form, here it is:

First, the data.  Look at the Mean/Median/Weighted Mean figures.  That really is an horrific collapse in sales.

US_Newspaper_circulation_data

Second, the distribution (click on the image for a full-sized version):

US_Newspaper_circulation_distribution

Finally, a scatter plot of year-over-year change against the latest circulation figures (click on the image for a full-sized version):

US_Newspaper_circulation_scatterplotAs Megan alluded in the second paragraph I quoted, there appears to be a weak relationship between the size of the paper and the declines they’ve suffered, with the bigger papers holding up better.  The USA Today is the clear exception to that idea.  Indeed, if the USA Today is excluded from the (already very small!) sample the R^2 becomes 30%.

To really appreciate just how devestating those numbers are, you need to combine it with advertising figures.  Since newspapers take revenue from both sales (circulation) and advertising, the fact that advertising revenue has also collapsed, as it always does in a recession, means that newspapers have taken not just one but two knives to the chest.

Here’s advertising expenditure in newspapers over recent years, taken from here:

Year Expenditure (millions of dollars) Year-over-year % change
2005 47,408
2006 46,611 -1.7%
2007 42,209 -9.2%
2008 34,740 -17.7%

Which is ugly.  Remember, also, that this expenditure is nominal.  Adjusted for inflation, the figures will be worse.

So what do you do when your ad sales and your circulation figures both fall by over 15%?  Oh, and you can’t really cut costs any more because, as Megan says:

For twenty years, newspapers have been trying to slow the process with increasingly desperate cost cutting, but almost all are at the end of that rope; they can’t cut their newsroom or production staff any further and still put out a newspaper. There just aren’t enough customers who are willing to pay for their product what it costs to produce it.

Which, in economics speak, means that the newspaper business has a large fixed cost component that isn’t particularly variable even in the long run.

Tyler Cowen, in an excellent post that demonstrates precisely why I read him daily, says:

I believe with p = 0.6 that the world is in for a “great disruption.”  It has come to MSM first but it will not end there.  In the longer run I am optimistic about the results of this change — computers will free up lots of human labor — but in the meantime it will have drastic implications for income redistribution, across both individuals and across economic sectors.  For a core metaphor, the internet displacing paid journalism and classified ads is a good place to start.  The value of newspapers has been sucked into Google.

[…]Once The Great Disruption becomes more evident, entertainment will be very very cheap.

Which may well be true, but will be cold comfort for all of those traditional journalists out there.

Once more on bankers’ pay

Megan McArdle makes a perfectly sensible point when she writes:

More than one smart analyst thinks that the yearly bonus regime encouraged both traders and their managers to take excess risk. I’m not sure, as an empircal matter, that I buy this argument. Most of those bankers who were allegedly gambling for free with (implicit) taxpayer money in fact lost half or more of their own fortunes in the ensuing crash. From this I infer that they did not, in fact, realize that they were gambling.

I still think that some regulation on bonuses is warranted. Indeed, I think it warranted precisely because the bankers didn’t fully appreciate the risks they were taking. By holding bonuses in escrow for, say, five years, we serve to increase the risk aversion of those bankers.  Megan implies partial agreement with the conclusion, if not the logic, a little later on:

But enforcing, say, a multi-year bonus scheme wouldn’t be terribly destructive, and it might help.

Continuing immediately on, she writes:

On the other hand, if the government starts meddling with the level of compensation, this will be disturbing both because it will not do good things for the American financial services industry, and because, well, who the hell is the government to start telling private firms that are not receiving any taxpayer money how much to pay their employees?

In general I’d agree, but we should also consider the recent work by Thomas Philippon and Ariell Reshef suggesting that remuneration in the finance sector relative to the rest of the economy for a given level of education has been especially high lately.  Here is an ungated version of their paper.  Here is the abstract:

We use detailed information about wages, education and occupations to shed light on the evolution of the U.S. financial sector over the past century. We uncover a set of new, interrelated stylized facts: financial jobs were relatively skill intensive, complex, and highly paid until the 1930s and after the 1980s, but not in the interim period. We investigate the determinants of this evolution and find that financial deregulation and corporate activities linked to IPOs and credit risk increase the demand for skills in financial jobs. Computers and information technology play a more limited role. Our analysis also shows that wages in finance were excessively high around 1930 and from the mid 1990s until 2006. For the recent period we estimate that rents accounted for 30% to 50% of the wage differential between the financial sector and the rest of the private sector. [emphasis added]

… which is prima facie evidence in support of some sort of regulation on remuneration in the finance sector.

