Economist's View

"Not All Bubbles Present a Risk to the Economy"

Frederic Mishkin says there's no reason to worry that a new bubble is inflating:

Not all bubbles present a risk to the economy, by Frederic Mishkin, Commentary, Financial Times: There is increasing concern that we may be experiencing another round of asset-price bubbles that could pose great danger to the economy. Does this danger provide a case for the US Federal Reserve to exit from its zero-interest-rate policy sooner rather than later, as many commentators have suggested? The answer is no. ...

Asset-price bubbles can be separated into two categories. The first and dangerous category is ... “a credit boom bubble”, in which exuberant expectations about economic prospects or structural changes in financial markets lead to a credit boom. The resulting increased demand for some assets raises their price and, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more, creating a positive feedback loop. This feedback loop involves increasing leverage, further easing of credit standards, then even higher leverage, and the cycle continues.

Eventually, the bubble bursts and asset prices collapse, leading to a reversal of the feedback loop. ... Indeed, this is what the recent crisis has been all about.

The second category of bubble, what I call the “pure irrational exuberance bubble”, is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fueled by a feedback loop between bank lending and rising equity values... This is one of the key reasons that the bursting of the bubble was followed by a relatively mild recession. ...

Because the second category of bubble does not present the same dangers ... as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker. ... Nonetheless, if a bubble poses a sufficient danger to the economy as credit boom bubbles do, there might be a case for monetary policy to step in. ...

But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy.

Tightening monetary policy in the US or Europe to restrain a possible bubble makes no sense... At this critical juncture, the Fed must not take its eye off the ball by focusing on possible asset-price bubbles that are not of the dangerous, credit boom variety.

I've mostly heard the worries expressed in terms of inflation. I think the risks are asymmetric. Raising rates too soon and sending the economy tumbling back into a recession is much more costly than an outbreak of inflation that persists until the Fed can bring it back under control.

"A New Approach to Gauging Inflation Expectations"

Good news for those worried about inflation: A new measure of inflation expectations indicates that "longer-term inflation expectations remain near historic lows, in the neighborhood of 2 percent":

A New Approach to Gauging Inflation Expectations, by Joseph G. Haubrich, Economic Commentary, FRB Cleveland: This Economic Commentary explains a relatively new method of uncovering inflation expectations, real interest rates, and an inflation-risk premium. It provides estimates of expected inflation from one month to 30 years, an estimate of the inflation-risk premium, and a measure of real interest rates, particularly a short (one-month) rate, which is not readily available from the TIPS market. Calculations using the method suggest that longer-term inflation expectations remain near historic lows. Furthermore, the inflation-risk premium is also low, which in the model means that inflation is not expected to deviate far from expectations.

Policymakers at the Federal Reserve and other central banks continually face the “Goldilocks” question—is monetary policy too tight, too loose, or just right? It would help if the central bank knew what real interest rates and expected inflation actually were, but these are not easy to observe. Visible indicators of these factors, such as Treasury inflation-protected securities (TIPS), survey measures of expected inflation, and nominal interest rates, are useful, but none of them alone quite tells the whole story. Nominal interest rates change with both real rates and expected inflation; survey measures ask about only a few horizons, and measures of inflation expectations coming from inflation-protected securities conflate expectations with risk premia. Uncovering a purer measure is possible, but it takes a careful combination of the available data and the application of economic theory.

This Economic Commentary explains a relatively new method of uncovering inflation expectations and real interest rates and describes what light those numbers can shed on the current status of the U.S. economy.

People’s expectation of inflation enters into nearly every economic decision they make. It enters into large decisions: whether they can afford a mortgage payment on a new house, whether they strike for higher wages, how they invest their retirement funds. It also enters into the smaller decisions, that, in the aggregate, affect the entire economy: whether they wait for the milk to go on sale or buy it before the price goes up.

Real interest rates also play a key role in many economic decisions. When businesses invest—or don’t—in plants and equipment, when families buy—or don’t—a new car or dishwasher, they are making judgments about the real return on the object and the real cost of borrowing. As such, real interest rates can be an important guide to monetary policy. As Alan Greenspan once explained,¹ keeping the real rate around its equilibrium level (which is determined by economic and financial conditions), has a “stabilizing effect on the economy” and it helps direct production “toward its long-term potential.”

What's Wrong with Modern Macroeconomics?

The travel references are referring to this. (My first trip to Germany - I set up a bunch of posts before I left - through Sunday just in case - but will add what I can.)

Brad DeLong: Slouching Toward Sanity

Brad DeLong says government action during the crisis may have prevented another Great Depression:

Slouching Toward Sanity, by J. Bradford DeLong, Commentary, Project Syndicate: In America today ... the Republican congressional caucus is just saying no: no to short-term deficit spending to put people to work, no to supporting the banking system, and no to increased government oversight or ownership of financial entities. And the banks themselves are back to business-as-usual: anxious to block any financial-sector reform and trusting congressmen eager for campaign contributions to delay and disrupt the legislative process.

I do not claim that policy in recent years has been ideal. If I had been running things 13 months ago, the United States Treasury and Federal Reserve would have let Lehman and AIG fail – but I would have discounted their debt for cash at face value, provided that the debt also came with sufficient equity warrants. That would have preserved the functioning of the system while severely punishing the banking and shadow-banking systems’ equity holders...

If I had been running things 19 months ago, I would have nationalized Fannie Mae and Freddie Mac and ... shifted monetary and financial policy from targeting the Federal Funds rate to targeting the price of mortgages. Ever since 1825, the purpose of monetary policy in a crisis has been to support asset prices to prevent the financial markets from sending to the real economy the price signal that it is time for mass unemployment. Nationalizing Fannie and Freddie, and using them to peg the price of mortgages, would have been the cleanest and easiest way to accomplish that.

Nevertheless, policy over the past two and a half years has been good. A fundamental shock bigger than the one in 1929-1930 hit a financial system that was much more vulnerable to shocks than was the case back then. Despite this, unemployment will peak at around 10%, rather than at 24%, as it did ... during the Great Depression... Nor will we have a lost decade of economic stagnation, as Japan did in the 1990’s. ...

It is worth stepping back and asking: What would the world economy look like today if policymakers had acceded to the populist demand of no support to the bankers? What would the world economy look like today if Congressional Republican opposition to the Troubled Asset Relief Program program and additional deficit spending to stimulate recovery had won the day?

The only natural historical analogy is the Great Depression... That is the only time when (a) a financial crisis caused a widespread, lengthy, and prolonged reinforcing chain of bank failures, and (b) the government neither intervened nor passed the baton to a consortium of private banks to support the system as a whole.

It is now 19 months after Bear Stearns failed ... and industrial production stands 14% below its peak in 2007. By contrast, 19 months after the Bank of the United States ... failed on December 11, 1930 ... industrial production ... was 54% below its 1929 peak.

Opponents of recent economic policy rebel against the hypothesis that an absence of government intervention and support could produce an economic decline of that magnitude today. After all, modern economies are stable and stubborn things. Market systems are resilient... A 54% fall in industrial production between its 2007 peak and today is inconceivable – isn’t it? ...

The problem, though, is that all the theoretical reasons to think that depressions as deep as the Great Depression simply do not happen to market economies applied just as well to the 1930’s as they do to today.

But it did happen. And it could have happened again.

[Traveling: Preset to post automatically.]

Woodford on Financial Markets

Part of an interview of Michael Woodford:

Q&A: Economist Woodford on Fed and Rate Expectations, RTE: ...Given the importance of financial stability for the wider economy, do you think financial stability should play a greater or explicit role in the Federal Reserve’s policy strategy?

Woodford: No doubt, the Fed should give greater attention to financial stability than it did in the past. One should try and set up a framework to safeguard financial stability, and it may very well be that ... central banks should play a key role. But, ideally, one would be scrutinizing the risks developing and adjust capital requirements accordingly, rather than using monetary policy to respond to these risks. You’ve got to realize that pretending you can do everything with one tool means you won’t do any of them too well.

Should the Fed be more reactive — leaning against the wind -toward sharp moves in asset prices, such as house prices and equities? Should the Fed include a broader range of asset prices in its policy strategy?

Woodford: I’m not too sympathetic of that way of putting things. Using monetary policy to prevent certain moves in asset prices wouldn’t be a terribly effective tool. And to the extent that it would be effective, it’d involve important costs for the rest of the economy. It’d be particularly bad for the Fed to be saying “we have a view on where asset prices should be, and we’re going to get them there by using monetary policy.” Instead, the focus of the Fed’s investigation should be on what kind of risks financial institutions get themselves into — not on asset prices as such.

The Fed has downgraded the role of money and credit aggregates in its policy strategy. Given the more recent developments, do you think it’s now time to reconsider, or reverse the move?

Woodford: The issue that deserves more attention is monitoring risks to financial stability and identifying possible systemic risks. Unfortunately, traditional monetary and credit statistics aren’t that closely related to the things you really ought to be measuring. For example, lending by non-bank entities has played an important role in the recent real-estate euphoria. Given the emergence of new kinds of institutions and financing arrangements, you cannot simply revert to the old statistics people used to look at decades ago. There should be more research on understanding which measures are in fact the valuable indicators.

The last section is important. Many people have said that we cannot tell when a bubble is inflating (and thus when risks are increasing), but how hard have we actually tried? Have we seriously looked at data on, to name just one element of what I have in mind, leverage cycles? Do we know how leverage cycles relate to crises, that kind of knowledge that years of hard work by a variety of researchers brings about? Some people likely know the answer to this, or at least have some idea about this, but it's not data you'll find in standard sources such as FRED. As another example, what about measures and data on the degree of financial market connectedness? This can be measured in principle, but little effort has been devoted to doing so. Even traditional measures such as P/E ratios and Q-ratios haven't received the attention they deserve.

Until we dig in and try seriously to develop new empirical measurements that can monitor and identify risks, measures intended to inform us when risks are increasing to dangerous levels, we won't know if we can identify bubbles or not. I understand that financial theory says such predictions are impossible, and this has led people to shy away from such work, but that result relies upon assumptions that may not be true. The crisis has revealed the shaky foundation those models rest upon, so it's no  longer an excuse for not trying, or, as in the past, for dismissing work along these lines as unimportant and a waste of time.

"Fed Chief Cites Trade Imbalances’ Role in Crisis"

Ben Bernanke:

Fed Chief Cites Trade Imbalances’ Role in Crisis, by Edmund Andrews, NY Times: Ben S. Bernanke, the chairman of the Federal Reserve, said on Monday that global trade imbalances played a central role in the global economic crisis and warned that the both the United States and fast-growing Asian nations needed to do more to prevent them from recurring.

“We were smug,” Mr. Bernanke said of the United States, saying the American financial regulatory system was “inadequate” at managing the immense inflows of cheap money from China and other countries that had huge trade surpluses.

Though the Fed chairman acknowledged that trade imbalances have declined sharply as a result of the crisis, mainly because trade itself plunged, he warned that American foreign indebtedness will aggravate the imbalances once again unless the United States reduces its soaring federal budget deficit.

“The United States must increase its national saving rate,” he said. “The most effective way to accomplish this goal is by establishing a sustainable fiscal trajectory, anchored by a clear commitment to substantially reduce federal deficits over time.” ...

By the same token, he said, Asian countries needed to rely less on exports and more on their consumption at home for their economic growth. One way to increase Asian household consumption, he said, would be for countries like China to increase social insurance programs and reduced the uncertainty that currently hangs over many consumers. ...

With the Asian economy expanding at an annualized rate of 9 percent in the second quarter of this year, and China’s economy expanding at rates of more than 10 percent, Mr. Bernanke said, “Asia appears to be leading the global recovery.”

But the Fed chairman warned that the United States-led crisis was fueled in large part by huge inflows of cheap money to the United States from countries like China that were trying to recycle dollars from their huge trade surpluses.

The Fed chairman noted that global trade and financial imbalances have narrowed considerably since the crisis began... But he cautioned that the imbalances could widen out again as economic growth revives. While the United States has to tighten its belt by saving more and consuming less, China and other Asian countries need to increase their consumer spending in order to promote faster domestic economic growth.

Mr. Bernanke avoided what was in many ways the elephant in the room: the value of the United States dollar. The dollar has dropped sharply in recent weeks against the euro and the Japanese yen, which has helped increase American exports by making them cheaper in some foreign markets. But the dollar has not budged in more than a year against China’s renmimbi...

There were three important factors in the crisis, global imbalances (Bernanke's savings glut), low interest rate policy by the Fed, and the failure of markets and regulators to provide the checks and balances necessary to prevent the crisis from occurring. The global imbalances combined with the Fed's low interest rate policy led to the massive build up of global liquidity looking for a safe, high return home, and the market and regulatory failures allowed the extra liquidity and the false promise of high, safe returns to concentrate risk in the mortgage markets.

Bernanke focuses on two of these causes of the crisis, global imbalances and regulatory problems (market failures get less attention), but he does not focus on the Fed's role in the crisis at all. So let me say that I hope the Fed is more willing to consider popping bubbles as they inflate than it has been in the past. But that is not the main point I want to make.

The crisis, according to Bernanke, occurred when the excess global liquidity overwhelmed financial markets -- it was too much for either regulators and markets to handle. Think of a hurricane hitting a city that is so strong and powerful that it overwhelms levees and other flood/damage control mechanisms. That's essentially Bernanke's explanation, the shock was too big for the mechanisms we had in place to control the damage. One solution to the hurricane problem is to hope that such large shocks don't happen again and simply rebuild the same defenses as before, and another response is to recognize that such shocks will occur every so often and to build the stronger defensive measures needed to get ready.

Bernanke acknowledges that the defenses, i.e. the regulation of financial markets, need to be strengthened, but he seems to place a lot of emphasis on reducing the size of future shocks (reduce the budget deficit, have Asian countries consume more to reduce imbalances, etc.). I think that is fine, we should reduce the danger as much as we can, but we need to accept that global imbalances are possible, that a shock of this magnitude could and probably will happen again at some point in the future, and we need to make sure that markets don't fail like they did this time (i.e. we need to fix the bad incentives in these markets). But more importantly, we need to strengthen our regulatory defenses in anticipation of the next big shock. If it's fair to blame the government for not having levees, etc. ready for Katrina, if we insist that the defenses need to be strengthened going forward, then the same argument can be made in financial markets. Despite our best efforts to reduce the chances that a large shock will occur through deficit reduction and higher domestic saving rates, we should expect that global imbalances will rear their head again at some point, and the system cannot be overwhelmed again like it was this time.

For that reason, I'm a bit disappointed in Bernanke's willingness to point fingers at external causes and say other countries must change their consumption habits, or to blame budget deficits, at a time when financial regulation is coming onto the legislative agenda (though he didn't say anything about the exchange rate). Those are important problems and I don't mean to dismiss them, but right now financial regulation is being considered by congress, and it's essential that we get the regulations in place that can withstand the next big shock. Blaming external forces for the crisis will make it easier for opponents of regulation to blame China and other countries, and that gives legislators an excuse to give in to pressure (e.g. campaign contributions) from the financial industry to go soft on regulatory changes.

Update: Paul Krugman comments on Bernanke's remarks: America’s Chinese disease (not quite what you think).

"Reviewing the Recession: Was Monetary Policy to Blame?"

David Altig says "it is yet far from clear that the financial crisis can be explained by a misstep in the setting of the federal funds rate" due to a failure to base monetary policy rules on models that include a well developed credit channel:

Reviewing the recession: Was monetary policy to blame?, by David Altig: In a recent speech given at the University of South Alabama, Federal Reserve Bank of Atlanta President Dennis Lockhart added his voice to what is now the general consensus: "I agree with all who are declaring that a technical recovery is under way."

There is still much work to be done, of course, not least the continuing examination of just what led to the recession and how a repeat performance can be avoided. One theme of this examination appeared in last week's Financial Times:

"It is certainly true that the most recent bubble, its bursting and the Fed's actions in the aftermath have inspired existing critics and recruited new ones. The first charge is that interest rates under Alan Greenspan, [current Fed Chairman Ben] Bernanke's predecessor, were kept too low for too long, contributing to a bubble of easy credit."

Here is an exercise that that I find intriguing. Suppose we try to estimate, as closely as we can, the actual interest rate decisions of the Federal Open Market Committee (FOMC) over the period spanning the beginning of Greenspan's tenure to the present. It turns out that by using an approach based not only on measures of inflation and actual output relative to potential but also on the lagged fed funds rate, you can actually get pretty darn close to statistically describing what the FOMC did:

I'm going to resist the temptation to call this approach a "Taylor rule." The estimating "rule" used here does in fact include realizations of inflation and a measure of the output gap (that is, a measure of how different gross domestic product is from its potential). These are the essential ingredients of the Taylor rule, but not the source of the close fit evident in the chart above. Over the period covered by the chart, you could have done a pretty good job mimicking the actual federal funds rate outcomes in any given month using knowledge of the previous month's rate. (If you are interested in the details of the estimating rule, you can find them here.)

The interpretation of the tendency for today's federal funds rate to generally follow yesterday's rate—sometimes referred to as interest rate smoothing—is controversial. Glenn Rudebusch (from the Federal Reserve Bank of San Francisco) explains:

"Many interpret estimated monetary policy rules as suggesting that central banks conduct very sluggish partial adjustment of short-term policy interest rates. In contrast, others argue that this appearance of policy inertia is an illusion and simply reflects the spurious omission of important persistent influences on the actual setting of policy."

Rudebusch is decidedly in the second camp, but for our purposes here the exact interpretation may not be that important. Though I am glossing over some not insignificant caveats—such as the difference between final data and the information the FOMC had to react to in real time—the chart above suggests that whatever the underlying structure of policy decisions, after the fact the FOMC appears to have behaved in an extraordinarily consistent way over the period extending from the late 1980s. This observation, in turn, suggests to me that there was nothing all that unusual about monetary policy in 2003 once you account for the state of the economy.

Which leads me to my main point on the chart above: If you are of the opinion that interest rate policy was good through the late 1980s and 1990s, then there seems to be a good case the FOMC was just sticking with "proven" success as it set interest rates through the dawning of the new millennium.

There is, of course, the possibility that the pattern of the funds rate depicted in the chart above was incomplete all along in the sense that whatever variables are explicit and implicit in the estimated rule, they did not include information to which the FOMC should have responded. In calmer times, the story would go, not including potentially pertinent information was not much of a problem. Eventually the missing-data chickens could come home to roost. The prime omitted variable suspect would, of course, be some sort of asset prices.

Scratch any gathering of macroeconomists these days and out will bleed a steady stream directed at incorporating credit and financial market activity into thinking about the aggregate economy. The necessity of proceeding with that work was emphasized by no less an authority than Don Kohn, vice chairman of the Federal Reserve Board of Governors, speaking at just such a gathering of macroeconomists last week:

"It is fair to say, however, that the core macroeconomic modeling framework used at the Federal Reserve and other central banks around the world has included, at best, only a limited role for the balance sheets of households and firms, credit provision, and financial intermediation. The features suggested by the literature on the role of credit in the transmission of policy have not yet become prominent ingredients in models used at central banks or in much academic research."

I will admit that economists were not exactly ahead of the curve with this agenda, but prior to 2007 it was not at all clear that detailed descriptions of how funds moved from lenders to borrowers or how short-term interest rates are transmitted to longer-term interest rates and capital accumulation decisions were crucial to getting monetary policy right. Models without such detail tended to deliver policy decisions not far from the sort depicted above, and, as I noted, they seemed to be working quite well in terms of macroeconomic outcomes.

Thus far, one of the lessons from models in which financial intermediation is taken seriously is that interest rate spreads or stock prices or other asset prices do become part of the policy rate recipe. Your response might well be something along the lines of "duh." You are entitled to that opinion, and I won't push back too hard. But it is yet far from clear that the financial crisis can be explained by a misstep in the setting of the federal funds rate caused by the failure to make whatever adjustments might have been indicated by the inclusion of pertinent financial variables in implicit rate-setting rules of thumb. Furthermore, early versions of research I have seen that combines capital regulation policy and interest rate policy suggest that the macroeconomic consequences of getting the former wrong may be much greater than the consequences of getting the latter wrong. To me, that conclusion has the ring of truth.

