Archive for September 2012


All hail Ben Bernanke

Here’s John Hilsenrath, the reporter with the best Fed sources:

Drawing broad support for the plan was important to Mr. Bernanke in part because the policies he was formulating could outlast him. His term as Fed chairman ends in January 2014. Seeing a return to U.S. full employment as a distant goal, Mr. Bernanke needed the support of officials who might remain at the Fed after he left.

.  .  .

To move forward, Mr. Bernanke needed to corral several colleagues, including regional Fed bank president Dennis Lockhart from Atlanta, who had a vote on the Federal Open Market Committee, the Fed’s decision making body. Under Fed rules, four of the 12 regional Fed banks vote on the committee on a rotating basis; a fifth, the New York Fed, always votes.

.   .   .

Like others, Mr. Lockhart had reservations about the effectiveness of Fed policies. Earlier bond buying hadn’t yet produced strong growth. The banking system, still damaged by the financial crisis, wasn’t delivering credit the way economists expected, given historically low interest rates. Still, Mr. Lockhart thought a program targeting the U.S. housing market might help.

Mr. Bernanke also worked on nonvoters, including Narayana Kocherlakota, who was going through his own transformation.

Several months after becoming president of the Minneapolis Fed in 2009, Mr. Kocherlakota believed the job market had structural problems beyond the reach of monetary policy””for example, too many construction workers who couldn’t easily be trained for other jobs.

Mr. Kocherlakota joined Fed skeptics, so-called hawks, who doubted the effectiveness of central bank activism. During his turn as a Fed voter last year, he voted twice against loosening credit, moves championed by Mr. Bernanke.

.   .   .

Mr. Kocherlakota and Mr. Bernanke exchanged emails over months, debating structural unemployment””the idea that unemployment was caused by mismatches between employer needs and the skills and location of workers. In Mr. Bernanke’s view, employers weren’t hiring because of weak demand for their goods and services, which Fed policies might help remedy.

“I’ve learned a lot by talking to him,” Mr. Kocherlakota said in an interview after the September meeting. Mr. Bernanke’s “thinking is framed by data and models,” he said. “It beats coming in there with just your gut.”

By summer, Mr. Kocherlakota said, his views about structural unemployment were shifting as he found the evidence less than persuasive. This left an opening for Mr. Bernanke.

As the Fed’s August meeting approached, Mr. Bernanke and his inner circle, which included Fed Vice Chairwoman Janet Yellen and New York Fed President William Dudley, were thinking that any Fed action should be a comprehensive and novel package, rather than an incremental step, according to people familiar with their views. They agreed to take time to confirm their views of the U.S. economy and develop consensus for a plan.

.   .   .

The Fed’s policy committee emerged from the August meeting with familiar fissures. Opponents of the Fed’s easy-money policies said the measures weren’t giving the economy much of a lift, while risking future inflation.

Dallas Fed president Richard Fisher said the Fed was like a doctor over-prescribing Ritalin to attention-deficient Wall Street traders. Richmond Fed president Jeffrey Lacker dissented in August for the fifth straight meeting, taking issue with a policy already in place: An assurance the Fed had given that short-term interest rates would remain near zero through late 2014. Philadelphia Fed President Charles Plosser said in an interview that he urged Mr. Bernanke to wait until year-end before deciding on any new programs.

Despite their public disagreements, Fed officials were friendly behind the scenes. Mr. Plosser, who favors tighter credit policies, and the Chicago Fed’s Charles Evans, who wants easier credit, play golf together. They joined Mr. Fisher and Mr. Lockhart for a round at the Chevy Chase Country Club after the August meeting.

.   .   .

Many Fed activists wanted a open-ended program of bond purchases that would continue until the economy improved. Among them, some wanted to go big””at least a few hundred billion dollars worth over several months””with a promise to keep buying as needed. Moreover, some wanted to replace Operation Twist with bigger purchases of mortgage-backed securities and Treasurys.

As the September meeting neared, Mr. Bernanke needed to assure colleagues who still had reservations about moving too aggressively. In addition to Mr. Lockhart, Cleveland Fed president Sandra Pianalto had been wavering. She was among those who worried more Fed bond buying could disrupt markets.

Another fence-sitter was Washington-based Fed Governor Elizabeth Duke, a plain-spoken Virginia banker nominated to the Fed board by President George W. Bush in 2007.