The Chrysler bankruptcy

This is not a post about how Chrysler might work going forward, nor a post about how dastardly the hold-outs are.  This is a post about the distribution of haircuts and the move from White House-led negotiation to bankruptcy court.

There are broadly four groups of creditors:  The (sole remaining) shareholder, the union/pension-fund, the bond holders and the US government.

Clearly the shareholder should be wiped out.  The question is how much of a haircut everybody else should take.

I believe that by law, the US government would take the smallest haircut (get the largest fraction of their money back) as they’re super-senior, then the bond holders in decreasing order of seniority and the union/pension fund should get the biggest kick in the teeth.  The hold-outs were secured creditors, which means that if the company is liquidated they get a pretty senior claim on the proceeds.

[Update: Duh.  The government isn’t a super-senior bond holder, it’s a preferred share holder, which means that it’s claims, in principle, ought to be subordinate to the bond holders]

As I understand it, the deal on the table had the order differently.  The unions were getting back something like 60c on the dollar, the government 45c on the dollar and the bondholders 25c on the dollar (those numbers are made-up, but indicative).

That conflict between what would normally happen and the deal on offer was what gave rise to this sort of comment from Greg Mankiw:

The Rule of Law — Not!

Via the WSJ, here is the view from a “secured (sic) creditor” of Chrysler:

“Like many others I made the mistake of buying what I believed was ‘value,'” Mr. Gwin says, adding that investors who bought at the time believed the loans were worth more than their market price. “We did not contemplate having our first liens invalidated by a sitting president,” he adds.

As the President intervenes in more and more industries, a key question is how he does it and what he is trying to achieve. Is he trying to reorganize insolvent firms while, as much as possible, preserving the rights of stakeholders as established under existing contracts? Or is he trying to achieve a “fair” outcome as he judges it, regardless of preexisting rules and agreements? I fear it may be the latter, in which case politics may start to trump the rule of law.

Mankiw has an uncanny ability to irritate me at times and although he has a bloody good point, even a vitally important point, this post did irritate me because I suspect that most bankruptcy arrangements aren’t fair, for a few reasons:

First, bond-holders, like equity holders, are ultimately speculators.  We differentiate the seniority of their claims legally, but the fact is that a guy holding a Chrysler bond is just as much of a punter as the dude holding one of the shares.  They (presumably) had the same access to information about Chrysler’s future and they (hopefully) both knew that their investment came with risk.  The idea of one subset of one factor of production being largely protected from the risk of the company’s failure is silly.

Second, employees are not speculators in the same way that the providers of capital are.  The cost of taking your money out of a company’s bonds or shares and moving it to another company is negligible.  The cost of taking your labour out and moving it to another company is significant.  At the very least, you are often geographically tied down while your money is not.  Therefore the socially optimal decision would help insure the employees against the risk of the company failing but leave the capital to insure itself.  Since US unemployment benefits (the public insurance framework) is so measly, it seems reasonable to grant employees partial access to the assets of the company.

Third, in every company to some extent (although varying depending on the industry), the employees are the company.  At an extreme, ask what a law firm would be worth if you fired all the lawyers.  Therefore, even if labour were perfectly mobile, there is a game-theoretic basis for giving the employees a stake in the game:  Principal-Agent problems exist all the way down to the floor sweepers.  This is an argument for German-style capitalism where the workers are also minority shareholders.  You might argue against workers’ representatives on the board of directors, but I do think they ought to have a share holding.