I have advocated targeting a price index that includes asset prices as part of the policy rule, but I share the view that this likely would not have been enough by itself to stop the crisis from occurring. Targeting a broader price index might have tempered the downturn some, or even quite a bit -- it sounds like I am more optimistic than David along about how well this might work -- but changes in regulation must be an essential component of reform if we are going to prevent problems from reoccurring in the future.

However, I think that not having models with detailed descriptions of the credit transmission mechanism was costly. The New Keynesian model that is used to inform monetary policy decisions relies upon wage and price rigidities to explain how changes in monetary policy and/or financial market conditions are transmitted to the broader economy. Thus, the price/wage rigidity transmission channels must serve as a proxy for the effects that work through credit (or other) channels, and it is not evident to me that they are adequate proxies for this task (e.g. what would a government spending multiplier look like within a model that had a richer set of connections between financial markets and the real economy?). Whether or not having such models would have prevented the crisis is an open question, and I won't push back too hard against David's view of this, but not having such models once this crisis hit did, I think, make it more difficult for us to evaluate the appropriate policy response. Not having the models we needed led to uncertainty from policymakers that showed up in the seemingly, if not actual ad hoc and trial and error nature of many of the policy responses.

The Bank Lending Channel

Many economists, Ben Bernanke foremost among them, have argued that monetary policy has effects that are independent of the traditional interest rate channel (where an increase in the money supply lowers the real interest rate and induces more investment and consumption spending). The alternative models include a "credit channel" for monetary policy, which is often further divided into financial accelerator models and bank lending channel models.

One class of models within the bank lending channel branch relies upon a difference in the availability of credit for large and small firms. If smaller businesses have fewer sources of credit than large firms (who can issue bonds, stocks, commercial paper, etc.), then a credit shock induced by policy or some other factor will have an asymmetric negative effect on the activity of large and small firms. Since smaller firms have trouble getting credit from non-bank sources, a disruption in bank credit can cause them to contract their activities much more than large firms. (If all firms have perfect substitutes for bank credit, e.g. borrowing from foreigners on the same terms, then monetary policy cannot affect real output through the bank lending channel. The point of this research is that some firms do not have close substitutes for bank credit, and therefore monetary policy can have real effects.) According to this, there's some evidence that these effects are operable:

Credit Tightens for Small Businesses, NY Times: Many small and midsize American businesses are still struggling to secure bank loans, impeding their expansion plans and constraining overall economic growth...

Bankers worry about the extent of losses on credit card businesses as high unemployment sends cardholders into trouble. They are also reckoning with anticipated failures in commercial real estate. Until the scope of these losses is known, many lenders are inclined to hang on to their dollars rather than risk them on loans to businesses in a weak economy...

Bankers acknowledge that loans are harder to secure than in years past, but they say this attests to the weakness of many borrowers rather than a reluctance to lend.

“Banks want to lend money,” said Raymond P. Davis, chief executive of Umpqua Bank, a regional lender based in Portland, Ore. “The problem is the effect that the recession is still having on us. Some of these businesses are still trying to come out of it. For them to go to a bank, if they are showing weak performance, it is harder to borrow.”

As the financial crisis has largely eased in recent months, big companies have found credit increasingly abundant, with bond issues sharply higher.

But for ... many smaller companies,... borrowing remains tough. ...

Recall this graph posted here not too long ago (discussed further at the source):

It may be hard to see at first glance, but the graph shows the "disproportionate effect the recession has had on very small businesses." In 2001, only 9% of the job losses came from small businesses, while in the current recession - where credit problems are a much larger factor - small business accounts for 45% of lost jobs. Part of the discussion of the graph notes this comment from William Dudley, the president of the Federal Reserve Bank of New York:

In a speech yesterday,... he said:

"For small business borrowers, there are three problems. First, the fundamentals of their businesses have often deteriorated because of the length and severity of the recession—making many less creditworthy. Second, some sources of funding for small businesses—credit card borrowing and home equity loans—have dried up as banks have responded to rising credit losses in these areas by tightening credit standards. Third, small businesses have few alternative sources of funds. They are too small to borrow in the capital markets and the Small Business Administration programs are not large enough to accommodate more than a small fraction of the demand from this sector."

It will take more careful analysis to make the case that the bank lending channel has been important in this recession, but it is suggestive.

Paul Krugman: Misguided Monetary Mentalities

We need to avoid thinking and acting in ways that got us into trouble in the past:

Misguided Monetary Mentalities, by Paul Krugman, Commentary, NY Times: One lesson from the Great Depression is that you should never underestimate the destructive power of bad ideas. And some of the bad ideas that helped cause the Depression have, alas, proved all too durable: in modified form, they continue to influence economic debate today.

What ideas am I talking about? The economic historian Peter Temin has argued that a key cause of the Depression was ... the “gold-standard mentality.” By this he means not just belief in the sacred importance of maintaining the gold value of one’s currency, but a set of associated attitudes: obsessive fear of inflation even in the face of deflation; opposition to easy credit, even when the economy desperately needs it, on the grounds that it would be somehow corrupting; assertions that even if the government can create jobs it shouldn’t, because this would only be an “artificial” recovery.

In the early 1930s this mentality led governments to raise interest rates and slash spending, despite mass unemployment, in an attempt to defend their gold reserves. And even when countries went off gold, the prevailing mentality made them reluctant to cut rates and create jobs.

But we’re past all that now. Or are we? ...[A] modern version of the gold standard mentality ... could undermine our chances for full recovery.

Consider first the current uproar over the declining international value of the dollar. The truth is that the falling dollar is good news. For one thing, it’s mainly the result of rising confidence: the dollar rose ... as panicked investors sought safe haven in America, and it’s falling again now that the fear is subsiding. And a lower dollar is good for U.S. exporters...

But if you get your opinions from, say, The Wall Street Journal’s editorial page, you’re told that the falling dollar is a ... sign that the world is losing faith in America (and especially, of course, in President Obama). ...

And ... there are worrying signs of a misguided monetary mentality within the Federal Reserve system itself. In recent weeks there have been a number of ... Fed officials ... calling for an early return to tighter money... What’s ... extraordinary ... is the idea that raising rates would make sense any time soon. After all, the unemployment rate is a horrifying 9.8 percent and still rising, while inflation is running well below the Fed’s long-term target. This suggests that the Fed should be in no hurry to tighten — in fact, standard policy rules ... suggest that interest rates should be left on hold for the next two years or more, or until the unemployment rate has fallen to around 7 percent.

Yet some Fed officials want to pull the trigger on rates much sooner. To avoid a “Great Inflation,” says Charles Plosser of the Philadelphia Fed, “we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels.” Jeffrey Lacker of the Richmond Fed says that rates may need to rise even if “the unemployment rate hasn’t started falling yet.”

I don’t know what analysis lies behind these itchy trigger fingers. But it probably isn’t about analysis, anyway — it’s about mentality, the sense that central banks are supposed to act tough, not provide easy credit.

And it’s crucial that we don’t let this mentality guide policy. We do seem to have avoided a second Great Depression. But giving in to a modern version of our grandfathers’ prejudices would be a very good way to ensure the next worst thing: a prolonged era of sluggish growth and very high unemployment.

Fed Policy in the Financial Crisis: Arresting the Adverse Feedback Loop

Has Federal Reserve policy been able to break the "adverse feedback loop"?:

Fed Policy in the Financial Crisis: Arresting the Adverse Feedback Loop by Danielle DiMartino Booth and Jessica J. Renier, Economic Letter, Vol. 4, No. 7, September 2009, Federal Reserve Bank of Dallas: An adverse feedback loop takes hold when a weakening financial system and a slowing economy feed off each other. A crisis or shock curtails lending, hobbling the real economy; the more production and employment falter, the more lending contracts, causing further harm to the economy. The result is a downward spiral of business and financial activity.

The Federal Open Market Committee (FOMC) warned of the danger in late January 2008, when few analysts recognized that a recession had begun the previous month. It noted “the especially worrisome possibility of an adverse feedback loop; that is, a situation in which a tightening of credit conditions could depress investment and consumer spending, which, in turn, could feed back to a further tightening of credit conditions.”[1]

The financial crisis validated the FOMC’s concern, igniting what has become the worst post-World War II economic downturn in terms of length and, by some measures, depth and breadth. Housing market troubles began in 2006 and deepened well into 2009. As the economy sank into recession, an October 2008 Fed survey found that two-thirds of banks had tightened standards for the highest-quality residential mortgages and over three-quarters had reined in business lending. The credit contraction sent spending down and unemployment up, exacerbating threats to the financial sector and dimming prospects for stability in housing.

Arresting the adverse feedback loop could prove to be the seminal challenge of early 21st century monetary policymaking. Since sounding the alarm in January 2008, the Fed has taken a series of actions—many unprecedented—to prevent additional damage to financial markets and restore lending activity. These policies have had some success in loosening the grip of the adverse feedback loop and may have finally positioned the economy for growth. Still, doubts linger. The risk remains that the actions may prove insufficient to put the economy on a clear path to rising employment and stable prices.

Fed Watch: Hawkishness Dominates

Continuing with the same theme, but with monetary rather than fiscal policy, Tim Duy is worried about unwarranted hawkishness:

Hawkishness Dominates, by Tim Duy: As I await the employment report, I am reflecting on the flow of information over the past week and find myself somewhat dismayed by the apparent policy implications. The spate of FedSpeak in recent days leaves one with the uneasy feeling that monetary policymakers are more willing to use unconventional monetary policy to support Wall Street than Main Street. The most hawkish appear eager to normalize policy at the earliest opportunity possible, and even the dovish, grasping onto green shoots, appear to think they have done enough to support recovery. It is as if the FOMC has concluded that the risks are now entirely one-sided toward inflation. To be sure, Bernanke & Co. have shifted direction often during the past two years. But the FOMC looks to be developing something of a blind spot with regard to downside risks to the economy, suggesting that even if the economy stagnates in a jobless recovery, the bar to further easing is very high.

Governor Kevin Warsh fired the shot across the bow last week, first with a Wall Street Journal op-ed, followed by a speech that included the key paragraphs:

Ultimately, when the decision is made to remove policy accommodation further, prudent risk management may prescribe that it be accomplished with greater swiftness than is modern central bank custom. The Federal Reserve acted preemptively in providing monetary stimulus, especially in early 2008 when the economy appeared on an uneven, uncertain trajectory. If the economy were to turn up smartly and durably, policy might need to be unwound with the resolve equal to that in the accommodation phase. That is, the speed and force of the action ahead may bear some corresponding symmetry to the path that preceded it. Of course, if the economy remains mired in weak economic conditions, and inflation and inflation expectation measures are firmly anchored, then policy could remain highly accommodative.

"Whatever it takes" is said by some to be the maxim that marked the battle of the last year. But, it cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns. If "whatever it takes" was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Fed's institutional credibility. The asymmetric application of policy ultimately could cause the innovative policy approaches introduced in the past couple of years to lose their standing as valuable additions in the arsenal of central bankers.

While Warsh does note that weak economic conditions would defer tightening, the message is clear: we are looking to tighten, and will do so aggressively when economic activity firms. Moreover, we will do so preemptively, which means we are looking for opportunities prior to the emergence of very solid data.

Note one of the concerns identified by Warsh:

In my view, if policymakers insist on waiting until the level of real activity has plainly and substantially returned to normal--and the economy has returned to self-sustaining trend growth--they will almost certainly have waited too long. A complication is the large volume of banking system reserves created by the nontraditional policy responses. There is a risk, of much debated magnitude, that the unusually high level of reserves, along with substantial liquid assets of the banking system, could fuel an unanticipated, excessive surge in lending. Predicting the conversion of excess reserves into credit is more difficult to judge due to the changes in the credit channel.

Are we really worried about a lending explosion by itself, or that the regulatory environment remains so weak that financial institutions will quickly repeat the experience of this decade's debt bubble? Considering the question always draws me back to this chart, which for me epitomizes the difference between the 1990s and the 2000s:

The 1990s saw a remarkable period of sustained, high levels of investment in equipment and software. In contrast, a sustained period of very low interest rates during this decade was barely able to coerce firms to invest in the high single digits. That, in my mind, is a critical problem, reflecting low expected returns to capital investment. In effect, the policy error might not have been low rates. Indeed, rates do not look to have been low enough to stimulate sufficient investment demand to absorb the productive capacity of the nation, the classic Keynesian problem:

This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.

Moreover the richer the community, the wider will tend to be the gap between its actual and its potential production; and therefore the more obvious and outrageous the defects of the economic system. For a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members. If in a potentially wealthy community the inducement to invest is weak, then, in spite of its potential wealth, the working of the principle of effective demand will compel it to reduce its actual output, until, in spite of its potential wealth, it has become so poor that its surplus over its consumption is sufficiently diminished to correspond to the weakness of the inducement to invest.

But worse still. Not only is the marginal propensity to consume weaker in a wealthy community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate....

With the primary build out of the internet backbone complete, the US appeared to experience a dearth of traditional investment opportunities (I suspect that the need to expand production domestically was made moot by an international financial arrangement that favored the establishment of productive capacity overseas), and, like water flowing downhill, capital was thus allocated this decade to residential investment, which, we now know was more about consumption than investment, and the resulting economic activity was anemic by historical standards.

This line of argument leads one to believe that withdrawing monetary stimulus would be a significant policy error, especially if investment growth remains constrained as we saw this decade. In fact, it would lend additional credence to reports that the Fed needs to do much, much more - a massive, unsterilized expansion of the balance sheet - should they even hope to stimulate sufficient investment demand to absorb underutilized labor. Instead, FOMC members appear to be concerned that stimulative policy will be the root cause of the next financial crisis. That, however, appears to me to confuse monetary with regulatory policy. The former should speak to inducement to invest, while the latter speaks to protecting against significant misallocations of capital.

Following the Warsh speech, Vice Chair Donald Kohn looked to tamp down expectations of an imminent rise in rates:

Although economic conditions have apparently begun to improve--partly in response to the extraordinary steps the Federal Reserve and other authorities have taken--resource utilization is quite low, inflation is subdued, and continuing restraints on credit are likely to constrain the speed of recovery. For that reason, as the FOMC stated last week, exceptionally low interest rates are likely to be warranted for an extended period. Given the highly unusual economic and financial circumstances, judging when the time is appropriate to remove policy accommodation, and then calibrating that removal, will be challenging. Still, we need to be ready to take the necessary actions when the time comes, and we will be.

Still, like Warsh, Kohn looks determined to find an opportunity to remove accommodation. This despite expected high rates of unemployment. From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke said U.S. economic growth next year probably won’t be strong enough to “substantially” bring down the jobless rate, which may remain above 9 percent at the end of 2010.

“Most forecasters including the Fed are currently looking at growth in 2010, but not growth so rapid as to substantially lower the unemployment rate,” Bernanke said in response to questions at a House Financial Services Committee hearing today in Washington. Growth of 3 percent means the rate would “still probably be above 9 percent by the end of 2010,” Bernanke said.

Interesting how the Fed is encouraging expectations of policy withdrawal even though unemployment rates will remain unacceptably high through 2010. And, if above 9 percent at the end of next year, certainly unacceptably high during 2011 as well. Richmond Federal Reserve President Jeffrey Lacker even goes one step further in a Bloomberg interview:

The Federal Reserve will need to raise interest rates when the economic recovery is “firmly” in place, even if unemployment lingers near 10 percent, Federal Reserve Bank of Richmond President Jeffrey Lacker said.

“I am going to be looking for when growth reestablishes itself firmly enough that it is clear real interest rates need to rise,” Lacker said today in a Bloomberg Radio interview. “I think the growth outlook, particularly the consumer spending outlook, are more fundamental than labor-market conditions.”

Seriously, raising rates even if unemployment is 10%? LACKER SAYS THIS ON THE DAY WE GET CORE PCE INFLATION SLIDING TO 1.3% Y-O-Y! This redefines the term "hawk."

From where does this fear of inflation emanate? That brings us to perma-hawk Philadelphia Fed President Charles Plosser:

Unfortunately, slack was poorly measured and turned out to be not as significant as first estimated. Thus, the Fed's monetary expansion led to rising inflation for the balance of the 1970s. One lesson learned during this episode is that inflation expectations can matter a great deal, and if they become unanchored — that is, if the public comes to believe that the Fed will not do what is necessary to preserve price stability — then inflation can rise quickly regardless of the amount of so-called slack in the economy. The price we paid to regain control of inflation and the Fed's credibility to do so came in the form of the 1981-82 recession and was a steep one.

Consequently, just as the Fed has taken aggressive steps in flooding the financial markets with liquidity during this crisis to reduce the possibility of a second Great Depression, it will also have to take the necessary steps to prevent a second Great Inflation. Our credibility depends on it. As the economy and financial markets improve, the Fed will need to exit from this period of extraordinarily low interest rates and large amounts of liquidity. We recognize the costs that significantly higher inflation and the ensuing loss of credibility will impose on the economy if we fail to act promptly, and perhaps aggressively, when the time comes to do so. The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels. The issues of when and the pace at which we unwind the extraordinary measures taken during the financial crisis and recession are ones that are high on my list of priorities and are the subject of ongoing discussions within the Fed.

The experience of the 1970s is such a tired and faulted analogy. To generate a wage-price inflation spiral, you need to explain the mechanism by which rising inflation expectations (which don't exist anyway) get translated into high wages. I do not see that current institutional arrangements in the US allow this; nor do we see it in the data:

One could at least wait for significant - or any, for that matter - year over year gains in unit labor costs before declaring that we are at the doorstep of the 1970's. Moreover, the seeds of that inflation did not sprout overnight; the signs were evident but ignored in the late 1960's. Only in Plosser's mind exists the need for an imminent withdrawal of policy.

Bottom Line: The data this week has not been supportive of a rapid exit from accommodative policy. Indeed, the opposite could very well be the case. Despite this, Fed officials, albeit to varying degrees, are uniformly signaling that the actions to expand the balance sheet are only temporary and will be reversed absolutely as soon as possible, which only undermines the stimulative potential of those actions. This is definitely not quantitative easing, and uncomfortably harkens back to the fear of inflation that constrained policy at the Bank of Japan. It is interesting that Fed Chairman Ben Bernanke has worked so hard to avoid a repeat of that experience yet appears ready to risk repeating it nonetheless.

"Auditing the Fed"

Bruce Bartlett and Barry Ritholtz on Ron Paul's call for the Fed to be audited:

Auditing the Fed, by Bruce Bartlett: Ron Paul finally got his wish yesterday and the House Financial Services Committee held a hearing on his legislation to audit the Federal Reserve. There were only two witnesses: the Fed's general counsel and Tom Woods, a historian from the Ludwig von Mises Institute. The testimony is available here.

I urge those curious about this issue to read both statements. I think it is abundantly clear that this is a crackpot idea. The Fed is already thoroughly audited in every area except two: monetary policy and dealings with foreign central banks. The only purpose of having additional audits of the Fed is to undermine its independence precisely with regard to these two areas. If Woods presents the best argument for doing so, the argument is very shallow indeed.

Whatever one thinks of the Fed's policies in recent years--and there certainly are grounds for criticism--there is no reason whatsoever to believe that undermining its independence and putting the Congress in control of monetary policy--Ron Paul's goal--would improve matters at all. Indeed, there is every reason to believe that full congressional control of monetary policy would be a disaster. Instead of getting Switzerland-like stability, as Paul foolishly imagines, the more likely result would be Zimbabwe-like hyperinflation.

In the end, I agree with Barry Ritholz that whatever the Fed's failings, those of Congress are vastly worse.  As he put it in explaining why he didn't testify yesterday:

I was invited to testify this week to the House Financial Services Committee about reform and regulation.

I politely demurred.

While I have been critical of the Federal Reserve (especially the Greenspan years), my beef with them has been their judgment and decision-making process. Congress, on the other hand, is a whole different matter. Its not their judgment, but rather, the fact they are owned not by the American people, but by lobbyists, and corporate interests. They have become structurally deformed.