Fed officials described the Fed chairman’s phone calls as low-pressure conversations. Mr. Bernanke sometimes dialed up colleagues while in his office on weekends, catching them off guard when their phones identified his private number as unknown. He gave updates on the latest staff forecasts, colleagues said. He asked their thoughts and what they could comfortably support, they said.

The calls helped Mr. Bernanke gauge how far he could push his committee. It also won him trust among some of his fiercest opponents, officials said. Nearly all of Mr. Bernanke’s colleagues described him as a good listener.

“Even if you disagree with him on the programs, you know your voice has been heard,” said Mr. Fisher, one of his opponents. “There is no effort to bully.”

Negotiations stepped up in the week before the meeting. Fed staff circulated language for policy options. Officials debated how different approaches would be described in the policy statement, which would be released after the meeting.

Officials at Fed policy meetings typically consider three options: one representing activists who want to use monetary policy aggressively; another supporting officials seeking conservative use; and a middle-ground option that typically prevails.

The premeeting documents this time listed four options, including an aggressive approach favored by activists, and no bond buying, favored by hawks. Among two middle-ground proposals was a compromise that Ms. Duke originated.

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At the meeting the following week, the Fed adopted the compromise that Ms. Duke helped spur. The Fed would continue Operation Twist through December but add an open-ended mortgage-bond buying program.

Activists got what they most wanted: An open-ended commitment to buy mortgage bonds until the job market improved, with the strong possibility of additional Treasury purchases later. Fence-sitters got a promise to review the plan before deciding to proceed with a bigger program in 2013. Mr. Lockhart said the chance to reassess the program based on inflation and the performance of the job market helped win him over.

With an agreement on bond buying largely in place, Fed officials at the September meeting left unanswered this question: When could they leave growth of the U.S. economy on its own? Mr. Kocherlakota and Mr. Evans failed to get agreement for inflation and unemployment thresholds to determine when to raise short-term rates, according to people familiar with the talks.

That’s exactly how a leader should manage a committee.

No one can say Bernanke is not well-intentioned, even if they wish he’d moved a bit faster.  Does anyone know how the timing of bringing in the management consultant (Robinson) compares to Larry Ball’s paper on Bernanke’s quiet personality?

Yes, but what would the poll have looked like 4 years ago?

JimP sent me the following poll from The Economist:

Evan Soltas on the 1920s housing “bubble.”

Here’s an interesting new Evan Soltas piece in Bloomberg:

The U.S. economy slips into recession. The stock market takes a tumble as heady expectations for future growth cool. Interest rates fall as the Federal Reserve quickly trims the discount rate in hope of cushioning the business cycle.

The low interest rate environment sets off a massive wave of home construction and an asset bubble in real estate. By the time the Federal Reserve takes action, the boom is completely out of control. Bank balance sheets and household savings have become dependent on the profound mispricing of real estate and other equity holdings.

The heedless extent of leverage makes the financial system extremely vulnerable to capital losses. As the housing bubble implodes, it pushes the economy into a long, deep recession.

This is the economic story of the last decade — and of the 1920s.

After a sharp deflationary recession at the end of World War I, the newly created Federal Reserve slashed interest rates, setting off a housing bubble of such an incredible scale that it dwarfs its recent counterpart. When the bubble ended, what seemed to be a calm and contained contraction turned violent, culminating in the macroeconomic implosion of the Great Depression.

It sounds a lot like the recent crisis, but I also see some important differences:

1.  Monetary policy was not expansionary during the 1920s.  And indeed Evan doesn’t present any evidence suggesting it was easy.  Take whatever criteria you like, starting with interest rates.  Evan mentions that interest rates fluctuated between 3% and 7%, but fails to mention that the 1920s began with deflation (1920-21), and then saw level prices for the rest of the decade.  With inflation expectations near zero (typical of a gold standard regime) real rates ranged for normal to high. The monetary base was flat during the 1920s, a decade that saw rapid growth in population and RGDP.  Even if you take sub-periods where the base increased, it was certainly not expansionary compared to most other periods of history.  NGDP rose slightly during the 1920s, but fell sharply in per capita terms (which is very unusual.)  And there was no “bubble” in real estate prices, Soltas mentions a price bubble in Manhattan, which did occur, but there was no significant nationwide change in either real or nominal house prices during the 1920s.