Fourth, even if all of the above balanced out to zero, there might (might!) be be beneficial social welfare to ensuring that the company is an ongoing concern rather than liquidated.  When they pushed Chrysler into bankruptcy, the hold-outs were doing so because they would get more money under liquidation than the deal on the table.  If there is a benefit to social welfare in keeping the company open, there ought to be a way to force the bond-holders to take a hefty haircut rather than liquidating the assets, even – and this is where Professor Mankiw might really get upset – if it wasn’t Pareto improving (the needs of the many …).

Nevertheless – and this is why Mankiw managed to get under my skin on this occassion – I am glad that Chrysler has gone into bankruptcy.

I am glad because even though I largely agree with the White House’s proposal, and even if my four points are all true, it is not the job of the executive to be making these decisions.    There are entire institutions set up for it.  The bankruptcy courts and the judges who preside over them specialise in this stuff.  By all means the White House might make a submission for consideration (as the executive of the country, not just as a stakeholder), but it should be up to the judge to decide.

I suspect, or at least like to imagine, that Barack Obama knows all this already (he is a constitutional lawyer, after all) and that he pushed the negotiation down the path it has taken because politically he needed to be seen to be trying to “save” Chrysler from bankruptcy and economically ne needed to avoid the market turmoil that would have ensued from a sudden move to bankruptcy rather than the tortuously gradual one we have seen.

One of the challenges in negotiation for Israel/Palestine

There’s a perennial idea of proposing Northern Ireland as a model of how progress might be achieved in the fighting between Israelis and Palestinians.  After reading this recent posting by Megan McArdle, one of the difficulties in such an idea becomes plain.

In Northern Ireland, both sides had moral, if not logistical, support from larger powers that were themselves allies.  So while the nationalists found it difficult to trust the British government, they would generally trust the US government, who in turn trusted the British government, while the same chain applied in reverse for the loyalists.

By contrast, while Israel receives moral and logistical support from the USA, none of America’s close allies really comes close to giving the Palestinian cause at large, let alone Hamas in particular, the sort of tacit support that America gave the Irish nationalists.

Killing the worlds’ poor through good intentions

This sort of stuff makes me very, very angry.

Kerry Howley, writing at Reason, does an interview with Robert Paarlberg:

In May 2002, in the midst of a severe food shortage in sub-Saharan Africa, the government of Zimbabwe turned away 10,000 tons of corn from the World Food Program (WFP). The WFP then diverted the food to other countries, including Zambia, where 2.5 million people were in need. The Zambian government locked away the corn, banned its distribution, and stopped another shipment on its way to the country. “Simply because my people are hungry,” President Levy Mwanawasa later said, “is no justification to give them poison.”

The corn came from farms in the United States, where most corn produced—and consumed—comes from seeds that have been engineered to resist some pests, and thus qualifies as genetically modified. Throughout the 90s, genetically modified foods were seen as holding promise for the farmers of Africa, so long as multinationals would invest in developing superior African crops rather than extend the technology only to the rich. When Zambia and Zimbabwe turned away food aid, simmering controversy over the crops themselves brimmed over and seeped into almost every African state. Cast as toxic to humans, destructive to the environment, and part of a corporate plot to immiserate the poor, cutting edge farming technology is most feared where it is most needed. As Robert Paarlberg notes in his new book, Starved for Science: How Biotechnology is Being Kept Out of Africa (Harvard University Press), in 2004 the Sudanese government “took time out from its genocidal suppression of a rebellion in Darfur to issue a memorandum requiring that all food aid brought into the country should be certified as free of any GM ingredients.”

Starved for Science includes forwards by both Jimmy Carter and Norman Borlaug, the architect of Asia’s Green Revolution and the man credited with saving more human lives than anyone else in history. Paarlberg, a Professor of Political Science at Wellesley and a specialist in agricultural policy, wants the West to help small African farmers obtain promising technologies just as it helped Asia discover biological breakthroughs in the 60s and 70s. Instead, he says, a coalition of European governments and African elites are promoting a Western vision of rustic, low-productivity labor.