How weird is it for me, who spent so many pages blaming the Fed for a lot of the recent crisis, to find myself in a position of defending them from outside political pressure? The choice we face is the recent Fed regime of secrecy, nonfeasance, irresponsibility, and easy money — versus something possibly likely to be a whole lot worse. ...

If the Fed has been a major source of problems, Congress is much worse. They were the great enablers of the crisis, readily corruptible, bought and paid for by the banking industry. I find Congress to be the worse of two evils — lacking in objectivity, incapable of producing legitimate regulatory review. ...

As I've made clear in the past, I also think that auditing the Fed, or reducing its independence in other ways, is a bad idea. The strange marriage of the populists and libertarians on this issue has given it more momentum that I expected, but hopefully not enough to carry the day.

Fed Watch: Rushing to the Exits?

Tim Duy is worried that the inflation hawks on the FOMC are gaining too much influence (Update: This was written before the WSJ editorial from Federal Reserve Governor Kevin Warsh saying that the Fed may move faster and more aggressively than people expect, a statement that Tim anticipates in his comments below):

Rushing to the Exits?, by Tim Duy: A missive from a former colleague prompted me to reconsider the Fed's behavior in light of their most recent forecast and the evolution of economic data. That in turn started to shed light on some little pieces of information sitting on my computer that I knew were important, but just couldn't quite see how they fit. And has left me somewhat concerned that the Fed may be more likely than I believed to stifle the pace of the recovery by, at a minimum, halting the growth of policy accommodation.

The Fed gave and took at the September FOMC meeting. Policymakers reiterated support for their near zero rate policy, while offering a slightly hawkish nuance that was noted by Jon Hilsenrath at the Wall Street Journal:

Today’s Federal Open Market Committee statement included a nuanced tip of the hat to hawks on the central bank’s policy making committee who think the Fed is putting too much weight on the argument that the economy’s substantial slack will drive down inflation.

Slack is the economy’s productive capacity that doesn’t get utilized — unemployed workers, empty hotel rooms, unsold homes, idle factory floors, etc. When there’s a lot of slack, it puts downward pressure on prices in the short-run. It’s one very important reason why the Fed has felt comfortable assuring markets that it is likely to keep interest rates exceptionally low for a long time. Because slack is likely to keep inflation low, the Fed will keep rates low.

But Fed officials have been engaged in an intense debate in recent months about how much slack matters. Some hawks believe other factors are more important ingredients in near-term inflation. One of those other factors is inflation expectations — if investors, businessmen and consumers expect more inflation, they could cause it by demanding higher prices and wages in anticipation. The Fed indirectly acknowledged this argument in the September statement: “With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.”

In previous recent statements, it hasn’t mentioned inflation expectations. It focused mostly on slack. Here’s how the Fed put it in August: “Substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.”

The practical implication of this little wording change? Keep an eye on measures of inflation expectations, such as inflation-protected Treasury bonds and University of Michigan surveys of consumers. They have been stable. But if they start rising, the Fed’s inflation view could change and tilt it toward a more hawkish stance.

The shift in wording, then, appears to be the result of some more hawkish FOMC members, illuminating the smidgen of truth behind a rumor that was circulating earlier this month. From Across the Curve:

I was not planted here at my work station yesterday but roaming through the myriad of emails I receive it seems that one of the reasons for the weakness yesterday was a report by an advisory firm, Smick Medley, that the Federal Reserve at its upcoming meeting would comment on and discus raising rates sooner rather than later.

Given the FOMC's own forecast, any consideration of tightening seems silly:

While the Fed may find it necessary to raise the estimate of GDP growth for this year on the back of a relatively sharp inventory correction, unemployment is almost certain to exceed the range for this year, and even if it didn't, it remains unacceptably high through 2011. Moreover, the downward pressure on pricing has increased in recent months, bringing the core-PCE forecasts into question:

On top of this, the concern of some hawks that inflation expectations will suddenly trigger a wage price spiral seems simply silly unless one can explain how, given current institutional arrangements in the US, price increase will translate into wage increases. Indeed, unit labor costs are giving you the exact opposite story:

And employment compensation for the private sector is likewise trending down:

Sure, one could turn to the commodity markets for inflation signals, but I think the critical price there is oil, which is finding the $72 mark extremely challenging to break through. That may have something to do with reports that quantity supplied to running well ahead of quantity demanded:

Crude oil declined for a second day in New York after a U.S. government report showed a larger-than- expected increase in fuel stockpiles in the world’s largest energy-consuming nation.

Gasoline stockpiles in the U.S. surged 5.4 million barrels last week, the Energy Department said. That’s more than the 500,000-barrel increase forecast in a Bloomberg News survey of analysts. Diesel and heating oil inventories jumped 2.9 million barrels, double what was expected. Crude oil supplies climbed 2.86 million barrels last week.

“The market has a glut of crude oil and refined products right now,” Victor Shum, a senior principal at consultants Purvin & Gertz Inc. in Singapore, said in a Bloomberg Television interview. “If we get a big correction in equities, the loss of optimism in that demand recovery will continue to drive down prices.”

And even if oil broke through the $72 mark, if $150 oil couldn't trigger a wage-price spiral, what is $80 oil going to do? The Fed's seeming eagerness halt monetary accommodation also runs in contrast to forecasts that they really need to be doing much, much more to support growth. From Goldman Sachs (no link):

In recent months, we have argued that the zero lower bound (ZLB) on nominal interest rates represents a meaningful constraint on monetary policy in particular and economic policy in general. Specifically, combining a variant of the Taylor Rule for monetary policy with our forecast for growth and inflation, we have long concluded that the Federal Open Market Committee (FOMC) would want to push its target for the federal funds rate significantly below zero – to levels of -6% or lower – if it had that option.

The -6% number suggests a much, much more aggressive expansion of the balance sheet, while the Fed in contrast is willing to let the current programs play themselves out over the course of the next six months.

So, given the unemployment outlook is sad, wage growth continues to deteriorate, core inflation is falling, and we seem to lack an institutional arrangement to force higher prices, should they even emerge, into higher wages, what is the Fed thinking? Should they really be worried about winding down programs? Are they really confident enough that an inventory correction that will undoubtedly spike GDP numbers will also translate into sustainable growth? Even knowing full while that after the last recession, the US economy languished despite the inventory correction, only to be revived on the back of the housing bubble? In effect, the Fed looks to be putting much weight on the cyclical story playing out, while ignoring the structural story of the necessity of asset bubbles to fuel growth. Pondering this, a little noticed Bloomberg report jumped to mind:

Federal Reserve policy makers are concerned about making “a colossal policy error” leading to higher inflation if they don’t withdraw extraordinary monetary stimulus soon enough, said Laurence Meyer, vice chairman of Macroeconomic Advisers LLC and a former Fed governor.

“When you talk to committee members you see a little bit more angst than you’d expect,” Meyer said in an interview yesterday at the Kansas City Fed’s monetary policy conference in Jackson Hole, Wyoming. “In public they say they’re confident they’ll get it right, they’re confident they have the tools to get it right. But when you talk to them in private there’s some concern there.”

So, added to the Medley rumor, the pieces start to fall together. Internally, perhaps a wide range of FOMC members believe, in their hearts if not in the data, that they have gone so far that the balance of risks have shifted toward inflation. But this is troubling; the basis for the inflation story falls entirely on the Fed's expansion of its balance sheet. Just a meager $1.3 trillion expansion give or take in the wake of an over $11 trillion decline in household wealth? And the bulk of that expansion is sitting in excess bank reserves? Not really much of an inflation story. But why else are they so eager to withdraw? Just to prove to critics they can? With much fanfare, from Bloomberg today:

The Federal Reserve and U.S. Treasury said they’re scaling back emergency programs aimed at combating the financial crisis, reducing support for firms that now have an easier time getting funding.

The central bank today said it will further shrink auctions of cash loans to banks and Treasury securities to bond dealers, reducing the combined initiatives to $100 billion by January from $450 billion. The Treasury has “begun the process of exiting from some emergency programs,” the chief of the government’s $700 billion financial-rescue fund said separately.

Bottom Line. The Fed is moving toward the exit as they look toward the conclusion of their securities purchases programs. But it is not clear that such a move is justified by their own forecasts or the inflation/wage/employment data. There may be an internal fear they have gone too far, a fear that the hawks can exploit. To be sure, I see no reason to expect the Fed will raise rates for a long time. And the Fed maintains it has policy flexibility, claiming to be ready to revive asset purchases should economic or financial conditions justify. But I now suspect the bar for renewed expansion of Fed accommodation may be much higher than I had anticipated. And that the dominant push for expansion would have to come from financial market conditions, while they would be willing to tolerate persistently high unemployment rates so long as U. Michigan inflation expectations say elevated, regardless of the actual inflation data.

As Expected, Fed Keeps Target Rate on Hold

[Money Watch link] After its rate setting meeting today, the Fed announced that it "will maintain the target range for the federal funds rate at 0 to 1/4 percent," and that it "continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period." Very few analysts thought the Fed should raise the rate, calls for higher rates came from a few inflation hawks but that's about it, and nobody I know of expected the Fed to change its interest rate policy. So no surprises here.

Of more interest are the Fed's characterization of economic conditions, its plans for the special facilities and other non-standard monetary policy options it has put in place to deal with the crisis, and its exit strategy.

Fed Watch: Even With Growth, A Long, Hard Road

Tim Duy looks forward to the Federal Open Market Committee rate setting meeting later this week:

Even With Growth, A Long, Hard Road, by Tim Duy: The economic backdrop behind this week's FOMC meeting is almost startlingly refreshing. The recession likely ended at some point during the summer, an occasion effectively confirmed this week by the highest authority in the land, Federal Reserve Chairman Ben Bernanke. For those still in denial, industrial production posted its second consecutive gain, and there is little doubt that GDP will post a significant positive reading for the third quarter. Finally, in a seemingly impossible development, the retail sales report suggested that consumers eagerly converged onto the nation's shopping establishments in August. The economic summary paragraph in the upcoming FOMC statement will certainly identify the positive economic developments since their last gathering. But will improving conditions be sufficient to prod the FOMC to adopt language that points in the direction of tighter policy? Almost certainly not. The exit from the recession is clearly much too tenuous - and much too dependent on fiscal and monetary life support - to allow the risk of premature policy withdrawal. Moreover, even if economy activity were on a self-sustaining upward trend, the hole we are climbing out of is so deep that it could literally be years before resources are sufficiently utilized as to allow for significant policy reversal.

Let's start off with the good news. The stabilization of consumer spending that we saw begin earlier this year is supporting an inventory correction story. Firms are no longer chasing spending plans down, which alone gives some boost to final output. Moreover, some restocking is likely occurring; anecdotally, I hear from firms that are surprised to learn that their suppliers are running low on inventories despite weak final sales. Restocking is also a consequence of the "Cash for Clunkers" program, as auto firms look to rebuild depleted inventories. And, the August retail sales report points to sales gains across a wide range of retail stores. All in all, the inventory cycle looks to be making a pretty clear turn, offering support to activity:

In addition, the strength of fiscal stimulus is coming to bear on the economy. And one cannot discount the additional boost delivered by the first time homebuyers credit, which helped support a bottom into the new housing market this summer. Adding everything together, it is not difficult to see why forecasters are looking for growth in the range of 3 to 4% this quarter. Not surprisingly, industrial production numbers are turning:

"What the Economy Needs Now"

Lawrence Mishel of the Economic Policy Institute (link)

"The Triumph of Central Banking?"

Paul Volcker discusses the usefulness of macroeconomic policy:

Paul A. Volcker In Conversation with Gary H. Stern, Minneapolis Fed (pdf): ...Economic knowledge and central banking

Stern: You’ve obviously been involved for a long time directly with the Federal Reserve, at senior levels, from the mid ’70s and even earlier than that in the Treasury as well. In your view, has macro policy or monetary policy changed significantly over those many years? Or are we still pretty much at the state of knowledge, and is the state of our responses pretty much where it was?

Volcker: [Laughter] It’s interesting you ask that question because I recently commented to some of my economist friends that I’m not aware of any large contribution that economic science has made to central banking in the last 50 years or so.

Our ability to forecast is still very limited. The old issues of the relative role of fiscal and monetary policies are still debated. Markets are certainly more complex, and some of the old approaches toward monetary control seem less relevant. Recent events have certainly illustrated limitations in our understanding of the economy.

The advent of floating exchange rates, which partly reflects a shift in academic thinking, has certainly been important, but the underlying problems of policy seem familiar.

Right now, we are in the midst of a very large unsettled question. Are the unprecedented Federal Reserve and other official interventions in financial markets a harbinger of the future? Is reasonable financial stability really dependent on such government support?

On the technical side, there has been continuing change in the approach of central banks to the market, away from more quantitative approaches like the volume of bank reserves to much more emphasis on precise control of short-term interbank interest rates. The point is that in establishing and conducting policy, you need some means of reaching operational decisions. Those approaches have differed and evolved. But none of that breaks new conceptual ground.

Stern: Well, let me explore that a little further because I happened to be reading some of the [Federal Open Market Committee meeting] transcripts from the 1970s, after the oil price shock but before you became chairman, so neither of us was at the meetings.

Volcker: Well, actually I was at the meetings from 1975 as president of the New York Fed.

Stern: Of course, right. So these transcripts were a little earlier in the ’70s. Anyway, all the talk was about “cost-push” inflation and how monetary policy couldn’t do anything about it. That was not only the consensus in the United States, but Federal Reserve officials who were traveling in Europe and talking with their counterparts heard the same message. Looking back at that from today’s perspective, I think you’d be hard-pressed to find policymakers or economists who would accept that view.

Volcker: No, I think that’s basically true. You know, the clearest articulation of that point of view was in Burns’ farewell speech, “The Anguish of Central Banking,” which was a long lament about how the Federal Reserve couldn’t deal with inflation because of all the political and economic pressures, and wasn’t that too bad. He made that speech at an IMF [International Monetary Fund] meeting about two months after I had become chairman.

So, when I gave my valedictory speech, I called it “The Triumph of Central Banking?” I put a question mark at the end. Somebody ought to write about this, how central banks became so important in the public mind and in their own mind in the past 10 years or so. Independence of central banking became part of the approach in almost every country. And I think you can make a case that it’s been a little overdone, that central banks suffer from hubris, like everybody else.

Stern: I think that might be right, and I want to explore that a little bit, but I would say, you’re personally responsible for that, because not only did you and your colleagues at the Fed succeed in bringing down inflation, but you did so when the general consensus was that nothing could be done about inflation, that we just had to live with it. So I think your success in bringing down double-digit inflation helped to establish the significance of monetary policy and central banks.

Volcker: You know, talking about whether economists have learned anything or contributed to monetary policy in the last several decades, Chairman Bernanke gave a speech at Princeton right after he took office which was an intellectual review of economists’ views of monetary policy.

I don’t recall all the substance of it, but he said basically that economists were ahead of central bankers in understanding important issues, going back to the 1920s and before and certainly in the Great Depression. But he went on to say that there was one area where the policymakers were ahead of the economists.³

It was an interesting comment. I don’t know if he made it because he knew I was in the audience at the time. But he said something to the effect that the academic economists had to learn from central banking about the importance of maintaining a strong sense of price stability. He has translated that into inflation targeting, I guess.

The effectiveness of policy

Stern: You mention that you thought, maybe now, or certainly in the last 10 years, there was a point where we had too much confidence, too high a level of expectations for monetary policy. I’ve been thinking about that as well, because obviously we’ve had a very significant financial shock to the economy, and one of the consequences of that has been a long and deep recession, and high unemployment. You’re familiar with all this. There seems to be a view that policy, both monetary and fiscal, can somehow fix this quickly. I guess I’m very uncomfortable about that.

Volcker: I don’t think it can. I’ve been dealing with this in a political environment. The other day I’d gotten a paper prepared for the presidential advisory board that I’m the chairman of. It talked about housing and mortgages and so forth. It concluded, “We’ve got to do something to support housing,” so it recommended means of spurring mortgage creation.

But then it went on, “We’ve got to do something to support consumption.” There I begin to wonder. We can do something to support consumption, but are we really dealing with the underlying pressures in the economy without permitting a relative decline in consumption to proceed?

Stern: Right.

Volcker: It’s not an easy question, if you try to explain that. Mr. Obama is out there every day having to explain things and would he say, “Well, I don’t think I want to push a big stimulus on consumption”? I don’t think he’s about to say that, but he probably should be saying that.

Stern: The pressure seems to be now from the press I follow, “You’ve got to find policies that will create jobs,” and again, who could object to that? But it’s not obvious that there are a lot of tools that would be effective at that in the short run.

Volcker: No, I think this period we’re going through is kind of a curative process; it’s a purgative. There is something to the old view that you have to have a recession once in a while to deal with the excesses of a boom. And I think we had excesses in this boom, for sure, and we’ve got a really difficult recession. You want to relieve the sharp edges, without any question, but I don’t think it’s been possible to pump it up so there’s no recession at all.

Stern: Yes, and part and parcel of recessions are resource reallocations. And we clearly had too many resources in housing and probably too many in finance and in autos—just to name three obvious places.

Volcker: Exactly. We need a recovery that emphasizes investment and competitiveness, and that ends or reduces our dependence on foreign borrowing. ... [Interview conducted July 15, 2009.]

Who Has All the Answers?

Justin Fox:

Hyman Minsky didn't have all the answers, by Justin Fox: Economist Hyman Minsky, who never got much attention while he was alive, has become one of the big celebrities of this financial crisis. In Sunday's Boston Globe, Stephen Mihm has the best account of Minsky's life and significance that I've seen so far. A sample:

Today most economists, it's safe to say, are probably reading Minsky for the first time, trying to fit his unconventional insights into the theoretical scaffolding of their profession. If Minsky were alive today, he would no doubt applaud this belated acknowledgment, even if it has come at a terrible cost. As he once wryly observed, “There is nothing wrong with macroeconomics that another depression [won't] cure.”

But did Minsky really have much to add beyond the crucial insight that financial systems are inherently unstable? His former student Eric Falkenstein, responding on his blog to Mihm's article, isn't so sure:

I was Minsky's TA while a senior at Washington University in St.Louis in 1987, and took a couple of his advanced classes, which regardless of the official name, were all just classes in Minskyism. He was a maverick, but perhaps a bit too much, being a little too dismissive of others, as he hated the traditional Samuelson/Solow Keynesians as much as the Friedmanite Monetarists. He always thought a market collapse was just around the corner. The S&P was 250 when I took his course, it went to 1500 in 2007 and then back to 735 in 2009. Does that prove he was right all along? ...

The problem ... is that his top-down theory is rejected by the data. Aggregate leverage ratios do not closely correspond to business cycles. If Minsky took microeconomics more seriously he could have made his theory more relevant, by noting that crises tend to occur in specific subsets in the economy: in 1990, hotels and Commercial real estate, in 2001, high tech, in 2008, mortgages. The mistake is not one made in aggregate, but in different sectors each recession. By noting these areas, but not the aggregate economy, had too much leverage, and depended on expected future increases in collateral value, he might have been more successful proselytizing his colleagues. But he was a traditional Keynesian, who liked to look at aggregate equations, like Profits=Investment + Deficits + Net Imports.

I think the broader point here is that there is no one Theory That Explains Everything in economics. Neoclassical economics certainly doesn't explain everything. Neither does Minskyism. Nor Austrian business cycle theory. Nor complexity theory. It seems like the best approach would be an eclectic one that takes lots of different economic models into account. But eclecticism doesn't get you far in academia.

There is no grand, unifying theoretical structure in economics. We do not have one model that rules them all. Instead, what we have are models that are good at answering some questions - the ones they were built to answer - and not so good at answering others.

If I want to think about inflation in the very long run, the classical model and the quantity theory is a very good guide. But the model is not very good at looking at the short-run. For questions about how output and other variables move over the business cycle and for advice on what to do about it, I find the Keynesian model in its modern form (i.e. the New Keynesian model) to be much more informative than other models that are presently available (as to how far this kind of "eclecticism" will get you in academia, I'll just note that this is exactly the advice Mishkin gives in his textbook on monetary theory and policy).