2.  Although money wasn’t easy, it’s still possible that the huge rise and fall in housing construction somehow caused a depression to begin in 1929.  But it’s hard to see how that would have occurred.  Suppose NGDP had remained stable after 1929, instead of falling by 50%, does anyone seriously believe a housing decline would have caused a depression?  I suppose one could use a re-allocation story, but then other sectors should have been booming, and they were also declining. Furthermore, a substantial amount of decline took place between the peak of 1926 and mid-1929, and yet the economy continued booming. Previously I’ve pointed to the fact that the US economy didn’t fall off a cliff between January 2006 and April 2008, despite a huge decline in housing construction.  But the 1926-29 period is even more problematic for bubble worriers, as while 2006-08 saw an economic slowdown, 1926-29 was actually a boom period.  It’s not obvious why the boom could not have continued into 1930.

3.  So the problem wasn’t tight money, and the problem wasn’t the decline in housing construction.  Perhaps the decline in housing construction somehow caused a banking crisis, which dragged down NGDP (due to the gold standard.)  But why would a decline in housing construction have caused banking crisis? Even worse, in 2007 we saw the banking system come under great stress, despite the economy not even being in recession.  Now contrast that with the period from August 1929 to October 1930, which saw a recession even deeper than 2009, and no banking crisis at all!  Why the difference?  I can only speculate, but perhaps there were two key differences.  In the 2000s banks made the sort of highly risky mortgage loans that banks did not make in the 1920s (although loan quality fell off a bit late in the 1920s.)  And second, in the 2000s there was a huge increase and then decrease in home prices.  Because there was no price bubble in the 1920s, there was no banking crisis in the first 14 months of the Depression.  Instead, tight money by the Fed, the BOE, and the Bank of France created world-wide deflation and drove NGDP much lower during 1929-30.  The banking crises only began to develop when falling NGDP drove nominal incomes much lower.

4. Now it is true that the fall in NGDP did eventually get so bad that a banking crisis developed, but you’d expect that with any severe decline in nominal incomes.   A very mild banking crisis occurred in Tennessee in November 1930, and then a more severe one developed all over the world in mid-1931.  That’s what you’d expect in a world on non-indexed debt and rapidly falling NGDP.  And that led to gold and currency hoarding, which drove NGDP still lower.

Of course in pointing to the fall in NGDP I’m not telling Evan anything he doesn’t already know, and indeed has written eloquently about.  If you don’t want a collapse in RGDP, tell the central bank not to allow a collapse in NGDP.

And make sure you don’t screw up the supply-side of your economy with disincentives to produce.

Inflation is a drug, but which kind of drug?

The New York Herald of 1933 suggests it’s the bad kind, a sort of monetary heroin:

As the effects of the first jab in the arm wear off, the country is plainly more than a little worried over the cure-all drug called inflation.  The first dose was just a promise – and what beautiful dreams it produced!  Exchange was about to be stabilized, stocks and commodities were to go kiting, everyone was to be prosperous – long live the 50-cent dollar!

Now the headache of the morning after is already unmistakable in many quarters.  Such is the familiar inevitable history of the inflation treatment, and it is interesting to see even the first preliminary stage following the classic formula.  Nothing is more certain to produce a temporary thrill, a delusion of wellbeing; nothing is more certain that, as the effects wear off, the patient feels worse than ever.  That is the chief viciousness of inflation.  It is in literal truth a habit-forming drug requiring ever larger and larger doses to keep the patient satisfied. (New York Herald, 4/27/33)

But Saturos sent me some recent research suggesting that it’s more like a drug to treat neurosis, helpful in allowing the economy to cope with irrational fears of lower nominal wages:

ScienceDaily (Mar. 27, 2009) “” What would you prefer: a three per cent wage rise at five per cent inflation? Or a two per cent wage-cut with stable prices? Many people, faced with this choice, would take the first option, although the true purchasing power of their income sinks in both cases by exactly the same amount, namely two per cent.

Researchers at Bonn University and the California Institute of Technology have now discovered the cerebro-physiological cause underlying this so-called “money illusion”. This effect is of great practical relevance in that it explains, for instance, why financial policy and inflation can have a beneficial effect on employment and economic growth.