Do read the entire thing. Megan McArdle offers her comment here:

My understanding at the time was that this was even worse than ignorance: Africans keep out relief grain because they know that farmers will hold some of it for seed. They were afraid that if GM entered the food chain, they would that never, ever be able to export any plant products to Europe because of their stringent regulations (these have, I believe, been somewhat relaxed). So even if the president of Zambia knew GM was harmless, he couldn’t risk permanently impairing his country’s economic future.

In fact, let me quote some more from Howley’s interview with Paarlsberg:

reason: Can you give us a sense of what an average African farmer in, say, Zambia, is currently working with?

Paarlberg: It would be a woman and her children primarily, and they would plant not a hybrid maize, but a traditional openly pollinated variety, and they would time the preparation of the soil and planting as best they could for when they thought the rains would come. But the rains might not come in time, or they might be too heavy and wash the seeds out of the ground. It’s a risky endeavor. They can’t afford fertilizer, and it’s too risky to use fertilizer because in a drought the maize would shrivel up and the fertilizer would be wasted. They don’t have any irrigation. As a consequence, even in a good year their yields per hectare will be only about one third as high as in Asian countries, 1/10 as high as in the United States.

reason: Just as it used to be in Asia.

Paarlberg: Everywhere!

reason: No African government other than South Africa’s has made it legal to plant GMOs. You call this “out of character” for the same governments.

Paarlberg: They have not yet enacted the law, set up the biosafety committee, and granted approval, which is the laborious process that [the United Nations Environmental Program] and the European governments have coached them into adopting.

It’s interesting. In no other area are governments in Africa particularly concerned about hypothetical environmental risks. They know better than to invoke the precautionary principle when it comes to unsafe food in open air markets. They know that they need to first get rid of actual food shortages and raise income; then and only then can they afford to impose the same extremely high standards of food safety on open air markets that are imposed on supermarkets in Europe. Yet curiously when it comes to GMOs they adopt the highly precautionary European standard, which makes it impossible to put these products on the market at all. I take that as evidence that this is not an authentic African response, it’s a response imported from Europe.

reason: So the romanticization of bucolic farm landscapes unmarred by scientific advance has an American and European pedigree.

Paarlberg: It’s not what we do at home—only two percent of agricultural products in the US are organically grown. And many of those that are organically grown are grown on industrial scale organic farms in California that don’t bear any resemblance to small bucolic farms. But it’s the image we promote in our new cultural narrative. It’s something that affects the way we give foreign assistance.

reason: Many of the anti-agricultural science gurus you mention in your book have a spiritual dimension. Can you talk a bit about Sylvester Graham?

Paarlberg: Sylvester Graham, the father of the modern graham cracker, was opposed to the modern flour milling industry. He didn’t like the industrialization of bread production, and he wanted women to go back to grinding flour. He was a religious man, a minister, and he had all of the narrow minded prejudices we might associate with a New England clergyman from the 19th century. He thought that women should stay in the home, he believed people should be vegetarians because that would keep their sexual appetite back. We sometimes forget what goes along with the food purist zealotry. It’s often zealotry about more than just a certain kind of food to eat.

In Zambia today there are expatriate Jesuits from the United States who have come to believe genetic engineering is against God’s teaching, though this is not a belief that is embraced by the Vatican. They believe that all living things, including plants, have a right not to have their genetic makeup modified. Of course we have been modifying the genetic makeup of plants ever since we domesticated them 10,000 years ago, but these particular fathers are focused only on genetic engineering.

reason: Isn’t it paternalistic to blame Europeans for the decisions of African governments? Is this something African elites are at least as complicit in?

Paarlberg: It’s a codependency. The African elites depend upon Europe for financial assistance, they depend upon European export markets, they depend on NGOs for technical assistance, it’s just easier for them to follow the European lead than to go against that lead. And to some extent the European governments depend upon having dependents in Africa that will, despite the difficult experience of colonization, continue to imitate and validate and honor European culture and taste.

reason: What exactly have European NGOs done to discourage productivity in farming? You quote Doug Parr, a chemist at Greenpeace, arguing that the de facto organic status of farms in Africa is an opportunity to lock in organic farming, since African farmers have yet to advance beyond that.

