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Saturday, March 24, 2007

What Conundrum?

Mohamed A. El-Erian of the Harvard Business School and Nobel laureate in economics Michael Spence say there's nothing puzzling or hard to understand about global imbalances, declining risk spreads, flattened yield curves, and declining market volatility. However, their analysis of these changes leads them to conclude that global imbalances raise "considerable challenges, as does the ability to maintain an orderly global reconciliation process over time":

Capital Currents, by Mohamed A. El-Erian and Michael Spence, Commentary, WSJ: For the past few years, the U.S. has generated insufficient domestic savings to cover its investment needs. The difference has been covered by large capital inflows from abroad, the counterpart of which is the much-discussed current account deficit, which has been running at unprecedented rates of 6%-7% of GDP. ...

This has raised concerns about its sustainability, including whether it will end in a sudden and disorganized manner that sharply reduces growth in the global economy and causes problems in global capital markets. And underlying the concern is a kind of puzzlement about the configuration of global savings -- one that runs counter to virtually every text book description: The world's richest country appears to be saving at a low rate and has to borrow from poorer, developing countries to maintain its consumption and investment.

Let's analyze this puzzle, beginning with the U.S. The financial assets of U.S. households have risen rapidly in the past 10 years, at rates well above inflation. The most dramatic increase occurred in household real estate, principally housing. At least some of these increases in asset values were not anticipated, relative to ... long-term ... savings and consumption plans... [I]t ... seems reasonable that U.S. households would consume a portion of their windfall ... over time.

The recent shakiness in the subprime mortgage market has created uncertainty as to whether this dynamic will be sustained. ... More generally, the potential pressure on house prices could also reduce household's propensity to consume out of their accumulated equity windfall. And ... there is concern in ... capital markets that global growth could be negatively impacted.

These concerns are worth monitoring carefully -- and they highlight a more general issue...: While individual consumption and savings decisions may have been largely rational, that does not mean that the decisions of individual households "add up" properly in the aggregate... In fact they easily might not have. ...

[W]e can consume and invest more than output by importing more than we export -- and we did. Hence the trade deficit. However, this ability is dependent on the ability and willingness of the rest of the global economy to accommodate the US desire for higher consumption by investing in the US. That accommodation has been forthcoming from emerging economies generally, including OPEC and China, as well as from Japan.

Their initial reaction to their improved external trade balances has been primarily to recycle the funds to the "risk free assets," U.S. Treasuries and Agencies. By financing U.S. consumption, many surplus countries are also meeting their domestic objectives, to promote exports, increase employment and build up significant reserve cushions to deal with the possibility of sudden disruptions in global capital markets.

This constellation of conditions was largely unanticipated by both markets and policy makers, and as a result it has been reflected in a host of unusual economic and market outcomes -- referred to as conundrums, aberrations, puzzles, etc. The most visible is ... global "imbalances"; also of note is the excessive compression in risk spreads, the unusual collapse in market volatility, the inverted shape of the U.S. yield curve...

Now to the future. Over time, emerging markets will inevitably divert more of their assets to more sophisticated investments abroad. ... One effect will surely be to put upward pressure ... on the cost of capital in the U.S., as the incremental demand for treasuries declines.

While the shift is inevitable, it would be unlikely that the emerging economies as a group would deliberately ... undermine global economic markets. There will also be domestic pressure on policy makers in emerging countries to gradually shift their emphasis away from the producer and towards the consumer. That will mean lowering the savings rate relative to investment, increasing consumption and letting it assume a more important role (relative to exports...) in driving growth.

Under this state of the world, domestic consumption in the rest of the world picks up over time, facilitating the needed adjustment in the U.S. The result is a gradual journey to a more normal relationship between assets and income returns, with savings moving to a more normal long-run pattern.

But this process is not automatic and faces significant disruption risks; and it is particularly sensitive to "policy mistakes." Among these policy mistakes, protectionism measures in the U.S. would derail the global adjustment So, too, would the inability of emerging economies to navigate their complex policy challenges.

Geopolitical shocks would also be a problem... Finally, significant "market accidents" ... associated with excessive leverage and ... sudden and large portfolio changes and credit rationing, would add to the policy complexity.

So where does all this leave us? The current configuration of global imbalances, while highly unusual is not a real puzzle. It is the result of a series of individual decisions in both advanced and emerging economies that were largely rational when considered at the micro level. ...