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“We had now confronted our test subjects with two different situations”, Falk explains. “In the first, they could only earn a relatively small amount of money, but the items in the catalogue were also comparatively cheap. In the second scenario, the wage was 50 per cent higher, but now all the items were 50 per cent more expensive. Thus, in both scenarios the participants could afford exactly the same goods with the money they had earned – the true purchasing power had remained exactly the same.” The test subjects were perfectly aware of this, too – not only did they know both catalogues, but they had been explicitly informed at the start that the true value of the money they earned would always remain the same.

Despite this, an astonishing manifestation emerged: “In the low-wage scenario there was one particular area of the brain which was always significantly less active than in the high-wage scenario”, declares Bernd Weber, focusing on the main result. “In this case, it was the so-called ventro-medial prefrontal cortex – the area which produces the sense of quasi elation associated with pleasurable experiences”. Hence, on the one hand, the study confirmed that this money illusion really exists, and on the other, it revealed the cerebro-physiological processes involved.

An Explanation for the unpopular “Teuro”?

The results achieved by these scientists in Bonn demonstrate that as far as the brain is concerned money is represented as being “nominal”, and not only “real”. In other words: people like to be seduced by large numbers. This is of great practical relevance as the money illusion explains, for example, why the economy allows itself to be reflated by expansive financial policy. It also offers an explanation for why nominal wages rarely sink, whereas true wages, in contrast, fall in value in periods of inflation. Many economists also see the money illusion as an explanation for speculative bubbles, such as those in the property or shares markets. Armin Falk declares: “Even minor departures from rational behaviour, i.e. a “little money illusion” can have major economic consequences”.

I’m often taunted by RBC-types: “Where’s your model.”  “That’s not scientific.”  We now have hard science showing money illusion exists.  In contrast, the RBC belief in the non-existence of money illusion is akin to religious faith.  “Our models say it shouldn’t exist, so it can’t.”

Unfortunately, it does exist.

PS.  I was thinking of entitling this post; “It’s the ventro-medial prefrontal cortex, stupid.”  But I already overuse the term ‘stupid.’

PPS.  I had breakfast the other day with Louis Woodhill, the guy who first noticed that each rise in the IOR was associated with a stock market crash.  We were talking about the possibility of a Greek devaluation.  He pointed out that rather then reduce the “length” of their monetary measuring stick, they could just increase the “length” of the second.  Make seconds 50% longer.  This would lower real wages as long as nominal wages were sticky.  And he pointed to an additional benefit; it would reduce interest payments, which also involve units of time.  I thought it was a great idea.  Then I found out he was being sarcastic, using a reductio ad absurdum argument to show the folly of devaluing your way to prosperity.  Bob Murphy would have probably noticed that before I did.


Is China re-balancing?

When I was in China I noticed some curious articles in the local paper. They suggested that firms in the coastal areas were really struggling, with a big drop in export orders from Europe.  GDP growth was slowing and there was lots of pessimism.  At the same time they suggested that the labor market in Chinese cities was very strong.  I also noticed the following sign in a hair cutting salon:

5  positions:  8000 to 20000/month

5 positions:  6000 to 15000/month

20 positions:  3000 to 10000/month

10 positions: 2500 to 8000/month

I can’t read Chinese, but my wife told me the positions ranged from managers down to entry level hair cutters.  The salaries are in yuan, so divide by 6.3 to get dollars.  Then I started seeing these signs in lots of other businesses.  This is all very anecdotal, but consider the following story:

  • On September 26, ZHANG Yansheng, an official with the National Development and Reform Commission, said that although China’s GDP growth had slowed to 7.6 percent in 12Q2, the number of new jobs in urban areas still managed to increase by 9.1 million in the January-August period. The figure was only 11 million annually during the 2006-2010 period.
  • Despite decelerating economic growth, China’s current employment situation is significantly better off than in the 11th five-year period when the nation’s GDP growth reached 11.2 percent year-on-year.

Even taking into account the fact that China’s urban population is twice the total US population, that’s a rather striking number—more than a million jobs a month.  I don’t know if the numbers are accurate, but casual empiricism suggests that the service sector in China’s cities is growing rapidly.

It’s true that the SOEs are engaged in a lot of wasteful investment, but let’s not lose sight of the fact that 70% of the economy is private, and in some respects more unregulated than the US (and far more unregulated than Europe.)

It wouldn’t surprise me if lots of smaller service businesses did a lot of off-the-books transactions, if only to evade taxes.  Beijing and Shanghai certainly don’t seem like places where consumption is only 35% of GDP.