Paarlberg: Some of it is well intentioned. The organic farming movement believes this is an appropriate corrective to the chemical intensive farming that they see in Europe. In Europe, where prosperous consumers are willing to pay a premium for organic products, it sometimes makes sense to use a more costly production process. So they think, “Well it’s the wave of the future here in Europe, so it should be the future in Africa as well.”

So they tell Africans who don’t use enough fertilizer that instead of using more they should go to zero and certify themselves as organic. That’s probably the most damaging influence — discouraging Africans from using enough fertilizer to restore the nutrients they mine out of their soil. They classify African farmers as either certified organic, or de facto organic. Indeed, many are de facto organic. And their goal is not to increase the productivity of the organic farmers, but to certify them as organic.

I just find that to be lacking in moral clarity.

Are US policy-makers panicking?

With respect to fiscal policy, I suspect that the stimulus package will help, but believe – like every other political cynic – that the package is being undertaken principally so that candidates in this year’s congressional, senate and presidential elections can be seen to be acting.  I am not at all surprised that debate over the precise structure of the package never really rose above the blogosphere, since although that is of enormous significance in how effective it will be, it is of near utter insignificance from the point of view of being seen to act.  I find myself agreeing both with Paul Krugman, who points out that only a third of the money will go to people likely to be liquidity-constrained and with Megan McArdle, who (here, here, here, here and here) argues that if you’re going to give aid to the poor of America, doing it via food stamps is, to say the least, less than ideal.

On the topic of monetary policy, I will prefix my thoughts with the following four points:

  • The decision makers at the US Federal Reserve are almost certainly smarter than I am (or, indeed, my audience is)
  • They certainly have more experience than I do
  • They certainly put more effort into thinking about this stuff than I do
  • They certainly have access to more timely and higher quality data than I do

As I see it, there are three different concerns:  whether (and if so, how) monetary policy can help in this scenario; whether the Fed’s actions come with added risks; and whether the timing of the Fed’s actions were appropriate.

First up, we have concerns over whether monetary policy will have any positive effect at all.  Paul Krugman (U. Princeton) worries:

Here’s what normally happens in a recession: the Fed cuts rates, housing demand picks up, and the economy recovers.  But this time the source of the economy’s problems is a bursting housing bubble. Home prices are still way out of line with fundamentals … how much can the Fed really do to help the economy?

By way of arguing for a a fiscal package, Robert Reich (U.C. Berkley) has a related concern:

[A] Fed rate cut won’t stimulate the economy. That’s because lending institutions, fearing their portfolios are far riskier than they assumed several months ago, won’t lend lots more just because the Fed lowers interest rates. Average consumers are already so deep in debt — record levels of mortgage debt, bank debt, and credit-card debt — they can’t borrow much more, anyway.

Menzie Chinn (U. Wisconsin) looks at these and other worries by going back to the textbook channels through which monetary policy works, concluding:

In answer to the question of which sector can fulfill the role previously filled by housing, I would say the only candidate is net exports. The decline in the Fed Funds rate has led to a depreciation of the dollar. In the future, net exports will be higher than they otherwise would be. However, the behavior of net exports, unlike other components of aggregate demand, depends substantially on what happens in other economies. If policy rates decline in the UK, the euro area, and elsewhere, additional declines of the dollar might not occur. (And as I’ve pointed out before, if rest-of-world GDP growth declines (as seems likely [2]), then net exports might decline even with a weakened dollar).

I think the main point is that the decreases in interest rates, working through the traditional channels, will have a positive impact on components of aggregate demand. With respect to the credit view channels, the impact on lending is going to be quite muted, I think, given the supply of credit is likely to be limited. In fact, I suspect monetary policy will only be mitigating the negative effects of slowing growth and a reduction of perceived asset values working their way through the system.

James Hamilton (U.C. San Diego) is more sanguine, arguing that:

[I]t is hard to imagine that the latest actions by the Fed would fail to have a stimulatory effect.

[A]lthough interest rates respond immediately to the anticipation of any change from the Fed, it takes a considerable amount of time for this to show up in something like new home sales, due to the substantial time lags involved for most people’s home-purchasing decisions … According to the historical correlations, we would expect the biggest effects of the January interest rate cuts to show up in home sales this April.