But the New Keynesian model has its limits. It was built to capture "ordinary" business cycles driven by price rigidities of the sort that can be captured by the Calvo model model of price rigidity. The standard versions of this model do not explain how financial collapse of the type we just witnessed come about, hence they have little to say about what to do about them (which makes me suspicious of the results touted by people using multipliers derived from DSGE models based upon ordinary price rigidities). For these types of disturbances, we need some other type of model, but it is not clear what model is needed. There is no generally accepted model of financial catastrophe that captures the variety of financial market failures we have seen in the past.

But what model do we use? Do we go back to old Keynes, to the 1978 model that Robert Gordon likes, do we take some of the variations of the New Keynesian model that include effects such as financial accelerators and try to enhance those, is that the right direction to proceed? Are the Austrians right? Do we focus on Minsky? Or do we need a model that we haven't discovered yet?

We don't know, and until we do, I will continue to use the model I think gives the best answer to the question being asked. The reason that many of us looked backward for a model to help us understand the present crisis is that none of the current models were capable of explaining what we were going through. The models were largely constructed to analyze policy is the context of a Great Moderation, i.e. within a fairly stable environment. They had little to say about financial meltdown. My first reaction was to ask if the New Keynesian model had any derivative forms that would allow us to gain insight into the crisis and what to do about it and, while there were some attempts in that direction, the work was somewhat isolated and had not gone through the type of thorough analysis needed to develop robust policy prescriptions. There was something to learn from these models, but they really weren't up to the task of delivering specific answers. That may come, but we aren't there yet.

So, if nothing in the present is adequate, you begin to look to the past. The Keynesian model was constructed to look at exactly the kinds of questions we needed to answer, and as long as you are aware of the limitations of this framework - the ones that modern theory has discovered - it does provide you with a means of thinking about how economies operate when they are running at less than full employment. This model had already worried about fiscal policy at the zero interest rate bound, it had already thought about Says law, the paradox of thrift, monetary versus fiscal policy, changing interest and investment elasticities ina  crisis, etc., etc., etc. We were in the middle of a crisis and didn't have time to wait for new theory to be developed, we needed answers, answers that the elegant models that had been constructed over the last few decades simply could not provide. The Keyneisan model did provide answers. We knew the answers had limitations - we were aware of the theoretical developments in modern macro and what they implied about the old Keynesian model - but it also provided guidance at a time when guidance was needed, and it did so within a theoretical structure that was built to be useful at times like we were facing. I wish we had better answers, but we didn't, so we did the best we could, and the best we could involved at least asking what the Keynesian model would tell us, and then asking if that advice has any relevance today. Sometimes if didn't, but that was no reason to ignore the answers when it did.

Fed Watch: Riding The Fed Train

Tim Duy looks at how the Fed is likely to respond to recent data that "continues to point to a turning point in economic activity":

Riding The Fed Train, by Tim Duy: It is difficult if not impossible to deny the firming of economic data in recent months. But that firming has been inexorably tied to a host of fiscal and monetary stimulus measures. Fiscal stimulus is dependent upon political will and Treasury's ability to sell debt cheap. And anything less than 4% on the 10-year bond looks pretty cheap historically, especially given the mountain of paper issued by the US Treasury. On the monetary side, the Fed looks poised to sustain that stimulus until a potentially inflationary situation emerges. From policymaker's perspective, that remains a distant threat. What - and how many - global distortions will emerge as a result of the Fed's extended zero-interest rate policy? And what will bring the new house of cards crashing down?

The flow of data continues to point to a turning point in economic activity. The ISM manufacturing report pushed above the 50 mark, rising to its highest level since the summer of 2007 on the back of a surge in new orders. Likewise, the nonmaufacturing counterpart moved higher as well, although the gain was not as dramatic, and overall activity failed to cross the boundary into expansion. Firmer activity in manufacturing suggests that the July gain in industrial production will be repeated this month. Adding to the manufacturing upswing are leaner inventories, with the inventory to sales ratio falling to 1.38 from its cycle high of 1.46 in January of this year. Even that much beleaguered housing sector is showing signs of life, with housing starts apparently bottoming in the spring; the cessation of the freefall is certain to support third quarter GDP. Finally, households are feeling a bit more confident, and that translated into consumption growth in July. Anecdotally, the word on the street is more positive, as summarized in the opening paragraph of the most recent Beige Book:

Reports from the 12 Federal Reserve Districts indicate that economic activity continued to stabilize in July and August. Relative to the last report, Dallas indicated that economic activity had firmed, while Boston, Cleveland, Philadelphia, Richmond, and San Francisco mentioned signs of improvement. Atlanta, Chicago, Kansas City, Minneapolis, and New York generally described economic activity as stable or showing signs of stabilization; St. Louis remarked that the pace of decline appeared to be moderating. Most Districts noted that the outlook for economic activity among their business contacts remained cautiously positive.

All in all, it seems a fair bet that the NBER recession cycle dating team will pin the end of the recession sometime during the summer of 2009.

That said, even the most optimistic bull will note that I just cherry-picked the data. While time and inventory control have come into play, firming activity has been inexorably linked to a host of fiscal and monetary stimulus measures. Consumption and manufacturing have both been boosted by the now concluded "Cash for Clunkers" program; we are now anxiously waiting for the likely painful hangover from that spectacular demolition derby where all contestants won a prize. And, interestingly, despite the car buying binge, consumer credit contracted by a whopping 10% annualized in July, a testament to the mix of restriction to and aversion of credit that continues to weigh on household spending plans. Likewise, housing sales have been supported by the $8,000 tax credit for "first-time" buyers, which has been estimated to fatten real estate agent wallets with the addition of almost 400,000 home sales. Like the Clunkers program, the homebuyer's tax credit is set to expire, threatening to pull the rug out of the housing market just as foreclosure activity looks to be heading higher. Should it be extended? Not just real estate agents and home builders think extension - and enhancement - is a no brainer:

Rogoff: Is a Debt Crisis Next?

Ken Rogoff says the debt crisis he has been warning about for many years is still a risk:

From Financial Crisis to Debt Crisis?, by Kenneth Rogoff, Commentary, Project Syndicate: ...How can policymakers be so certain that financial catastrophe won't soon recur when they seemed to have no idea that such a crisis would happen in the first place?

The answer is not very reassuring. Essentially, there is still a risk that the financial crisis is simply hibernating as it slowly morphs into a government debt crisis.

For better or for worse, the reason most investors are now much more confident than they were a few months ago is that governments around the world have cast a vast safety net under much of the financial system. At the same time, they have propped up economies by running massive deficits, while central banks have cut interest rates nearly to zero.

But can blanket government largesse be the final answer? Government backstops work because taxpayers have deep pockets, but no pocket is bottomless.

And when governments, particularly large ones, get into trouble, there is no backstop. With government debt levels around the world reaching heights usually seen only after wars, it is obvious that the current strategy is not sustainable. ...

We are constantly reassured that governments will not default on their debts. In fact, governments all over the world default with startling regularity, either outright or through inflation. Even the U.S., for example, significantly inflated down its debt in the 1970s, and debased the gold value of the dollar from $20 per ounce to $34 in the 1930s. ...

The ... rate at which government debt is piling up could easily lead to a second wave of financial crises within a few years. Most worrisome is America's huge dependence on foreign borrowing, particularly from China... The question today is not why no one is warning about the next crisis. They are. The question is whether political leaders are listening. ...

How Paul Krugman might respond:

So is there anything to worry about? Yes, but the dangers are political, not economic. ... Over the really long term,... the U.S. government will have big problems unless it makes some major changes. In particular, it has to rein in the growth of Medicare and Medicaid spending.

That shouldn’t be hard in the context of overall health care reform. After all, America spends far more on health care than other advanced countries, without better results, so we should be able to make our system more cost-efficient.

But that won’t happen, of course, if even the most modest attempts to improve the system are successfully demagogued — by conservatives! — as efforts to “pull the plug on grandma.”

So don’t fret about this year’s deficit; we actually need to run up federal debt right now and need to keep doing it until the economy is on a solid path to recovery. And the extra debt should be manageable. If we face a potential problem, it’s not because the economy can’t handle the extra debt. Instead, it’s the politics, stupid.

Note also that the bond price data do not show any signs of worry over inflation, default, or crowding out.

One more note. This is Rogoff in June 2008. He argues that there should be no stimulus, the risk posed by deficits is too large, and that interest rates should be raised to prevent inflation:

[P]olicymakers must refrain from excessively expansionary macroeconomic policy ... and accept the slowdown... For most central banks, this means significantly raising interest rates to combat inflation. For Treasuries, this means maintaining fiscal discipline rather than giving in to the temptation of tax rebates and fuel subsidies. In policymaker’s zealous attempts to avoid a plain vanilla supply shock recession, they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater and more protracted downturn.

My own view is that "significantly increasing interest rates" in June 2008 would have been a disaster, and that deficit spending was needed to prevent conditions from deteriorating even further. Opposition to deficit spending from people like Rogoff only served to delay putting this policy in place. (Also: This was prior to Lehman, inflation was being driven by commodity price increases, i.e. by relative price changes which do not pose long-run inflation risks, and had the Fed followed this advice and raised rates, it would have likely reversed course after Lehman further undermining its credibility at a time when credibility was needed the most.)

*****

[I may do more with this later, but since Rogoff's opening line is about economists missing the crisis, note also Paul Krugman's How Did Economists Get it So Wrong? Update: See also Where Does Macroeconomics Go From Here? and Which Economists Got it So Wrong?, both by Brad DeLong.]

Triple Time-Inconsistent Policy

The middle of a financial crisis is the wrong time to try to reestablish credibility:

Dumping Russia in 1998 and Lehman ten years later: Triple time-inconsistency episodes, by Guillermo Calvo, Vox EU: In the last decade we have witnessed two major systemic financial crises, namely, the 1998 Russian crisis and the current crisis, the latter initially associated with the subprime mortgage market (henceforth, subprime crisis). A critical event in the subprime crisis was the Lehman Brothers’ episode in September 2008. Lehman’s collapse, coming on the heels of the sell-off of Bear Stearns, took the market by surprise. The ensuing about-face regarding AIG was perhaps less surprising but still added a heavy dose of policy uncertainty.

Many observers have been critical of that erratic policymaking and see it as directly responsible for the worldwide collapse of stock markets and near panic that took place soon afterwards. Repeated bouts of time inconsistency – as I will characterize this type of episode – have also been argued to have triggered the spreading of the Russian crisis across most emerging market economies in August 1998. As the argument goes, the market was aware that Russia was facing an unsustainable fiscal deficit before August but it was expecting that if a run against Russian public debt obligations materialized, the IMF and other multilateral institutions would rise to the occasion and bail them out. One often-heard reason for this was that Russia was “too nuke to fail.” However, the bailout did not happen, Russia was forced to default and, as if coordinated by a magic wand, the JP Morgan EMBI for all emerging markets went through the roof, with the average interest spread exceeding 1500 basis points. This episode raised fears that Brazil – Latin America’s kingpin – would follow suit and collapse, and apparently led the IMF to soften its stance and extend a very generous standby loan to Brazil on the basis, according to rumour, of skimpy fiscal account information – likely lowering IMF’s credibility as enforcer of market discipline.[1]

These episodes are cases of what one might call “triple time inconsistency”. First, a public institution is expected to depart from earlier statements and offer a bailout to prevent a major crisis (this is the first round of time inconsistency); then, in an attempt to regain credibility, the bailout is pulled back (the second round) and, finally, having witnessed the wreckage caused by the policy surprise, it resume bailouts of the still-standing dominoes (third round). This seesaw policymaking cannot be right. The initial refusal to continue offering bailouts can only be justified as a warning signal to market players against getting involved in situations in which they will need a bailout. But this “investment in credibility” goes to waste as the policymaker chickens out and bailouts resume.

The example below aims at making these intuitions more precise. I think the effort is worth it, given that the similarity between the episodes highlighted above suggests that the phenomenon is likely to repeat itself unless we better understand it and develop ways to prevent it. I would like to point out, however, that the example focuses on the costs of different rounds of time inconsistency but stops short of addressing the policy uncertainty generated by policies that are not in line with private-sector expectations. The latter is a major task that requires more substantive research.

"Obama Lucky to Have Bernanke"

Brad DeLong explains why presidents are willing to reappoint Fed chairs that are members of opposing political parties:

Obama lucky to have Bernanke, by J. Bradford DeLong, Commentary, Project Syndicate: William McChesney Martin, a Democrat, was twice reappointed chairman of the ... Federal Reserve by Republican President Dwight D. Eisenhower.

Paul Volcker, a Democrat, was reappointed once by the Reagan administration (but not twice: there are persistent rumors that Reagan's treasury secretary, James Baker, thought Volcker too invested in monetary stability and not in producing strong economies to elect Republicans).

Alan Greenspan, a Republican, was reappointed twice by Bill Clinton. And now Barack Obama has announced his intention to renominate Republican appointee Ben Bernanke...

The reason American presidents are so willing to reappoint Fed chairmen from the opposite party is closely linked to ... confidence of financial markets that the Fed will pursue non-inflationary policies.

If financial markets lose that confidence - if they conclude that the Fed is too much under the president's thumb to wage the good fight against inflation, or if they conclude that the chairman does not wish to control inflation - then the economic news is almost certain to be bad.

Capital flight, interest-rate spikes, declining private investment, and a collapse in the value of the dollar - all of these are likely should financial markets lose confidence in a Fed chairman.

And if they occur, the chances of success for a president seeking re-election - or for a vice president seeking to succeed him - are very low. By reappointing a Fed chairman chosen by someone else, a president can appear to guarantee to financial markets that the Fed is not too much under his thumb. ...

It may or may not be true, especially these days, that what is good for General Motors is good for America and vice versa, but certainly what is good economically for America is good politically for the president.

It is here that Obama has lucked out. Ben Bernanke is a very good choice for Fed chairman because he is intelligent, honest, pragmatic and clear-sighted in his vision of the economy. He has already guided the Fed through two very tumultuous years with only one major mistake - the bankruptcy of Lehman Brothers.

This probably helped with Obama's willingness to reappoint Bernanke:

For years, some of his closest friends did not know that Ben S. Bernanke was a Republican. ... "If you read anything he's written, you can't figure out which political party he's associated with," said Mark L. Gertler, a professor of economics at New York University who has written more than a dozen papers with Mr. Bernanke. Mr. Gertler, who said he did not know his close friend's political affiliation until relatively recently, added: "He's not ideological. I could imagine Ben working with economists in the Clinton administration." Alan S. Blinder, a longtime colleague at Princeton who has advised numerous Democratic presidential candidates, also said he had worked alongside Mr. Bernanke for years without having any sense of his political views. "We wrote articles together and sat at the same lunch table thousands of times before I knew he was a Republican," Mr. Blinder recalled. "We never talked politics." ...

Hope or Evidence?

I think this is a fair response to my contention that Bernanke will be effective at pushing for new regulation of the banking industry. Thinking about it more, it's probably true that it is based more on hope than on evidence:

Ben's Second Term, by  Kevin Drum: What do we have to look forward to from Ben Bernanke's second term as chairman of the Fed?  The New York Times asked a bunch of economists for their predictions. Here's Mark Thoma:

My worry is that as time passes, we’ll forget how bad things were and the desire to impose necessary new regulation will fade. Here’s where I think Mr. Bernanke’s experience will be crucial. He was there at every step in the development of the Fed’s response to the crisis and he will not soon forget the problems he faced (nor repeat his mistakes), making it more likely that he’ll be a forceful and passionate advocate for new regulation before Congress. [Italics mine.]

Boy, do I hope this is true.  But it strikes me as woefully wishful thinking. One of the reasons I opposed reappointing Bernanke is that I'd like to have someone running the Fed who's serious about reregulating the financial industry, both at a macro and a consumer level. ...

Still, I remain hopeful.

Update: Free Exchange also responds:

What will Ben Bernanke do?, Free Exchange: Kevin Drum is collecting predictions about Ben Bernanke's second term. Here's Mark Thoma, for instance:

He was there at every step in the development of the Fed’s response to the crisis and he will not soon forget the problems he faced (nor repeat his mistakes), making it more likely that he’ll be a forceful and passionate advocate for new regulation before Congress. ...

Now, no Fed chairman (or potential Fed chairman) can or will pre-commit themselves to specific policy actions before they're nominated (nor should we want them to, given the importance of Fed independence). At the same time, nomination is the one time that political actors get some kind of say over what they want in a Fed chairperson. It therefore seems like it might be a good idea to ask what a nominee's priorities are ahead of time. ...

In other words, it shouldn't be unclear whether Mr Bernanke is going to forcefully advocate for needed regulatory changes. And maybe it isn't unclear to the president. But there's not necessarily any reason we ought to be flying blind with respect to the chairman's views on issues that will be hugely important during his second term. ...

Update: Tim Duy emails:

Bernanke will run away from financial reform if it means the risk of exposing the Fed to enhanced GAO oversight.  And maybe he should.

[End updates]

Here's Thomas Palley's view of Bernanke's reappointment. Thomas is, you will recall, a "heterodox economist" so it's not surprising that most of his criticism is directed at the profession itself rather than at Bernanke (much of which is in the full version of the article). Unfortunately, heterodox economists didn't do any better than mainstream economists at foreseeing and warning about the crisis. Thus, while I agree that new thinking and change is needed to prevent problems in the future, it's not clear that his call to open the Fed to "alternative economic views" would have done anything to help to prevent the problems we are having:

One Hand Clapping for Bernanke, by Thomas I. Palley, Commentary, Project Syndicate: President Barack Obama's nomination of Ben Bernanke to a second term as chairman of the U.S. Federal Reserve represents a sensible and pragmatic decision, but it is nothing to celebrate.

Instead, it should be an occasion for reflection on the role of ideological groupthink among economists, including Bernanke, in contributing to the global economic and financial crisis.

The decision to nominate Bernanke is sensible on two counts. First, the U.S. and global economies remain mired in recession. Though the crisis may be over in the sense that outright collapse has been avoided, the economy remains vulnerable. As such, it makes sense not to risk a shock to confidence that could trigger a renewed downturn.

Second, Bernanke is the best among his peers. He did eventually come to understand the nature and severity of the crisis, and then took decisive steps that contributed to halting the economic freefall.

That record, combined with doubts that any of his peers would have done better, means replacing him with another mainstream candidate makes little sense.

These two factors justify Bernanke's reappointment, but the faintness of praise is indicative of the deeper problems that his leadership has exposed. Those problems concern the state of economics and economic policy advice.

One such problem is Wall Street's implicit veto over the Fed. After all, a major reason for reappointing Bernanke is to avoid rocking financial markets. ...

In effect, financial markets have established an implicit veto over much of economic policy and the people who can hold top policymaking positions, and it is time to think how we can escape that hold.

A second problem concerns the state of economics. Though Bernanke may be the best in his peer group, the fact is that the economic crisis decisively proved him and his peers to have been wrong. ...

Though circumstances dictate that Bernanke is the best candidate and should be reappointed, the real challenge is to ensure a thorough intellectual housecleaning at the Fed in order to open space for alternative economic views.

The great danger is that reappointing Bernanke will be interpreted as a green flag for a flawed status quo.

That is where public debate and Bernanke's Senate confirmation hearings enter the picture. Those hearings should be an occasion for critical examination of what went wrong, and why.

If that happens, Bernanke's reappointment can serve as a trigger for constructive change rather than an endorsement of a discredited paradigm.

"The Dangers Ahead for Bernanke"

At the Room for Debate, we were asked "What’s the biggest challenge Mr. Bernanke faces in his second term?" Here are the answers:

James K. Galbraith
Tyler Cowen
Brad DeLong
Mark Thoma
Added: Vincent R. Reinhart

My response:

One important challenge Mr. Bernanke will face is to keep the financial sector recovery on track by not raising interest rates too soon, while avoiding inflation by not raising interest rates too late. It will be a difficult balancing act, particularly with the complications that a large budget deficit adds. I’m quite confident Mr. Bernanke is up to the task.