The aggregation of these decisions at the national and international levels raises considerable challenges, as does the ability to maintain an orderly global reconciliation process over time. The fundamental question, therefore, is whether these global considerations will be sufficient to minimize the risk of "policy mistakes" in a world that is subject to geo-political risk and bouts of excessive leverage.

One thing that bothers me about this story is that it begins with a run-up in asset prices as the source of global imbalances:

Let's analyze this puzzle, beginning with the U.S. The financial assets of U.S. households have risen rapidly in the past 10 years, at rates well above inflation. The most dramatic increase occurred in household real estate, principally housing.

However, prices are endogenous variables, and therefore this explanation leaves the primary driving force behind the run-up in asset prices unexplained. Jim Hamilton looks at the housing market in "Bubble, bubble, toil, and trouble." His analysis is concerned with whether or not housing prices have departed from underlying fundamentals, and he doesn't believe that they have. He concludes:

Low interest rates and rapid population and employment growth relative to the supply of available housing were the main factors driving house prices up...

To that, Jim adds:

The one thing to which I think I was not paying enough attention two years ago was the role of lax credit standards and even fraud ([1], [2]) in addition to low interest rates as factors fueling the boom. I have been coming around to the view that there may have been some significant market failures behind that. My first worry here is about Fannie Mae and Freddie Mac, and the second concerns whether some of our institutions have the right incentives for fund managers to properly value lower-tail risks. This ready availability of credit, over and above the low interest rates themselves, I now believe was an important factor contributing to the real estate boom.

I would also mention regulatory restrictions as an important factor, e.g. see Edward Glaeser's on zoning regulations or Krugman on Flatlands and Zoned Zones. But many people blame (or thank) the Fed for driving interest rates so low.

Which opens the door to "Did the Fed Do It?" from David Altig. David isn't so sure that the Fed is to blame for the escalation in housing prices:

Did The Fed Do It?, macroblog: The ISI Group's Andy Laperriere, writing on the opinion page of yesterday's Wall Street Journal, says the answer is yes (at least in part):

Federal Reserve officials and most economists believe the problems in the subprime mortgage market will remain relatively contained, but there is compelling evidence that the failure of subprime loans may be the start of a painful unwinding of a housing bubble that was fueled by easy money and loose lending practices...

The ... fallout from the second major asset price bubble in the last decade should prompt some broader questions. For example, what role did the Fed's loose monetary policy from 2002-2004 play in fueling the housing bubble? Should the Federal Reserve reexamine its policy of ignoring asset bubbles?

I know that the easy money claim has become something of a meme, but I often find myself pondering this picture:


What's the story here?  That the long string of federal funds rate cuts beginning in January 2001 caused the decline in long-term interest rates -- including mortgage rates -- that commenced a full half-year (at least) before the first move by the FOMC?  That low levels of short-term interest rates have kept long-term rates well below their pre-recession peaks?  Then what to make of the fact that rates at the longer end of the yield curve have barely budged in the face of a 425 basis point rise in the funds rate target?  Maybe it's "long and variable lags"? Should we then be expecting that big jump in long-term rates any day now?  I guess it's still a conundrum. But maybe, then, we should be a little circumspect about the finger pointing?

OK, here's part of the Laperriere article I can get behind:

It's not the size of foreclosure losses as a share of the economy that matters, it is the effect those losses have on the availability of credit.

Like I said.

In a recent speech, Fed Chair Ben Bernanke says the Fed still has the ability to affect long-term rates:

The empirical literature supports the view that U.S. monetary policy retains its ability to influence longer-term rates and other asset prices. Indeed, research on U.S. bond yields across the whole spectrum of maturities finds that all yields respond significantly to unanticipated changes in the Fed’s short-term interest-rate target and that the size and pattern of these responses has not changed much over time (Kuttner, 2001; Andersen and others, 2005; and Faust and others, 2006). ...

[G]lobalization of financial markets has not materially reduced the ability of the Federal Reserve to influence financial conditions in the United States. But, ... globalization has added a dimension of complexity to the analysis of financial conditions and their determinants, which monetary policy makers must take into account.

I'm also intrigued by David's suggestion, and hopefully more evidence can settle whether previous research has this wrong. But for now, my policy recommendations will still account for the possibility that the Fed can affect long-term rates.

    Posted by on Saturday, March 24, 2007 at 04:17 AM in Economics, Financial System, Housing, Market Failure, Monetary Policy | Permalink  TrackBack (0)  Comments (39)


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