[The scale of any effect is unknown, though.] Tightening lending standards rather than the interest rate have in my opinion been the biggest explanation for why home sales continued to deteriorate after January 2007 … The effect of rising unemployment and expectations of falling house prices on housing demand is another big and potentially very important unknown.

Going further, Martin Wolf at the FT worries that the Fed may be doing too much, that they the recent cuts in interest rates may serve only to renew or exacerbate the problems that caused the current crisis in the first place.

[P]essimists argue that the combination of declining asset prices (particularly house prices) with household overindebtedness and a fragile banking system means that monetary policy is, in the celebrated words of John Maynard Keynes, like “pushing on a string”. It may not be quite that bad. But, on its own, monetary policy will not act swiftly unless employed on a dramatic scale. The case for fiscal action looks strong.

Yet, in current US circumstances, monetary loosening should have some expansionary effects: it will encourage refinancing of home mortgages; it will weaken the exchange rate, thereby improving net exports; it will, above all, strengthen the health of banking institutions, by giving them cheap government loans.

This brings us to the biggest question: what are the risks? Unfortunately, they are large. One is indefinite continuation of an excessively low rate of US national saving. Others are a loss of confidence in the US currency and much higher inflation.Yet another is a further round of the very asset bubbles and credit expansion that created the present crisis. After all, the financial fragility used to justify current Fed actions is, in large part, the direct result of past Fed efforts at the risk management Mr Mishkin extols.

Moreover, the risks are not just domestic. If the US authorities succeed in reigniting domestic demand, this is likely to reverse the decline in the current account deficit. It will surely reduce the pressure on other countries to change the exchange rate, fiscal, monetary and structural policies that have forced the US to absorb most of the rest of the world’s huge surplus savings.

I find it impossible to look at what the US is now trying to do without feeling severely torn. If it succeeds it will renew and, at worst, exacerbate the fragility, both domestic and international, that triggered the turmoil. If it fails, the US and, perhaps, much of the rest of the world could well suffer a prolonged period of economic weakness. This is hardly a pleasant choice. But that it is indeed the choice shows how weakened the world economy and particularly the financial system has become.

In reaction at the FT’s hosted blog, Christopher Carroll (Johns Hopkins U.) argues:

This situation provides a more than sufficient rationale for the Fed’s dramatic actions: Deflation combined with a debt crisis make a toxic combination, because as prices fall, real debt rises. This point was amply illustrated in Japan, where deflation amplified both the number of zombies and the degree of zombification (among the initial stock of the undead). It was also the basis of Irving Fisher’s theory of what made the Great Depression great, and has clear echoes in the macroeconomic literature on the “financial accelerator” pioneered by none other than Ben Bernanke (along with a few other authors who have pursued more respectable careers).

In this context, the risk of an extra year or two of an extra point or two of inflation (if the deflation jitters prove unwarranted and the subprime crisis proves transitory) seems a gamble well worth taking.

Martin Wolf then replied:

[W]hat the Bernanke Fed seems to be trying to halt (with enthusiastic assistance from Congress and the president) is a natural and necessary adjustment, as Ricardo Hausmann argued in the FT on January 31st. I agree that this adjustment must not be too brutal. I agree, too, that both a steep recession and deflation should be avoided. I agree, finally, that market adjustments must not be frozen, as happened in Japan. But I disagree that the US confronts a huge threat of deflation from which the Fed must rescue the economy at all costs. What I fear it is doing, instead, is bailing out the banking system and so trying to reignite the credit cycle, with the consequent dangers of a flight from the dollar, considerably higher inflation and much more bad lending ahead.

Which leaves us with the third concern, over the timing of the rate cuts.  The first of them, of 75 basis points, was the largest single cut in a quarter century.  The fact that it came from an out-of-schedule meeting makes it almost unprecedented.  When we add the fact that the world was in the middle of a broad share sell-off – exacerbated, it turns out, by the winding out of US$75 billion of bets by Societe General – it definitely has the appearance of a panicked decision.  Adding the 50bp cut eight days later made for an enormous 1.25 percentage point drop in rates in a fraction over a week.