But the most important challenge is how to restructure the financial sector to reduce its vulnerability to a collapse like the one we just experienced. That’s a task that will require both institutional and regulatory change.

Some of this the Fed can do on its own, but other parts require Congressional approval. As the financial sector has started to show signs of life, we are already hearing protests against regulation. The most prominent objection is that regulation will stifle new financial innovation (never mind that it was this innovation that helped to cause the predicament we are in).

My worry is that as time passes, we’ll forget how bad things were and the desire to impose necessary new regulation will fade. Here’s where I think Mr. Bernanke’s experience will be crucial. He was there at every step in the development of the Fed’s response to the crisis and he will not soon forget the problems he faced (nor repeat his mistakes), making it more likely that he’ll be a forceful and passionate advocate for new regulation before Congress.

For example, the Fed needs the authority to dismantle “too big to fail” financial firms, authority it lacked but very much needed during the crisis. Mr. Bernanke knows first hand how hard it was to manage the crisis without this authority. He’s also seen the consequences of an unregulated shadow banking sector, and he knows how bad incentives and poor market structures created problems that could have been avoided.

There are two other factors working in Mr. Bernanke’s favor. If the financial recovery goes as I expect, his reputation will grow, giving him the authority he needs to persuade Congress to make needed regulatory changes. And just as important, unlike some past Fed chairmen, he’s been able to articulate complex ideas in ways that legislators seem to understand.

Update: This is from Barry Ritholtz. It addresses the view held by many that Bernanke should not have been reappointed because he helped to create the housing bubble (which implicitly assumes the Fed is responsible for the bubble - I think the low interest rate policy after the dot.com crash was one source of the liquidity that fueled the housing boom, but not the only source, the global savings glut also played a role, and there were other failures, i.e. false promises of high returns with low risk, that caused the funds to flow into mortgage markets and related securities rather than into other investments):

I am less critical ... regarding the Bernanke renomination [and] his 3 year term as Governor. Let’s not forget that Greenspan was known as the Maestro back then. Congress, which is now pillorying Bernanke every appearance, was adoring of Easy Al’s visage and garbled Greenspeak each and every appearance. AG ran the Fed as an unchallenged stronghold, a fiefdom where he was the central-banker-in-chief as rock star. No one challenged him directly.

That seems to be lost in a lot of the revisionism now taking place. Roach writes “While America’s head central banker deserves credit for being creative and courageous in orchestrating an unusually aggressive monetary easing programme, it is important to remember that his pre-crisis actions played an equally critical role in setting the stage for the most wrenching recession since the 1930s.”

Not exactly. It was Greenspan’s Fed. Under his leadership, the FOMC and its governors were all second bananas to the Wolrd’s most famous banker. In Bailout Nation, I criticize this deference: “The Federal Open Market Committee (FOMC) must take responsibility for following [Greenspan] so obsequiously, especially in the latter years of his reign.”

However much I blame the FOMC, I have a hard time holding them to the same level of accountability as I do Greenspan. He was the master architect, the maestro conducting the monetary policy orchestra.

Second bananas cannot should the blame for what the head of the bunch does. Once they become banana-in-chief, the standards and level of accountability all go up accordingly.

How Will We Know when the Economy Turns the Corner?

One question I am asked fairly often is how we will know when the economy turns the corner and we are on our way to a solid recovery. My answer is that we will be able to detect upticks in the data, though this may come with a bit of a lag, the important but harder task will be to understand why the data are showing improvement.

In order to be convinced that the economy is on solid footing and headed to better times, I will want to see several things. First, though not necessarily foremost, that banks are being recapitalized with private sector funds, and that this is happening without the aid of government guarantees or other such programs that encourage capital infusions (which is hard to determine while the government programs are in place). Second, I will want to see private sector non-residential investment improving, another sign that private sector funds are moving back into circulation. Presently, this hasn't even started heading back upward, though there are signs the decline is slowing:

[logged data - click for larger version]

And there are other important factors too, e.g. consumption rebounding (though not to pre-crisis debt sustained levels), stabilization in housing markets, and so on. The point is that a self-sustaining recovery will require that the private sector be the primary driver of new economic activity, and that is what I will be looking for.

Once the economy does start to recover, the hard but critical part will be to determine how much of the recovery is self-sustaining (as it will be if private sector funds are driving the activity), and how much is being driven by government stimulus programs. If the recovery is self-sustaining, and we are fairly certain of that, then we can begin to carefully wind down the government programs supporting the economy. But if the recovery is mostly due to government stimulus and there is little sign that the financial and real sectors are attracting robust levels of private sector funds, then pulling back on government programs could be disastrous and plunge the economy right back into recession. In fact, in such a case, we may need to provide even more stimulus to fully bridge the gap until the private sector can support the economy on its own.

So, in answer to the question, we will have a pretty good idea when the economy turns the corner, but it will take awhile to determine why, and we cannot risk pulling back on government programs until we are sufficiently certain that the private sector can support normal economic activity without the government's help.

Update: Nouriel Roubini:

A Phantom Economic Recovery, by Nouriel Roubini, Commentary, Project Syndicate: Where is the US and global economy headed? ... Data from the US ... suggests that the US recession is not over yet. A similar analysis of many other advanced economies suggests that, as in the US, the bottom is quite close, but it has not yet been reached. ...

Moreover, for a number of reasons, growth in the advanced economies is likely to remain ... well below trend for at least a couple of years.

The Anti-Greenspan

Dani Rodrik wants the Anti-Greenspan - someone who truly distrusts financial markets and the ideology that surrounds them - to be the next Fed Chair:

Let finance skeptics take over, by Dani Rodrik, Commentary, Project Syndicate: ...Federal Reserve Chairman Ben Bernanke’s term ends in January, and President Barack Obama must decide before then: either re-appoint Bernanke or go with someone else...

 [I]n recent decades central banks have become even more significant as a consequence of the development of financial markets. Even when not formally designated as such, central banks have become the guardians of financial-market sanity. The dangers of failing at this task have been made painfully clear in the sub-prime mortgage debacle. ...

This is a job at which former Fed Chairman Alan Greenspan proved to be a spectacular failure. ... As a member of the Fed’s Board of Governors under Greenspan..., Bernanke can also be faulted...

What hampered Greenspan and Bernanke as financial regulators was that they were excessively in awe of Wall Street... They operated under the assumption that what is good for Wall Street is good for Main Street. This will no doubt change as a result of the crisis, even if Bernanke remains at the helm. But what the world needs is a Fed chairman who is instinctively skeptical of financial markets and their social value.

Here are some of the lies that the finance industry tells itself and others, and which any new Fed chairman will need to resist.

Prices set by financial markets are the right ones for allocating capital and other resources to their most productive uses. That is what textbooks and financiers tell you, but ... there are far too many “market failures” in finance for these prices to be a good guide for resource allocation. ... Implicit or explicit bailout guarantees, moreover, induce too much risk-taking. ... So the prices that financial markets generate are as likely to send the wrong signals as they are to send the right ones.

Financial markets discipline governments. This is one of the most commonly stated benefits of financial markets, yet the claim is patently false. ... If in doubt, ask scores of emerging-market governments that had no difficulty borrowing in international markets, typically in the run-up to an eventual payments crisis.

In many of these cases ... financial markets enabled irresponsible governments to embark on unsustainable borrowing sprees. When “market discipline” comes, it is usually too late, too severe, and applied indiscriminately.

The spread of financial markets is an unmitigated good. Well, no. Financial globalisation was supposed to have enabled poor, undercapitalised countries to gain access to the savings of rich countries. It was supposed to have promoted risk-sharing globally. In fact, neither expectation was fulfilled. ...

Financial innovation is a great engine of productivity growth and economic well-being. Again, no. Imagine that we had asked five years ago for examples of really useful kinds of financial innovation. We would have heard about a long list of mortgage-related instruments... The truth lies closer to Paul Volcker’s view that for most people the automated teller machine (ATM) has brought bigger benefits than any financially-engineered bond.

The world economy has been run for too long by finance enthusiasts. It is time that finance skeptics began to take over.

My view is that Bernanke should be reappointed.

My Lucky Day

[If all goes according to plan, this will post at 11:30.]

I was lucky enough to draw jury duty today, and I'm assuming blogging from my iPhone won't be allowed, so I (probably) won't be able to post or talk about the press release from the FOMC meeting today until much later.

Is there anything in the press release that should be noted?

Update: Yahoo, after a long wait a plea bargain settled the case and I've been released. A quick scan of the news reports on the meeting indicate that two statements in the press release (see below) caught people's attention, the statement that "economic activity is leveling out" and the notice that the Fed will "gradually slow" its purchase of Treasury Securities and "anticipates that the full amount will be purchased by the end of October." The first statement is a slight nod toward recent improvements, and the second is an extension of earlier plans to end the purchases in September. This will keep options open, and recognizes that there is still considerable uncertainty about the path the economy will take:

Press Release Release Date: August 12, 2009: Information received since the Federal Open Market Committee met in June suggests that economic activity is leveling out. Conditions in financial markets have improved further in recent weeks. Household spending has continued to show signs of stabilizing but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing but are making progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.

Paul Krugman: Averting the Worst

[Note: The actual column, "Averting the Worst" by Paul Krugman, is here.]

*****

I heard you say that we aren’t going to have a second Great Depression. What saved us?

The answer, basically, is Big Government.

So the government fixed things? Does everyone go back to work tomorrow?

Just to be clear: the economic situation remains terrible. We haven’t yet reached the point at which things are actually improving; for now, all we have to celebrate are indications that things are getting worse more slowly.

We're still skidding towards the cliff, but we'll stop in time? I'll feel better when we're actually stopped, or better yet, headed in the other direction.

The latest flurry of economic reports suggests that the economy has backed up several paces from the edge of the abyss. A few months ago the possibility of falling into the abyss seemed all too real.

So what was so special about the way government reacted?

Probably the most important aspect of the government’s role in this crisis isn’t what it has done, but what it hasn’t done.

Okay, then what didn't the government do that was so special?

Unlike the private sector, the federal government hasn’t slashed spending as its income has fallen. (State and local governments are a different story.) Tax receipts are way down, but Social Security checks are still going out; Medicare is still covering hospital bills; federal employees, from judges to park rangers to soldiers, are still being paid.

All of this has helped support the economy in its time of need, in a way that didn’t happen back in 1930.

This means that budget deficits — which are a bad thing in normal times — are actually a good thing right now.

I can buy that the government had an “automatic” stabilizing effect through its normal expenditures and by supporting increased demand for programs such as unemployment insurance, food stamps, those sorts of things. I can also see how running a deficit is the only way to support these programs. But the financial bailout, surely you aren't going to tell me that was helpful too? Look how it was handled!

You can argue (and I would) that the bailouts of financial firms could and should have been handled better, that taxpayers have paid too much and received too little. Yet it’s possible to be dissatisfied, even angry, about the way the financial bailouts have worked while acknowledging that without these bailouts things would have been much worse.

The point is that this time, unlike in the 1930s, the government didn’t take a hands-off attitude while much of the banking system collapsed. And that’s another reason we’re not living through Great Depression II.

So what you are telling me is that the bailout worked, and was necessary, but we could have bailed out the system in a way that cost taxpayers less and the people responsible for the problems more? You're right about it being possible to be dissatisfied even though it worked. Anyway, since we're talking about poorly structured programs, above when you talked about automatic stabilizers, you didn't mention the stimulus package. Is that because it hasn't helped much yet?

From the beginning, I argued that the American Recovery and Reinvestment Act, a k a the Obama stimulus plan, was too small. Nonetheless, reasonable estimates suggest that around a million more Americans are working now than would have been employed without that plan — a number that will grow over time — and that the stimulus has played a significant role in pulling the economy out of its free fall.

So automatic stabilizers, an imperfect but effective enough financial bailout, and an imperfect but at least helpful stimulus package are all working together to overcome the problems in the economy?

Ronald Reagan was wrong: sometimes the private sector is the problem, and government is the solution.

That's not the only thing he was wrong about.

And aren’t you glad that right now the government is being run by people who don’t hate government?

Speaking of which, how do you think things would have been different if McCain had won the election?

We don’t know what the economic policies of a McCain-Palin administration would have been. We do know, however, what Republicans in opposition have been saying — and it boils down to demanding that the government stop standing in the way of a possible depression.

Yeah, Republicans aren't exactly fans of the stimulus package. They'd reverse it right now if they could.

I’m not just talking about opposition to the stimulus. Leading Republicans want to do away with automatic stabilizers, too. Back in March, John Boehner, the House minority leader, declared that since families were suffering, "it’s time for government to tighten their belts and show the American people that we ‘get’ it." Fortunately, his advice was ignored.

Ignoring Boehner's advice is a good idea in general. Ignoring him saved the day.

I’m still very worried about the economy.

Why?

There’s still, I fear, a substantial chance that unemployment will remain high for a very long time. But we appear to have averted the worst: utter catastrophe no longer seems likely.

And Big Government, run by people who understand its virtues, is the reason why.

Fed Watch: The Recovery Edges Forward

Tim Duy reviews the state of the economy in anticipation of the Federal Reserve meeting scheduled for Tuesday and Wednesday of this week:

The Recovery Edges Forward, by Tim Duy: Data flow continues to support those who argue that if the recession is not already over as of July, it soon will be. The July jobs report - while not exactly cheery news for those still losing their jobs - is another clear indicator that the employment picture is turning. Still, excitement over the end of the recession aside, the data also reveal that the economy is recovering in fits and starts, with tell-tale signals that the consumer orgy of this decade is not likely to be repeated.

The July employment report in many ways spoke for itself. Possibly most important is the clear improvement in the pace of job losses:

This serves as confirmation of what we already knew from initial claims - the worst damage to the job market is in the rearview mirror. Other positive signs included a rise in manufacturing hours and stability in aggregate hours. To be sure, not all is perfect. The decline in the unemployment rate was driven by an exodus from the labor force - not exactly a sign of improving conditions. And a key leading indicator of employment, temporary help payrolls, continues to decline. If the recession did in fact end in June, and we see evidence of that end in the July industrial production report to be released this week, the decline in temporary help employment is clearly a disappointment. Indeed, coupled with rising production, it would simply reek of jobless recovery.

Other data supported the notion of weak recovery as well. While industrial activity may be close to turning a corner on the back of inventory reduction and the cash for clunkers program, not all is well in the service sector. The ISM read on nonmanufacturing activity actually edged downward for the month, with declines in not only the headline number, but also business activity, new orders, and employment. Better than the freefall of last year, but nothing to suggest that a V-shaped recovery is imminent.

Perhaps the lack of enthusiasm in the service sector is a reflection of what is clearly a subdued consumer. The June personal income and outlays report reveals that consumer spending declined in for the month:

Fed Watch: Is a Jobless Recovery Your Best Friend?

Tim Duy on how the Fed is likely to respond to "the cyclical turn in the US economy":

Is a Jobless Recovery Your Best Friend?, by Tim Duy: Never underestimate the power of money. Especially lots of money coming on top of a cyclical recovery that is almost textbook at least as far as the timing is concerned. To be sure, you can question the sustainability of the recovery, the breadth or health of the recovery, and the nature of job growth. I have questioned all repeatedly and fail to see that the conditions that have dominated the US economic story for the past 25 years - primarily, a continued reliance on consumer spending to propel growth - can continue in the face of massive household debt burdens and stiffer (or, more accurately, realistic) underwriting conditions. But regardless of these concerns, evidence is clearly pointing to a shift in economic conditions for the better. Moreover, I suspect it will take at least two more quarters at a minimum - and maybe closer to two more years - before the more pessimistic or optimistic visions of the future will come into clear view. Until then, it seems likely the appetite for risk will continue to climb, and all the liquidity - liquidity fueled by new guarantees that massive financial institutions are too big too fail - has to go somewhere.

Which is to say that no matter how pessimistic you are in the medium and longer term, you need to recognize the potential for massive moves in markets as risk taking perpetuates more risk taking. And as long as that risk taking flows in directions that do not fundamentally change the US jobs and, by extension, wage picture, it is difficult to imagine the Federal Reserve will do anything but let the party roll on.

The second quarter GDP report (Jim Hamilton and Menzie Chinn at Econbrowser discuss the details) confirmed what was already well known - the pace of deterioration slowed markedly, setting the stage for a growth rebound in the second half of this year. The game now is upping near term growth forecasts accordingly - not a fool's errand at all, considering the inventory correction is running its course and new residential construction is mostly likely at the bottom (seriously, we were never moving to an economy where zero houses would be built). Moreover, as Calculated Risk reports, it looks like we hit the bottom of car sales, with no small boost being provided by the Cash for Clunkers program.  Say what you like about the economic wisdom of this program or its potential to magnify a double-dip by borrowing from future growth, it will goose the third quarter numbers and advance the pace of inventory correction in the auto industry. And, let's be honest, buying new cars is a whole bunch more fun than just writing massive checks to keep the industry afloat.

The July ISM manufacturing report only adds to the cyclical rebound story. The headline number is flirting with the all important 50 mark, while the new orders component surged into expansion territory. Production, export, and import components all gained. Even the employment reading rose higher, although it continues to signal ongoing job declines. All in all, a report that is predicting recovery in a time frame consistent with the deep cyclical plunges of late last year.

On a more somber note, labor market weakness continues to weigh on paychecks, a phenomenon confirmed by the employment cost index for the second quarter. Wages and salaries for private workers climbed a scant 0.2%. To be sure, this raises concerns about the durability of consumer spending going forward, especially when combined with fears of a jobless recovery. Indeed, I have argued that most if not all of the jobs in the manufacturing sector simply are not coming back. My suspicion is that firms will use the recession to expand overseas supply chains wherever possible. Moreover, firms will not be in a rush to hire back without a clear resurgence of growth, which seems unlikely to occur given precarious household debt burdens.

Now comes the tricky part - what does the evolving economic dynamic imply for financial markets? I am increasingly of the mind that although a jobless recovery will be a dreary fate for the American people, it offers the best outcome for financial markets for one simple reason: The jobless recovery offers the greatest probability that the Fed remains on the sidelines. The jobless recovery is what keeps the Fed goose laying the golden eggs.

True, one should be cautious about reading too much into near-term market action. Macro man puts it succinctly:

The problem that some so-called perma-bears have is is recognizing the temporary importance of such asset flow, and how far it can push asset prices. By the same token, the problem that some of the flow-of-funds, risk-on crowd have is is failing to recognize that buying something just because other people do is nothing more than an exercise in greater fool theory. And while the market may well be a voting machine in the short run, as Benjamin Graham observed it is a weighing machine in the long run.

With the Armageddon trade off the table, market participants need to move the mass of money provided by the Fed somewhere, and it is showing up in all the predictable places. US equities, commodities, oil, and foreign exchange. Indeed, without the Fed threatening to raise rates, there is no rush to exit Treasuries, which could explain the failure of the ten year bond to retake the 4% mark even as equities sure higher.

To be sure, these trades might collapse under their own weight, but the probability of finding a self-sustaining move, like the US housing boom earlier this decade, is higher the longer the Fed keeps rates at a rock bottom level. And the farther that money flows from the US the better for financial market participants; too much money close to home would raise the prospect of stronger growth and tighter monetary policy. Andy Xie (hat tip to Big Picture) believes he has found one such place in China:

Chinese stock and property markets have bubbled up again. It was fueled by bank lending and inflation fear. I think that Chinese stocks and properties are 50-100% overvalued. The odds are that both will adjust in the fourth quarter. However, both might flare up again sometime next year. Fluctuating within a long bubble could be the dominant trend for the foreseeable future. The bursting will happen when the US dollar becomes strong again. The catalyst could be serious inflation that forces the Fed to raise interest rate.

When will that bubble burst? Possibly 2012, after the Fed can no longer keep interest rates low:

It is not too hard to understand when the bubble would burst. When the dollar becomes strong again, liquidity could leave China sufficiently to pop the bubble. What’s occurring in China now is no different from what happened in other emerging markets before. Weak dollar always led to bubbles in emerging economies that were hot at the time. When the dollar turns around, the bubbles inevitably burst.

It is difficult to tell when the dollar will turn around. The dollar went into a bear market in 1985 after the Plaza Accord and bottomed ten years later in 1995. It then went into a bull market for seven years. The current dollar bear market began in 2002. The dollar index (‘DXY’) has lost about 35% value since. If the last bear market is of useful guidance, the current one could last until 2012. But, there is no guarantee. The IT revolution began the last dollar bull market. The odds are that another technological revolution is needed for the dollar to enter a sustainable bull market.

However, monetary policy could start a short but powerful bull market for the dollar. In the early 1980s Paul Volker, the Fed Chairman then, increased interest rate to double digit rate to contain inflation. The dollar rallied very hard afterwards. Latin American crisis had a lot to do with that.

The current situation resembles then. Like in the 1970s the Fed is denying the inflation risk due to its loose monetary policy. The longer the Fed waits, the higher the inflation will peak. When inflation starts to accelerate, it would cause panic in financial markets. To calm the markets, the Fed has to tighten aggressively, probably excessively, which would lead to a massive dollar rally. This would be the worst possible situation: a strong dollar and a weak US economy. China’s asset markets and the economy would almost surely go into a hard landing.

Bottom Line: Incoming data continue to confirm the cyclical turn in the US economy. But that cyclical turn is supported by a massive amount of government intervention, in and of itself a testament to the fragility of the recovery. The Fed will be in no rush to withdraw that liquidity - especially if a jobless recovery emerges. Indeed, it is easy to tell a story where the Fed holds rates near zero into 2011. That also means the Fed will not rock any boats. Thus, the jobless recovery is almost a dream come true for those trades dependent on easy Fed policy - which seem to be virtually all trades at the moment. Although there has been talk of the Fed acting preemptively to curtail bubbles, I am skeptical that any such action would be taken with US unemployment staring at double-digits. And there certainly would be no rush to react if low US interest rates fueled bubbles outside US borders; that, after all, would be the responsibility of foreign policymakers.

"Deep Recession Calls for Healthy Dose of Fiscal Stimulation"

A colleague, George Evans, discusses the need for aggressive policy to combat the recession:

Deep recession calls for healthy dose of fiscal stimulation, by George Evans, Commentary, Register Guard: ...The business cycle, with expansions occasionally interrupted by recessions, is an enduring feature of market economies. Asset price bubbles and crashes also appear to be intrinsic to markets. It is important to recognize that recessions are usually ... a surprise, resulting from large shocks that could not be offset in time by policy.

Economists do, however, have a set of policies to avoid or minimize the impact of recessions and to promote recovery. The standard policy tools for dealing with recessions are two-fold: 1) easing monetary policy by reducing interest rates, and 2) allowing normal fiscal “stabilizers” to work: in recession tax collections naturally decline and unemployment benefits and welfare payments naturally increase. At the federal level this can and should be financed by temporary increases in deficits. ...

When a recession is very large, as now, the usual anti-recessionary policies are insufficient, and aggressive fiscal policies are needed. When recessions are accompanied by a financial crisis, as now, special interventions are required to prevent a complete financial meltdown and ensure that credit remains available. Regulatory reforms are also needed... Experience has shown that recessions precipitated by financial crises are usually longer and deeper than typical recessions.

The reason why aggressive fiscal policies are essential ... is that the adverse shock has been so large that monetary policy is inadequate: cutting short-term interest rates to zero is not enough to ensure recovery. Without sizable fiscal stimulus there is the possibility of a destabilizing spiral of deflation and falling output.

The combination of aggressive monetary easing and sufficiently aggressive fiscal stimulus should be enough to stabilize the economy and eventually lead to recovery. This recovery will raise tax revenues and, with appropriate long-term fiscal planning, debt levels relative to GDP will gradually return to normal levels. As the recovery begins, the monetary authorities will start to unwind current policy ... to prevent inflation from becoming a problem.

It is possible that yet more fiscal stimulus will be needed... If so, additional stimulus should avoid across-the-board temporary reductions in personal income taxes, since these have small aggregate demand effects. More effective are temporary increases in government spending ... and additional funding to states and localities... Temporary investment tax credits to firms can also be effective...

We must avoid retreating to the economics of Herbert Hoover. The argument that government should behave like families in recessions, reducing spending because times are hard, is misguided, because the proximate cause of current high levels of unemployment and low levels of GDP is a collapse of the aggregate demand... This is a Keynesian moment in history, and in this situation, temporary increases in government spending lead to higher incomes and more jobs. Households may anticipate higher future taxes to pay for the deficit spending, but the net effect on GDP and incomes is positive and substantial, and this prevents a dangerous slide into deflation. If the government spending is on infrastructure, broadly construed, then this also lays the foundation for a more productive recovery.

Is the current federal stimulus program sufficient? There is no simple answer. Policy affects the economy after a delay that is long, variable and uncertain. ... The lags and uncertainties make policy difficult.

In this situation the guiding principles are as follows. [T]he biggest risk is a 1930s type depression triggered by a negative feedback loop of deflation, high “real” interest rates after correcting for deflation, and reduced private sector spending. We appear to have avoided this outcome, but ... policy needs to be continually revisited. The Federal Reserve Open Market Committee meets every six weeks to review monetary policy. U.S. fiscal policy should also be reviewed frequently. The next several months may indicate the start of recovery or they may suggest that further action is needed. Finally, we also need a long-term plan to ensure that, after the recovery is under way, total publicly held federal debt will eventually return to its normal range of, say, 30 percent to 70 percent of GDP. ...

Although reasonable people can disagree on the appropriate role and size of government spending, we can agree that spending should be as productive as possible and that tax rates should be set to finance this spending on average. However, whatever the choice of overall level, there is a strong macroeconomic case for maintaining government spending during recessions and for temporary increases in government expenditures in deep recessions.

I should make clear that George cannot be accused of applying old fashioned theory to modern problems. The commentary above is based upon his recent research -- here's a brief description of some of his recent papers:

We examine global economic dynamics under learning in a New Keynesian model in which the interest-rate rule is subject to the zero lower bound. Under normal monetary and fiscal policy, the intended steady state is locally but not globally stable. Large pessimistic shocks to expectations can lead to deflationary spirals with falling prices and falling output. To avoid this outcome we recommend augmenting normal policies with aggressive monetary and fiscal policy that guarantee a lower bound on inflation.

And here are links to the papers themselves (the first two are technical, the third was written more for general economists and central bank policymakers):

• Expectations, Deflation Traps and Macroeconomic Policy (with Seppo Honkapohja), July 6, 2009.
• Liquidity Traps, Learning and Stagnation (with Eran Guse and Seppo Honkapohja) Abstract, European Economic Review, Vol. 52, 2008, 1438 – 1463. Electronic reprint available by email on request.
• Monetary and Fiscal Policy under Learning in the Presence of a Liquidity Trap, Monetary and Economic Studies, December 2008, 59 – 86.

Thus, this gives a fairly simple policy prescription - guarantee a lower bound on inflation - that is grounded in modern New Keynesian structures augmented with the models of learning that George, Seppo, and others have been developing. In the models with learning, there are stable and unstable regions, and large shocks can push you into the unstable region. The guarantee of a lower bound for inflation prevents inflationary expectations (which are formed through learning) from entering the region where deflationary spirals with falling prices and falling output are possible.

Here's a bit more from the conclusion to the third paper above:

The recent theoretical literature on the zero lower bound to nominal interest rates has emphasized the possibility of multiple equilibria and liquidity traps when monetary policy is conducted using a global Taylor rule. Most of this literature has focused on models with perfect foresight or fully RE. We take these issues very seriously, but our findings for these models under adaptive learning are quite different and in some ways much more alarming than suggested by the RE viewpoint. We have shown that under standard monetary and fiscal policy, the steady-state equilibrium targeted by policymakers is locally stable. In normal times, these policies will appropriately stabilize inflation, consumption, and output. However, the desired steady state is not globally stable under normal policies. A sufficiently large pessimistic shock to expectations can send the economy along an unstable deflationary spiral.

To avoid the possibility of deflation and stagnation, we recommend a combination of aggressive monetary and fiscal policy triggered whenever inflation threatens to fall below an appropriate threshold. Monetary policy should immediately reduce nominal interest rates, as required, even (almost) to the zero net interest rate floor if needed, and this should be augmented by fiscal policy, if necessary, in the form of increased government purchases. Intriguingly, using an aggregate output threshold in the same way will not always successfully reverse a deflationary spiral.

When aggressive fiscal policy is necessary, this will lead to a temporary buildup of government debt. However, government spending and debt will gradually return to their steady-state values. An earlier implementation of the recommended policies will mitigate the use of government spending, and if our recommended policy is already in place at the time of the shocks, the immediate use of aggressive monetary policy can in some (but not all) cases entirely avoid the need to use fiscal policy. Raising the inflation target π* is an alternative way of reducing the likelihood of needing to employ fiscal policy, but this may be undesirable for other reasons.

Social Insurance and the Severity of Recessions

The question of how bad would economic conditions be right now if there had been no stimulus package and no financial bailout is receiving considerable attention. There's no way to know for sure, but I believe the economy would have been much worse off without these two policy interventions. But without actually running the alternative scenario - something we can't do - there's no way to know for sure.

But one thing I am fairly certain of, and something I don't think is getting enough attention, is the effect that automatic stabilizers have had in helping to ease the impact of the recession for individual households on and for the overall economy.

What are automatic stabilizers? Automatic stabilizers are taxes and transfers (e.g. unemployment compensation and food stamps) that automatically change with changes in economic conditions in a way that dampens economic cycles. For example, when the economy turns downward, the amount spent on food stamps automatically goes up as more people apply (or eligibility rules are eased), and the extra spending the food stamps helps to soften the downturn for the individuals receiving the help and for the businesses and employees where the money is spent (and then the multiplier process spreads the benefits more widely). Similarly, unemployment compensation, which obviously rises as jobs are eliminated, goes up when conditions deteriorate and that also provides a boost to demand. In addition, income tax as a share of GDP goes down in recessions and that helps to offset the fall in GDP as well.

How much worse would things be now if we had followed the advice of the hardcore rightwing and eliminated the welfare state programs that function so effectively as automatic stabilizers? It still wouldn't be like the pictures you see of the Great Depression because we are a much wealthier nation than we were then and thus have more private resources to rely upon. But even so, not everyone has wealth to rely upon and the recession would be much more evident, and the amount of human suffering would be much greater, without the social insurance programs we put in place in the years since the Great Depression -- programs that we, for the most part, now take for granted. I don't mean there is no suffering due to the downturn, there is and I don't want to minimize it - I wish our social insurance programs were even more generous than they are now for that reason - and I don't mean to say there are no signs at all of economic problems, there are, but we shouldn't overlook the important role that social insurance plays during recessions.

I think we can have a debate over the appropriate level and form of social insurance, as I said, I don't think it is generous enough and I would also broaden it to include health care. But I don't think there can be any doubt about the importance and effectiveness of social insurance in helping to limit the impact of economic downturns.

So when we are assessing the effectiveness of government interventions designed to ease the recession, there are two alternative (or baseline) scenarios to think about. One is a world without the stimulus package and without the financial bailout, and that would be bad enough. But the other is a world without the stimulus package, without the financial bailout, and without social insurance, and that would be much, much worse.

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...

Sigh.

Sigh.

Sigh.

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...

Fed Watch: More Confirmation of Steady Monetary Policy

Tim Duy sees, among other things, the possibility of another bubble:

More Confirmation of Steady Monetary Policy, by Tim Duy: Green shoots - or, as President Obama says - the beginning of the end of the recession aside, the Fed will not be ready to reverse their accommodative policy stance anytime soon. New York Federal Reserve  President William Dudley said as much in a speech today:

If the recovery does, in fact, turn out to be lackluster, the unemployment rate is likely to remain elevated and capacity utilization rates unusually low for some time to come. This suggests that inflation will be quiescent. For all these reasons, concern about “when” the Fed will exit from its current accommodative monetary policy stance is, in my view, very premature.

The Fed continues to expect that low levels of resource utilization will keep a lid on inflation. While some might object that emerging market economies can have both weak growth and high inflation, those economies still have an important transmission mechanism between higher prices and higher wages that appears to be missing in the US. Indeed, while the press focused on the old news "recession is ending" angle of the Beige Book, the money quote for policymakers was:

The weakness of labor markets has virtually eliminated upward wage pressure, and wages and compensation are steady or falling in most Districts; however, Boston cited some manufacturing and business services firms raising pay selectively, and Minneapolis said wage increases were moderate. Boston, Cleveland, Richmond, Chicago, Dallas, and San Francisco cited a range of methods firms are using to limit compensation, including cutting or freezing wages or benefit contributions, deferral of future salary increases, trimming bonuses and travel allowances, reducing hours, temporary shutdowns, periodic furloughs, and unpaid vacations.

Until economic growth is sufficient to propel wages upward, any residual price pressures are likely to be snuffed out by deteriorating real wage growth. Will the job market improve anytime soon? We get a fresh look at initial unemployment claims tomorrow morning, but the July consumer confidence report from the Conference Board indicates that households see a deteriorating jobs picture:

The share of consumers who said jobs are plentiful dropped to 3.6 percent, the lowest level since February 1983. The proportion of people who said jobs are hard to get climbed to 48.1 percent from 44.8 percent.

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.

"Surprising Comparative Properties of Monetary Models"

I need to read this paper:

Surprising Comparative Properties of Monetary Models: Results from a New Data Base, by John B. Taylor and Volker Wieland, May 2009 [open link]: Abstract: In this paper we investigate the comparative properties of empirically-estimated monetary models of the U.S. economy. We make use of a new data base of models designed for such investigations. We focus on three representative models: the Christiano, Eichenbaum, Evans (2005) model, the Smets and Wouters (2007) model, and the Taylor (1993a) model. Although the three models differ in terms of structure, estimation method, sample period, and data vintage, we find surprisingly similar economic impacts of unanticipated changes in the federal funds rate. However, the optimal monetary policy responses to other sources of economic fluctuations are widely different in the different models. We show that simple optimal policy rules that respond to the growth rate of output and smooth the interest rate are not robust. In contrast, policy rules with no interest rate smoothing and no response to the growth rate, as distinct from the level, of output are more robust. Robustness can be improved further by optimizing rules with respect to the average loss across the three models.

Should Bernanke Be Reappointed?

Nouriel Roubini says:

Ben Bernanke ... deserves to be reappointed. Both the conventional and unconventional decisions made by this scholar of the Great Depression prevented the Great Recession of 2008-2009 from turning into the Great Depression 2.0.

Anna Schwartz has a different perspective:

As Federal Reserve chairman, Ben Bernanke has committed serious sins of commission and omission — and for those many sins, he does not deserve reappointment.

Here's how I see it. It's true that we failed to notice that the patient was getting sick. The signs of disease were there, but we either didn't see the signs or they were misdiagnosed. In fact, there's a case to be made that we saw some of the changes in the patient as signs of improving health. Had we made the correct diagnosis early enough, maybe we could have prevented the patient from getting sick (though it's not clear the patient would have taken our advice, so stronger measures than mere advice may have been required).

And once the patient showed up in the office and was clearly sick, we didn't get it right initially either. We thought the patient needed fluids - liquidity as they say - and the patient did need some of that, but we didn't immediately see that there were also some key nutrient deficiencies and chemical imbalances that were threatening to cause further problems.

Bu we kept at it with tests and other diagnostics, and eventually got a handle on the problem. Once we did, we began to administer the medicine the patient needed. The patient will get better, the deterioration was rapid and turning it around will be difficult - it won't happen fast enough to suit any of us - but what has been done prevented a complete collapse, and is helping to move the patient towards recovery.

So I'm with Nouriel, Bernanke should be reappointed. It's true that the progression of the underlying disease was largely missed, but that's pretty much true across the board, all the doctors missed it. It's also true that there was some dispute over how to interpret the initial symptoms and test results, and what to do to cure the patient. But again that was largely true across the board in the tumultuous period just after the patient began to exhibit clear and serious problems. It's not like everyone except the patient's doctors knew exactly what to do. The uncertainty in that initial period created fear, and the fear made the patient - who needed calm above all else - even worse off.

But as just noted, the doctors who were put in charge - Bernanke in particular - persevered and began to understand more precisely what was going wrong and what was needed, and that allowed them to save the patient from a much, much worse fate. They deserve credit for that. The patient will live, and that wasn't always so clear. In the initial confusion they did what you need to do - they administered wide spectrum drugs and other procedures that were known to abate the symptoms they were observing, and these did help, and that gave them time to find more targeted remedies. They used the time wisely to find and structure better remedies, and once those remedies were ready they used them to attack the various ways in which the disease was shutting down vital systems (not everything they tried worked, but the things that did work helped quite a bit).

There was one scary point, however, and that was when they thought the patient had become strong enough to go without the medicine, and they withdrew it too soon (the Lehman episode). The result was that they almost lost the patient completely, and only quick action saved the day. That's the one point where I think the doctors could have done better. I understand the concerns over the side effects of this medicine, but it was too soon and it created too much unnecessary uncertainty and fear.

But overall, they did the things that needed to be done to make sure the patient did not suffer an even worse, prolonged, debilitating collapse, and those efforts were successful. Failing to diagnose a disease is different from not knowing what to do once you figure it out. The disease was a difficult one to diagnose or it wouldn't have missed so widely, and it wasn't clear at first precisely what was wrong, but in every case, once they understood the problem, they took the proper course of action.

Here's the question I ask myself. If I were to suddenly come down with the same disease, would I want the current group with it's current leadership in charge of bringing me back to health, or would I want a different group led by someone new who thinks they know what to do, but has never actually been through it? I'd want this group, the one with experience. They're likely to have learned enough to spot the disease the next time and head it off all together, one hopes so. But if not and I get the disease, they are also likely to know just what to do - while avoiding the missteps they took the first time - to get me back on my feet as fast as possible (and please don't let politicians second guess them).

Fed Watch: The Debate Continues

Tim Duy looks at the shape of things to come:

The Debate Continues, by Tim Duy: The debate over the shape of the  recovery continues unabated.  Equities, at least this week, are voting in favor of the V-shaped recovery, with the Dow pushing past the 9,000 mark for the first time since January.  Never one to accept good news at face value, Nouriel Roubini predictably took the opposite position:

A “perfect storm” of fiscal deficits, rising bond yields, “soaring” oil prices, weak profits and a stagnant labor market could “blow the recovering world economy back into a double-dip recession,” he wrote in a research note today. “It is getting more likely unless a clear exit strategy from the massive monetary and fiscal stimulus is outlined even before it is implemented.”

Roubini, chairman of Roubini Global Economics and a professor at NYU’s Stern School of Business, predicted that the global economy will begin recovering near the end of 2009. The U.S. economy is likely to grow about 1 percent in the next two years, less than the 3 percent “trend,” he said.

Roubini based his short-term outlook on the worsening condition of the U.S. housing and labor markets, which he called “inextricably linked.” He said a “weak” job market will contribute to another 13 percent to 18 percent drop in house prices, bringing total declines nationally to as much as 45 percent from their peak.

I would add to Roubini's pessimism that  bond market investors as of yet do not share the optimism of their brethren in the equity side of the industry.  The run up in yields that brought a 4-handle to the 10 year Treasury appears to have been stopped dead in its tracks, and that maturity has pulled back to the mid threes.  If the run-up in yields foreshadowed a burst of optimism in equities, the pull back would suggest that this rally has nearly run its course.

 The challenge here is two-fold.  The first challenge is to determine how much of the recent equity run is attributable to the weight of evidence that indicates the worst of the downturn is behind us.  With the Armageddon trade off the table, some gains were inevitable, just as was the rise in Treasury yields.  The more difficult challenge is the strength and pattern of the subsequent recovery.  To be sure, one should not ignore the possibility of a blowout quarter here and there, as GDP data can bounce quickly to bounces in underlying data such as a stabilization in auto sales.  But will such a bounce reflect fundamental underlying strength?  A slow, jobless recovery - my dominant scenario - would most likely produce the seesaw trading we saw in the wake of the tech bubble crash, a pattern that held until the housing bubble gained full traction.  Such an outcome looks consistent with the sentiment of Federal Reserve Chairman Ben Bernanke in this weeks Congressional testimony:

"The Fed is Lending to 'Foreigners' instead of Americans!"