So what’s my take?  Well …

1) The Fed is not as independent as central banks in other countries are.  Greg Mankiw may not like it, but the fact is that both Congress and the Whitehouse actively seek to influence monetary policy in the United States.  This photograph of Ben Bernanke (chairman of the US Federal Reserve), Christopher Dodd (chairman of the US senate’s banking committee) and Hank Paulson (US Treasury secretary) from mid-August 2007 is typical:

bernanke_dodd_paulson.jpg

As Martin Wolf noted at the time:

This showed Mr Bernanke as a performer in a political circus. Mr Dodd even announced Mr Bernanke’s policies: the latter had, said Mr Dodd, told him he would use “all the tools ” at his disposal to contain market turmoil and prevent it from damaging the economy. The Fed has its orders: save Main Street and rescue Wall Street.  Such panic-driven politicisation is almost certain to lead to both overreaction and the creation of bad precedents.

2) The Fed is mandated to keep both inflation and unemployment low.  By comparison, the other major central banks are only required to focus on inflation.  When they do look at unemployment, it plays lexicographic second fiddle to keeping inflation in check.  At the Fed, they are compelled to take unemployment into account at the same time as looking at inflation.

3) The banking and finance system is central to the real economy.  Without a ready supply of credit to worthy and profitable ventures, economic growth would slow dramatically, if not cease altogether.  Although it creates a clear moral hazard when bankers’ pay is not aligned with real economic outcomes, this – combined with the first two points – implies that the so-called “Bernanke put” is probably, to some extent, real.

4) The latest GDP numbers and IMF forecasts were released in between the two rate cuts.   I have nothing to back this up, but I wouldn’t be the least bit surprised to discover that the Fed gets (or got) a preview of those numbers.  Seeing that markets were already tanking, knowing that the reports would send them tumbling further, perhaps believing that they might already be in a recession, almost certainly fearing that the negative news, if released before the Fed had acted, might send risk premia skywards again and recognising that what they needed was a massive cut of at least 100bp, perhaps the Fed concluded that the best policy was to split the cut over two meeting, making a smaller but still unusually large cut before the reports were released to ensure that they didn’t trigger more credit-crunchiness and a second one after in notional “response.”

My point is this:  Which would seem more like a panicked response?  The way that things did pan out, or a global stock market melt-down that took several more days to settle, followed by the markets being hit with surprisingly negative reports from the IMF on the global economy and the BEA on the US economy, and then a 125 b.p. drop in a single sitting by the Fed?

From marriage to trade with China

In another great example of bouncing topics around in the often-academic blogs, we have this:

Betsey Stevenson and Justin Wolfers wrote an article for Cato Unbound: “Marriage and the Market“. Here is a brief summary of their idea (the exact snippet chosen is stolen directly from Arnold Kling):

So what drives modern marriage? We believe that the answer lies in a shift from the family as a forum for shared production, to shared consumption…the key today is consumption complementarities – activities that are not only enjoyable, but are more enjoyable when shared with a spouse. We call this new model of sharing our lives “hedonic marriage”.

…Hedonic marriage is different from productive marriage. In a world of specialization, the old adage was that “opposites attract,” and it made sense for husband and wife to have different interests in different spheres of life. Today, it is more important that we share similar values, enjoy similar activities, and find each other intellectually stimulating. Hedonic marriage leads people to be more likely to marry someone of their similar age, educational background, and even occupation. As likes are increasingly marrying likes, it isn’t surprising that we see increasing political pressure to expand marriage to same-sex couples.

…the high divorce rates among those marrying in the 1970s reflected a transition, as many married the right partner for the old specialization model of marriage, only to find that pairing hopelessly inadequate in the modern hedonic marriage.

It produced a flurry of responses and reactions, but the chain I want to follow is this one:

Which finally brings me to why I wrote this entry. I love this sentence from Tyler:

Symbolic goods usually have marginal values higher than their marginal costs of production; Americans for instance love the idea of their flags but the cloth is pretty cheap, especially if it comes from China.

Brilliant. 🙂