All of the people praising Alan Grayson for his gotcha questioning of Ben Bernanke might want to reconsider. Some deserved Economics of Contempt:

Dear God, Alan Grayson is a Tool, Economics of Contempt:  I just saw this video, which shows Rep. Alan Grayson questioning Ben Bernanke during his Humphrey-Hawkins testimony, and was being promoted by Zero Hedge and others a couple days ago. It's embarrassing....for Grayson.

He asks Bernanke about the currency swap lines that the Fed established with other central banks during the financial crisis, which he clearly doesn't understand (although he obviously thinks he does). He harps on the fact that Bernanke doesn't know which foreign financial institutions "got the money." Of course Bernanke doesn't know that. The Fed entered into currency swaps with foreign central banks, like the ECB and the BoE. Who those central banks then lent the dollars to is irrelevant—the Fed doesn't bear the credit risk of loans made by other central banks. The Fed only bears the credit risk of the central banks it established swap lines with, which, obviously, is vanishingly small.

Grayson then focuses on the Fed's swap line with New Zealand's central bank, which is where the wheels really come off the wagon. He apparently thinks a swap is the same thing as a loan, and that the Fed extended $9bn of credit to New Zealanders, which he considers an outrage (the Fed is lending to "foreigners" instead of Americans!). Of course, he doesn't even get his facts right (which is what happens when you hire people with no experience on Capitol Hill as Senior Policy Advisors). The Fed's swap facility with New Zealand central bank is $15bn, not $9bn, and more importantly, NZ's central bank never even drew on its swap line, which has $0 outstanding (pdf):

Grayson arrogantly laughs when Bernanke denies that the expansion of the swap lines on September 18th caused the dollar to rise 20%, which is amusing because the swap lines relieved the extraordinarily high demand for dollars from foreign financial institutions.

The best part of the video is when Barney Frank (easily my favorite Congressman) cuts Grayson off, which draws another of his arrogant laughs. Maybe Grayson should go back to losing millions in Ponzi schemes.

Fed Independence

Continuing the recent discussion here and elsewhere on Fed independence, this is not the first time audits and other threats to independence have been seriously considered:

On the mend, The Economist: It has been a long time since comments on the economy by an official of America’s Federal Reserve comments could be described as cheerful. Yet there was no denying the upbeat tone of Ben Bernanke’s testimony to Congress on Tuesday... His fingers may be crossed but it is clear that Mr. Bernanke thinks the recession, if not over now, soon will be.

That is a far cry, though, from seeing a threat from inflation and Mr. Bernanke made it clear that the federal funds target rate, now near zero, will remain there for a long time. On Wall Street, most reckon that means until well into 2010 at least.

Yet the Fed is already under pressure to explain how it intends to tighten monetary policy, even by congressmen who usually want nothing of the sort. ... Whether inflation [occurs] depends on if the Fed raises interest rates in time and thereby curbs the appetite for credit. Mr. Bernanke spent much of his testimony explaining how he can do just that. ...

Politics could ... interfere with the Fed’s willingness to tighten monetary policy in time. Congress’s nonpartisan investigative arm, the Government Accountability Office, can now audit the Fed with the exception of its monetary policy, lending programs or relations with foreign central banks. A bill in Congress would lift those prohibitions. Mr. Bernanke argued that the threat of such audits would lead investors to question the Fed’s willingness to do unpopular things, like tighten monetary policy, unsettling them and driving up long-term interest rates.

This is not idle speculation. Anti-Fed sentiment was also strong in the 1970s, when Congress first sought to have the GAO audit the central bank. Arthur Burns, chairman at the time, fought back, and a compromise was struck to allow audits, but with the current prohibitions. Mr. Burns later reflected that the effort of “warding off legislation that could destroy any hope of ending inflation” involved “political judgments” that may have weakened his anti-inflationary resolve.

For all the discussion, any tightening of policy is a long way off. ... 

I think one of the problems that people are trying to get at when they want to take away the Fed's independence is the concentration of power within the Board of Governors (the view by some that the Board represents special rather than public interests, e.g. Wall street, also plays a role), and they see devices such as audits from the GAO as a check on that concentration of power. Here's an edited version of part of an old post:

While the Fed was initially structured to balance competing interests and to share power, the system has evolved into an institution with centralized rather than shared power. The intent to share power and balance competing interests is evident in the structure of the Federal Reserve system. For example, individual district banks are overseen by a board of nine part-time directors. These directors come in three types. Three of the nine are type A and are bankers, and three are type B and represent the business community. Legislation prohibits type B board members from being bankers. In a further attempt to make the process representative, type A and type B directors representing banking and business interests are elected by member banks within each of the twelve Federal Reserve districts. Type C directors are appointed by the Board of governors and are intended to represent the public interest within the district banks.

Thus, the districts themselves provide geographic representation that is population based, while control of the district banks balances public, banking, and business interests. Initially, the district banks functioned as twelve cooperating banks and each district had considerable control of monetary conditions within the district. It was very much a shared power arrangement. As one example of the power district banks had, each bank had full control of the discount rate for its district (the discount rate was the only tool available for controlling the money supply when the Fed was formed, open-market operations were not well understood until later and there was no provision for the Federal Reserve system to control reserve requirements, another way to affect the money supply).

The shared power arrangement within the Federal Reserve system changed after the Great Depression when monetary authorities failed to respond adequately to crisis condition. The problem, or so it seemed, was the shared power nature of the system. The deliberative, democratic nature of the institution prevented it from taking quick, decisive action when it was most needed. Furthermore, the Fed did not have the tools it needed to deal with system-wide disturbances, it was mostly equipped to deal with problems at individual banks (the discount window is well-suited to help individual banks, but not system wide disruptions; on the other hand, open-market operations can inject reserves system-wide and hence is a better tool for systemic problems).

The solution to this was to concentrate power into the hands of the central bank so that should a crisis occur, they can act quickly. There are risks, of course, to concentrating power so narrowly, but in the aftermath of the Depression we were quite willing to take that risk if it helped to avoid another catastrophic outcome (as it may well have done).

Thus, after the Great Depression power was concentrated. For example, banks no longer control the discount rate in their districts. They can propose a change in the discount rate at an FOMC meeting, but the Board of Governors must approve the rate and they will only approve one rate, the rate they decide. So while the rates are still formally set in the districts, they are essentially set by the Board of Governors. When all such changes in the concentration of power over time from the districts to the Central Bank in Washington D.C. are considered, it becomes very clear that the Fed has evolved from a very democratic, shared power arrangement at its inception to one where it functions, for all intents an purposes, as a single bank in Washington, D.C,. with twelve branches spread across the U.S.

*****

I am not at all in favor of lessening the degree of independence that the Fed currently has, but I do think we need to make changes in the way the President and Boards of the district banks are chosen. As it stands, the Board of Governors in Washington has considerable influence over who is appointed to key positions such as the President of the district banks, and those Presidents represent five of the twelve votes at the meetings where monetary policy is set. More independence of the district bank Presidents and other district bank personnel from the Board of Governors would be a healthy change (there is also a question of whether geographic representation through district banks is the best way to capture the public interest, but I'll leave that aside for now).

"Bernanke's Bold Prose"

Mohammed El-Arian says Ben Bernanke can talk all he wants, but the credibility of his message about inflation depends upon the actions of fiscal authorities and is thus largely out of his hands:

Mohamed El-Erian on Bernanke’s bold prose, FT Alphaville: From Pimco’s chief executive…

While it may not rank quite as high as his appearance on the US news show ‘60 Minutes’ a few months ago, Chairman Bernanke’s Op Ed in today’s Wall Street Journal is nevertheless notable and important. It represents a bold attempt by the Federal Reserve to reach out broadly and pre-empt mounting concerns about the challenges facing monetary policy.

Bernanke’s bottom line is clear:  “Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so.”   ... Bernanke is signaling that the Fed is aware of the need to re-assure markets of its ability to strike that delicate balance between deflationary and inflationary concerns. ...

While ... this is important, it does not constitute major news as such.  Indeed, Bernanke has today confirmed a view that has increasingly prevailed in financial markets:  there will be no early hike in interest rates; and when the time comes to tighten monetary policy, the sequence will involve dealing first with the excess reserves. Yet this is not sufficient to ensure that the US is indeed able to balance well deflationary and inflationary risks.

To move from a necessary condition to one that is both necessary and sufficient, one must also consider what, increasingly, is the large elephant in the room when it comes to policies — namely, the design and conduct of fiscal policy.  This is an area where challenging short and longer-term imperatives need to be reconciled over time, and at several level of local, state and national governments. ...

After being heavily involved in stabilizing a highly disrupted economy, the Fed is transitioning from the driver seat to the passenger seat.

By virtue of its greater flexibility and responsiveness, the Fed ended up assuming the main role in responding to the crisis, with fiscal and other agencies (including the FDIC) playing important support roles. It is now the turn of the fiscal agencies to assume the main role, with the Fed and others playing the support roles.

Bottom line:  we have now entered the phase where fiscal policy is the more important determinant of the ability of the US to balance the risks of deflation and those of inflation. And, here, the jury is still out.

If we fail to make the changes in health care reform that are needed to bring the long-term budget into better balance, there will come a time when the Fed faces a choice about whether to monetize the debt and create inflation, or to refuse to monetize the debt potentially send interest rates very high causing the economy to stall. So it's not completely out of their hands. The Fed has faced this choice before, and its independence allowed it to send a message to fiscal authorities that it was willing to take whatever steps are necessary, including causing a recession, to prevent monetizing the debt and creating an inflationary environment. As Thomas Sargent notes in his book "Dynamic Macroeconomic Theory":

A game of chicken seemed to be occurring in the United States from 1981 to 1985 because the Fed announced a policy that is feasible only if the budget swings toward balance in a present value sense, whereas Congress and the President set in place plans for government expenditures and taxes that imply prospective net-of-interest deficits so large that they are feasible only if the Fed eventually creates more inflation. In such a situation, something has to give.

And, due to the degree of independence that it had, it wasn't the Fed that eventually gave in. With a less independent Fed, I'm not sure we get that outcome. (I should note that people such as Jamie Galbraith argue that fighting inflation during this time period was the wrong policy to pursue - one part of the the argument is that it suppressed wages and made workers worse off - but this is a point on which we disagree, and the general view within the profession is that the Volcker Fed acted wisely.)

Ben Bernanke: The Fed's Exit Strategy

Ben Bernanke says that when the economy starts to recover, the Fed will take the steps needed to prevent an outbreak of inflation (the substance of the arguments can be found in the full version):

The Fed’s Exit Strategy, by Ben Bernanke, Commentary, WSJ: The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the ... federal-funds rate ... nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets...

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem... We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds ... ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. ...

But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy. ...

[W]e have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination. ... [T]hese policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

As I've said many times, I'm not particularly worried about inflation, reserves can be removed or neutralized as described. The worry is not so much that they will be too slow at removing reserves, it's that they will get trigger happy and start raising interest too soon potentially stalling the recovery or perhaps even sending the economy back downward. The Fed will need to be sure that things are getting better before beginning to raise interest rates, that's why it's good to hear them use the phrase "extended period" twice when describing how long interest rates will stay low. But there are long lags associated with monetary policy, and by the time the Fed knows for sure that economy is heading solidly in the right direction, it won't have much time left to reverse course and begin removing reserves. Even so, they need to be patient and avoid the more serious mistake of raising interest rates too soon.

Fed Watch: FOMC Forecasts - Reality or Fantasy?

Tim Duy analyzes the economic projections in the minutes from the June FOMC meeting:

FOMC Forecasts - Reality or Fantasy?, by Tim Duy: It takes some time to work through the minutes from the June FOMC meeting. They are, in the words of David Altig, "meaty." Altig concentrated his remarks on the implications of the Fed's balance sheet explosion. I found myself pulled to the various economic projections spread throughout the minutes. Do those projections pass the laugh test? Are they realistic? Are they optimistic? Or just plain delusional? I think a little of all those descriptions are accurate.

The staff's projections comes first, and appear to be what Calculated Risk describes as an "immaculate recovery":

In the forecast prepared for the June meeting, the staff revised upward its outlook for economic activity during the remainder of 2009 and for 2010…The staff projected that real GDP would decline at a substantially slower rate in the second quarter than it had in the first quarter and then increase in the second half of 2009, though less rapidly than potential output. The staff also revised up its projection for the increase in real GDP in 2010, to a pace above the growth rate of potential GDP. As a consequence, the staff projected that the unemployment rate would rise further in 2009 but would edge down in 2010. Meanwhile, the staff forecast for inflation was marked up. Recent readings on core consumer prices had come in a bit higher than expected; in addition, the rise in energy prices, less-favorable import prices, and the absence of any downward movement in inflation expectations led the staff to raise its medium-term inflation outlook. Nonetheless, the low level of resource utilization was projected to result in an appreciable deceleration in core consumer prices through 2010.

Looking ahead to 2011 and 2012, the staff anticipated that financial markets and institutions would continue to recuperate, monetary policy would remain stimulative, fiscal stimulus would be fading, and inflation expectations would be relatively well anchored. Under such conditions, the staff projected that real GDP would expand at a rate well above that of its potential, that the unemployment rate would decline significantly, and that overall and core personal consumption expenditures inflation would stay low.

Leaving aside inflation (which will stay low over the long term if you assume that expectations remain anchored), the staff upgraded the forecast for 2009, is expecting growth to rebound to potential next year (which, is now less than six months away) and then accelerate further in subsequent years. Is such optimism justified? Yes and no.

I think it is fair to say that mounting evidence points to the formation of a rather clear bottom in the most recent stage of this economic cycle. Hear I refer to the sharp contractions beginning in late 2008, not to the "official" start of the recession in December 2007. Indeed, I think one would have to be almost blind to not see the clear signals emerging in a wide range of data, such as the ISM data:

See also consumption data:

"Congress Must not Touch the Federal Reserve"

Mark Gertler says the Fed's independence should not be compromised:

Congress must not touch the Federal Reserve, by Mark Gertler: The economy was experiencing the worst recession since the war. In Congress, members were beginning to wonder whether the Federal Reserve’s intervention strategy was extracting too great a toll on the economy. Some started to suggest publicly that it may be time to rein in the central bank’s independence.

Sound familiar? Though they bear a strong resemblance to ... today, the events I refer to in fact happened in the early 1980s, in the midst of what was then the most serious economic crisis since the Depression. The head of the institution under threat of losing its independence was none other than Paul Volcker.

Of course, Mr Volcker would go on to be recognised as one of the great central bankers of modern times. He would do so by standing firm against political pressures. By continuing on the course he set out, the economy recovered and a new era of price and output stability began. ... In the Volcker era, the political outcry occurred in the midst of the economic contraction that the Fed had engineered to tame inflation. The costs of the policy were plain to see, but the long-term benefits that would eventually emerge were difficult for many to imagine at the time.

The Fed’s role has been different this time round. Rather than trying to slow the economy, it has been acting to contain the damage brought on by the most complex financial crisis of modern history. By the accounts of many, the Fed has acted masterfully under difficult circumstances. ...

Given that hard times remain, nonetheless, it is natural that Congress is questioning the Fed, just as it did in the early 1980s. ... Unfortunately, the Fed cannot demonstrate what would have happened to the economy if it had not intervened in the way it did. Many observers agree that the situation would be far worse than it is today. Yet discussions of reining in central bank powers proceed as if the financial system would have stabilised itself without any Fed intervention.

The Fed well understands the lesson from the Volcker era that it can be effective only when it resists political attempts to influence its decisions. One can only hope that sober voices in Congress who appreciate the importance of central bank independence will help keep Capitol Hill from taking any measures that do permanent damage to the Fed.

A more constructive route for Congress would be to proceed with regulatory reform that would prevent a repeat of the current situation. At the core of the crisis is an antiquated regulatory system that permitted large financial institutions to take excessive risks. By giving the Fed the ability to monitor risk-taking by these institutions, Congress would diminish greatly the likelihood the central bank would again need to intervene directly in private credit markets.

The Fed may not have been perfect in its response to this or previous crises, but that doesn't mean that a less independent Fed would have done better. Taking away Fed independence - including subjecting the Fed to audits by the GAO - would be a mistake. In addition, if we are going to strengthen regulatory authority so that we can better monitor and reduce systemic risk that threatens the financial system - and we should - that authority needs to be in the hands of an independent entity, and the Fed is the natural place for this. Finally, its role in regulating system-wide risk is complementary to many of its other activities. For example, its role as a systemic risk regulator would involve monitoring risk within large institutions. Should a bank get into trouble, that would be helpful in assessing whether the bank should be granted access to the discount window in its capacity as lender of last resort.

We need to maintain an independent Fed, to give the Fed the powers it needs to monitor and regulate the level of overall risk, and to give the Fed the authority it now lacks to put banks through an orderly bankruptcy process so it can avoid bailing out financial institutions that are in trouble and a threat to overall the financial system.

Update: See Willem Buiter for a longer, more detailed version of many of the same points, e.g.:

Probably the single most damaging  failure of the US Treasury, the US Congress and the US financial regulators was there inability/unwillingness to create a special resolution regime (SRR) with structured early intervention and prompt corrective action for all systemically important financial institutions (those too big, too complex, to interconnected, too international or too politically connected to fail in the ordinary Chapter 11 or Chapter 7 way).  ...

But however weak its past performance and credentials, they are rock-solid compared to those of the other candidate institutions. ...

Only the Fed can fulfill the macro-prudential regulator-supervisor role.  That is because it has the short-term deep pockets.  It is the source of the ultimate, unquestioned liquidity in the economy, through its monopoly of the issuance of base money.  Without the short-term deep pockets, a macro-prudential regulator/supervisor cannot act as lender of last resort, market maker of last resort or provider of enhanced credit support.  It would be ... toothless...

He also makes this point:

The problem with this solution of the macro-prudential regulator/supervisor problem is that it is incompatible with central bank operational independence as interpreted since 1989 or thereabouts. ... When the central bank plays a quasi-fiscal role, as the Fed has been doing on an unprecedented scale in the current crisis, the fullest possible degree of accountability to the Congress, the tax payer and the citizens is essential.  The Fed has no mandate to engage in quasi-fiscal operations, even when it is for a good cause.  ...

If the same institution, the central bank, has to be in charge of both normal monetary policy and systemic risk regulation (albeit jointly with the Treasury for the systemic risk role), there is no elegant, first-best solution.  Either monetary policy will be driven by politicians whose macroeconomics is limited to a partial understanding of the Keynesian cross and whose monetary policy views can be summarised by the proposition that the have never seen an official policy rate so low they would not want it even lower, or the central bank continues to act as an off-budget, off-balance sheet special purpose vehicle of the Treasury.

You pick.

Okay. As much as possible, monetary policy should be kept out of the hands of politicians.

Update: Jim Hamilton (I also signed the petition a day or two ago):

I joined many of my colleagues in urging Congress and the President to remember just how valuable an independent central bank is for the ordinary citizens of this country. You may not pay much attention to central bank independence. But you'll miss it when it's gone.

Money Monopoly

Marshall Auerback says California is challenging the federal monopoly on money creation:

Schwarznegger to Obama: Watch and Learn, by Marshall Auerback: According to the San Diego Union-Tribune, Republicans and Democrats alike embraced legislation last Friday that would make California IOUs legal tender for all taxes, fees and other payments owed to the state.

Effectively, California is using its IOUs to create a currency. If this bill passes it would allow California to deficit spend just like the Federal Government and with the IOU's acceptable as payment of state taxes, it instantly imparts value to them. In effect, what you have is a state of the union creating a sovereign currency right under the noses of Treasury, Fed. They are stumbling their way into it... It will be viewed as a stop gap measure at first, and then could very well become entrenched as states realize they have a way to escape balanced budget requirements. ...

The ... Federal government retains this monopoly under our existing monetary arrangements. If California is successful here in allowing its IOUs to pay tax, it has profound constitutional ramifications. ...

It will be interesting to see what the exchange rate is between California IOU and US currency - the IOUs do offer a yield, so should be less than par by design. I wonder if NY is next.

This is like some sort of return to the 13 colonies with all kinds of ersatz currency floating about. It's hard to believe the Rubinite wing of the Democrats will just let it be, given the threat it represents to Wall Street's prevailing economic interests, but it is an understandable response...

There are political benefits for Obama...: If the Federal government allows this proposal of the state of California to go unchallenged, it would relieve the President of a major political quandary, which is, does he help California and then open himself to aid requests from other states?..., or, does he let California go and lose 56 electoral votes in the next election?

By allowing them to "solve" their own problem in the manner proposed by the legislation he avoids the quandary. And ... they just might let them do it until the import is fully understood.

It is true that this legislation represents a profound break from all federal laws. It is almost bound to incur some sort of constitutional challenge, representing as it does, a profound threat to the Federal government's currency monopoly powers. But this is another instance where Obama's inattentiveness to the ramifications of the states' respective fiscal crises has come back to haunt him. This situation would not have arisen had Obama embraced a simple revenue sharing plan with the states (so that the states' respective fiscal policies would be working in harmony with his proposals, rather than mitigating the impact of the Federal fiscal stimulus), as recommended by any number of prominent economists...

It will be interesting to see how this plays out. As California goes, will the nation follow? ...

Setting aside the particulars of the California case and whether or not the IOUs are actually functioning as money - that's debatable - very, very generally, the federal government has a budget constraint just like everyone else, well sort of like everyone else anyway -- most of us can't levy taxes or print money. Federal government finances must satisfy

G - T = ΔM + ΔB,

where Δ means "change in," G is government spending, T is taxes, M is the money supply, and B is bonds. The left-hand side is the deficit, and the right-hand is how it is financed. Thus, when G is greater than T so that there is a deficit in a given budget period, it must be financed by printing new money (ΔM) or issuing new bonds (ΔB). (If it helps, think of G as being 100 and T being 70 so that the deficit is 30. The deficit can be financed by printing 30 new dollars, by borrowing 30 dollars from the public, or some combination of the two)

Now, for states, ΔM is zero since that would be money creation, and they are not allowed to do that. Thus, a state's budget constraint is:

G - T = ΔB

This must be satisfied each budget period. Because this constraint must hold each budget period, notice what happens if there is a legal or political debt limit -- in some states it is effectively B=0 -- and B is already at the limit (which means ΔB cannot be positive since that would add to the debt). If the state's budget deficit rises in a recession due to decreased tax revenue and increased spending on social services, then G must fall to eliminate the deficit, or new taxes must be levied, and the cutback in spending and/or increase in taxes makes the recession worse.

But what if a state was suddenly granted the power to print money? Then it could pay for that year's deficit without increasing bonds (i.e. debt) any further, i.e. G - T could be financed solely by ΔM if it so chooses. That is, the state now has the constraint

G - T = ΔM + ΔB

If B is maxed out politically or legally so that ΔB must equal zero (or be negative), then a deficit, G - T, could still be financed with ΔM.

Having fifty different currencies isn't necessarily bad, there are pros and cons to having a single currency across all fifty states, i.e. to forming currency union. With a currency union, individual members lose the ability to conduct independent monetary policy - there is one money and one policy so everyone in the group gets the same treatment - but that is less costly when the the economic differences among the members of the union is small and the same policy is generally applicable. There are many advantages to having a single currency (no exchange rate uncertainty and lower transactions costs to name just two), and for countries considering forming a currency union, there is a list of factors that are cited as working for or against unification. Many of these factors involve social, political, economic, and geographic factors, and generally, though not always, the more similar the countries are, the more likely it is that a currency union will be beneficial (e.g. similar levels of development, a similar mix of products, similar legal institutions, same language). In the case of the fifty states within the U.S., I believe the advantages of a single currency far outweigh the disadvantages, and states should not be allowed to create their own currencies.

Did Greenspan Make a Mistake in 2001-2004 by Keeping Too Rates Low?

David Beckworth says Brad DeLong can quit wondering, Greenspan's "low interest rate policy in the early-to-mid 2000s was truly a mistake" [Update: see Brad Delong for more]:

Yes Brad, the Fed's Low Interest Rate Policy Was a Mistake, by David Beckworth: Brad Delong is wondering whether the Federal Reserves' low interest rate policy in the early-to-mid 2000s was truly a mistake:

There is, however, active debate over whether there was a fourth mistake: whether Alan Greenspan's decision in 2001-2004 to push and keep nominal interest rates on Treasury securities very very low in order to try to keep the economy near full employment was a fourth mistake...I am genuinely not sure which side I come down on in this debate.

Brad's uncertainty is understandable given he invokes the entire 2001-2004 time frame. For during this period there was a time when the U.S. economic recovery was sputtering along (2001-2002) and a time when the recovery began to take hold (2003-2004). It was during this latter period that Fed's low interest rates were a big mistake. But even for that period I think Brad is misreading the data:

People claim that the Greenspan Federal Reserve "aggressively pushed the interest rate below its natural level."... [T]he market interest rate[, however,] was if anything above the natural interest rate in the early 2000s... You ... cannot argue that he aggressively pushed the interest rate below its natural level. The low interest rate was at its natural level.

I think the evidence shows the opposite. The natural interest rate is a function of individual's time preferences, productivity, and the population growth rate. Of these three components, the one that changed the most in 2003-2004 was productivity as can be seen in the figure...

DeLong: Sympathy for Greenspan

Brad DeLong can't decide whether or not Greenspan made a mistake when he kept interest rates low after the collapse of the dot.com bubble:

Sympathy for Greenspan, by J. Bradford DeLong, Commentary, Project Syndicate: In the circles in which I travel, there is near-universal consensus that America’s monetary authorities made three serious mistakes that contributed to and exacerbated the financial crisis. ... US policymakers erred when:

-the decision was made to eschew principles-based regulation and allow the shadow banking sector to grow with respect to its leverage and its compensation schemes, in the belief that the government’s guarantee of the commercial banking system was enough to keep us out of trouble;

-the Fed and the Treasury decided, once we were in trouble, to nationalise AIG and pay its bills rather than to support its counterparties, which allowed financiers to pretend that their strategies were fundamentally sound;

-the Fed and the Treasury decided to let Lehman Brothers go into uncontrolled bankruptcy in order to try to teach financiers that having an ill-capitalised counterparty was not without risk, and that people should not expect the government to come to their rescue automatically.

There is, however, a lively debate about whether there was a fourth big mistake: Alan Greenspan’s decision in 2001-2004 to push and keep nominal interest rates on US Treasury securities very low in order to try to keep the economy near full employment. In other words, should Greenspan have kept interest rates higher and triggered a recession in order to avert the growth of a housing bubble? ...

Full employment is better than high unemployment if it can be accomplished without inflation, Greenspan thought. If a bubble develops, and if the bubble ... collapses, threatening to cause a depression, the Fed would have the policy tools to short-circuit that chain. In hindsight, Greenspan was wrong. But the question is: was the bet that Greenspan made a favourable one? ...

I am genuinely unsure as to which side I come down on in this debate. ... What I do know is that the way the issue is usually posed is wrong. People claim that Greenspan’s Fed “aggressively pushed interest rates below a natural level.” But what is the natural level? In the 1920’s, Swedish economist Knut Wicksell defined it as the interest rate at which, economy-wide, desired investment equals desired savings, implying no upward pressure on consumer prices, resource prices, or wages as aggregate demand outruns supply, and no downward pressure on these prices as supply exceeds demand.

On Wicksell’s definition — the best, and, in fact, the only definition I know of — the market interest rate was, if anything, above the natural interest rate in the early 2000’s: the threat was deflation, not accelerating inflation. The natural interest rate was low because, as the Fed’s current chairman Ben Bernanke explained at the time, the world had a global savings glut (or, rather, a global investment deficiency). ...

Greenspan’s mistake — if it was a mistake — was his failure to overrule the market and aggressively push the interest rate up above its natural rate, which would have deepened and prolonged the recession that started in 2001.

But today is one of those days when I don’t think that Greenspan’s failure to raise interest rates above the natural rate to generate high unemployment and avert the growth of a mortgage-finance bubble was a mistake. There were plenty of other mistakes that generated the catastrophe that faces us today.

I have argued the Fed's decision to keep interest rates low contributed to the bubble, but was not itself the sole cause of it. As to whether the Fed made a mistake, I'll just note that the tradeoff wasn't quite as stark as Brad implies, i.e. there were other policy instruments that Fed could have used to limit the housing bubble. Regulation is certainly one means the Fed had to that end, but Fed communication could have helped too. If Greenspan had, for example, told people to stay away from mortgages because they were toxic rather than implicitly encouraging them to invest in housing, things might have been different.

Would limiting the bubble through regulation, communication, or other means have limited the employment response, the primary worry? I don't think so, at least not enough to matter. The money would have been invested somewhere, housing had an opportunity cost after all, so the next best alternatives would have been pursued to the extent that they were profitable (and many would have been, just not as profitable - apparently anyway - as investing in housing and mortgages). So people still would have been employed somewhere as the money was invested, just not in housing, and that would have helped to insulate us from the housing crash. (And a lot of them might still have those jobs, unlike the people who depended upon the housing markets for employment.)

So narrowly, keeping interest rates low and employment high was the right thing to do. The mistake was letting all of the action brought about by those low rates, or most of it anyway, occur in a single sector, housing, rather than using regulation and other means to limit the flow of resources into the housing market in pursuit of profits based upon the misperception of risk. Those resources could have been redirected into other sectors and put to productive use rather than wasted building houses nobody wants, and achieving this result did not require the Fed to aggressively raise the target rate, it only needed to use the other tools it already had available.

Unfortunately, however, those tools were not used, and the ideology Greenspan brought to the Fed played a large role in this outcome.

Fed Watch: A Tangled Policy Web

Tim Duy:

A Tangled Policy Web, by Tim Duy: Incoming data continues to confirm an emerging period of relative economic tranquility following the financial storm of 2008. Importantly, the bleeding in consumer spending has been staunched, despite ongoing job losses that look likely to remain a feature of the American economic landscape for months to come. But incoming data also point to America's sustained and perplexing dependence on foreign capital inflows - a dependence that suggests an underlying economic vulnerability that has yet to be addressed. Whether it needs to be addressed next month, next year, or next decade is still a question that continues to haunt the followers of global macro trends.

The most recent Personal Income and Outlays report, for May 2009, highlights many of the trends currently impacting the evolution of economic activity. The headline jump in incomes, like that of the previous month, was driven by federal stimulus. Declining private wage and salary disbursements are a more telling indicator of the health of household finances, and are consistent with ongoing labor market weakness. The best bet is the that private wage gains remain subdued, even as conditions stabilize. Although the apparent peak of initial claims is in the rearview mirror, persistent high levels of claims points to a jobless recovery.

Of course, in the absence of federal stimulus, the underlying weak income growth indicates sustained pressures on consumer spending power. Indeed, the numbers tell a clear story of stabilization, but little to suggest that a V shaped recovery for consumer spending is at hand:

In addition, the report adds further credence to the claims that American's long affair with spending has ended in a bitter divorce, with the saving rate climbing to its highest level in 15 years. To be sure, some of the increase is likely not sustainable in the short run, as it partly reflects a time lag between federal stimulus and the spending it was meant to encourage. That said, the underlying saving increase is tempering the impact of stimulus spending, as households sock some of it away for the next rainy day and/or pay down crippling debt loads, effectively turning private debt into public debt. And note that large shifts in consumer behavior are not required to have significant macroeconomic implications. Small changes across households - a little less, percentage wise, spending here and there adds up. From Bloomberg:

What's behind Recent Changes in Long-Term Interst Rates?

Martin Feldstein says we need to cut social programs so that we don't "weaken demand in the near term and hurt economic incentives in the long run":

The Fed must reassure markets on inflation, by Martin Feldstein, Commentary, Financial Times: The interest rate on 10-year US Treasury bonds almost doubled in six months, rising from 2.26 per cent last December to 3.98 per cent in mid-June, before decreasing slightly in recent days. This sharp rise happened despite the Federal Reserve’s ... policy aimed at lowering long-term rates by buying $300bn of Treasuries and promising to buy more than $1,000bn of mortgage securities. ...

There is no single reason for the sharp rise in rates... The simplest explanation for the higher 10-year rate is that many investors now expect inflation to rise. ... The prospective decline of the dollar is also a potential source of inflation. ...

But such an explanation is deceptively easy. ... Those scared by Lehman Brothers’ collapse wanted the safety and liquidity of ordinary Treasury bonds, causing their yields to fall sharply...

Treasury yields rose this month to their level a year earlier because improving market conditions meant investors were no longer willing to pay for the extreme liquidity of Treasuries. Inflation was thus not the only, and perhaps not even the main, reason for the rise in rates.

Why did the Fed’s massive buying of long-term Treasury bonds not hold down the bond rate? The answer is that bond markets are less impressed by the $300bn of Fed purchases than by the official projection of $10,000bn of government borrowing over the next decade... The resulting crowding out of private investment will require higher future interest rates, and that is reflected in current long-term rates.

A further reason long rates remain high is a fear that foreign buyers may not be willing to continue buying dollar bonds to finance a large US current account deficit.

In short, higher long-term interest rates reflect investors’ concern about future inflation, future fiscal deficits and the future willingness of foreign investors to purchase US bonds. ...

It would be wrong for the Obama administration and Congress to reduce the fiscal stimulus in 2009 or 2010, since there is no clear evidence of a sustained upturn. But it would be equally wrong to allow the national debt to double to 80 per cent of GDP a decade from now. Increasing taxes even more than proposed would weaken demand in the near term and hurt economic incentives in the long run. The fiscal deficit should therefore be reduced by curtailing the increases in social spending that the president advocated in his election campaign.

The Fed must also be careful not to tighten too soon. But it needs to reassure markets that it will prevent the excess reserves of the banks from financing a surge of inflationary lending when the economy begins to expand. It must make clear now that it will be willing to do so even if that involves big rises in short-term rates.

Here's (my interpretation of) Paul Krugman's argument about the source of recent movements in long-term interest rates:

There are two reasons long-term rates might rise, first more worries about the debt and inflation in the future would drive rates up, and second the prospect of better economic conditions in the future would have the same effect, rates would go up.

Suppose we receive bad news about the current state of the economy. That should cause expectations of lower output growth in the future, and hence lower tax revenues and higher spending on social programs than would exist with a stronger economy. So the bad news should cause an expectation of a larger deficit and more inflation worries, and that would drive long-term interest rates up (these worries would also make foreign central banks less likely to fund US borrowing which would reinforce the increase in long-term interest rates).

But if it is future economic conditions that are driving the changes in long-term interest rates, bad news about the economy should drive rates down.

Last week, we received bad news about the economy. If the debt/inflation/foreign lending story is correct, long-term rates should have gone up. If the state of the economy story is driving rates, rates should have fallen. What did long-term rates actually do? They fell.

"Pure Political Theater, and I Don't Like It"

Jim Hamilton:

On grilling the Fed Chair, Econbrowser: I got a bit angry at accounts of the latest appearance of Federal Reserve Chair Ben Bernanke before the U.S. Congress. ...

It is one thing to have different views from those of the Fed Chair on particular decisions that have been made-- I certainly have plenty of areas of disagreement of my own. But it is another matter to question Bernanke's intellect or personal integrity. As someone who's known him for 25 years, I would place him above 99.9% of those recently in power in Washington on the integrity dimension, not to mention IQ. His actions over the past two years have been guided by one and only one motive, that being to minimize the harm caused to ordinary people by the financial turmoil. Whether you agree or disagree with all the steps he's taken, let's start with an understanding that that's been his overriding goal.

These interrogations reveal more about those doing the grilling than they reveal about Bernanke. I see this as pure political theater, and I don't like it.

If Congress wants to explore more usefully the wisdom and motives behind some of the decisions that have been made, it might want to investigate why some legislators are now pushing for Fannie and Freddie to guarantee a riskier category of mortgage condo loans.

Big Government Ben?

The GOP is targeting Bernanke as "a champion of government intrusion and an ally of President Obama":

G.O.P. to Paint Bernanke as Ally of Big Government, by Edmund L. Andrews and Louise Story, NY Times: In a peculiar role reversal, Republican lawmakers are mounting a ferocious attack on the Republican chairman of the Federal Reserve, while Democrats are coming to his defense.

Ben S. Bernanke ... will be grilled on Thursday by the House Oversight and Government Reform Committee about his role in orchestrating Bank of America’s controversial takeover of Merrill Lynch late last year.

The House investigation is heavily colored by partisanship. President Obama is proposing to give the Federal Reserve formidable new powers to regulate giant institutions, including Bank of America, that could pose risks to the financial system.

Republicans, along with some Democrats, argue that the Fed already has too much power.

Unhappy about the huge bank bailouts that the Fed arranged with the Treasury Department during the Bush administration, many Republicans are even more displeased that Mr. Bernanke is now working hand-in-glove with the Obama administration.

The result is a set of dueling narratives and agendas, all of which will be on full display when Mr. Bernanke testifies on Thursday. ...

Despite Mr. Bernanke’s Republican roots, and the fact that President Bush nominated him to be Fed chairman, the Republican memo prepared for the hearing on Thursday describes Mr. Bernanke as a champion of government intrusion and an ally of President Obama. ...

I don't think this is an attempt to negatively influence Obama's decision on Bernanke's reappointment as Fed chair as some have been hinting because that would not be in the GOP's best interest. There are open positions on the Federal Reserve Board, so even if Bernanke didn't resign as is customary in the event he was not reappointed - and nothing says he must - Obama would still be free to appoint a new Fed Chair from outside the present Board membership.

Obama would certainly appoint someone who shares his regulatory vision, and that person would likely be confirmed (e.g. someone like Janet Yellen would likely be confirmed even if there was lots of grumbling), so I don't see how the appointment of a new Fed chair would do anything but strengthen the support for the type of regulatory oversight the administration envisions. That's not what the GOP wants.

Instead, this looks much more like an attempt to by the GOP to maintain its usual anti-regulatory, anti-government stance by arguing that the Fed should not to be trusted with the powers envisioned in the proposed regulatory reform legislation. So the real goal is the Fed as an institution, Bernanke is simply the target being used to make that the point. E.g.:

The vast extent of the Fed’s actions in the past two years to commit trillions of dollars in government money to support the economy has raised significant concerns on Capitol Hill, some of which will be aired on Thursday when Bernanke testifies before the House Committee on Oversight and Government Reform.

Congressional investigators have been looking into the Fed’s role in encouraging Bank of America to purchase Merrill Lynch... Rep. Darrell Issa (R-Calif.), ranking member on the Oversight Committee, said on Wednesday that the Fed engaged in a “cover-up” and hid details about the merger, completed in January 2009, from other federal agencies.

Meanwhile, lawmakers from both parties are raising questions about Obama’s proposal to grant the Fed broad new powers to prevent another crisis.

Those concerns could make the next confirmation process far more contentious than the six that have occurred in the last two decades.

And:

Sen. Jim DeMint (R-S.C.) said, “It won’t be my decision whether he is held over or not, but right now I’m concerned that they have lost their independence and are too cozy with Treasury.”

It looks like we are going to get some version of a strategy that has the GOP saying that given what happened to the financial system, of course we need more oversight and regulation of the financial system. But any particular piece of legislation that is proposed will be fought tooth and nail by the GOP as being far too intrusive, granting the government too much power, and generally going far beyond what is needed to solve the problem. The fact that the will for reform will diminish with time works in their favor, and if they can string things out long enough with this strategy, the result will be that the legislation eventually passes in a much weaker form, or it won't ever pass at all.

Just ignore them. Altering a few words:

The Republicans, with a few possible exceptions, have decided to do all they can to make the Obama administration a failure. Their role in the financial regulation debate is purely that of spoilers who keep shouting the old slogan — Government is always the problem, never the solution! — hoping that someone still cares.