Don’t panic! There is an explanation.
At this point my indebtedness to GMU’s economics department is only slightly below the fast rising national debt. You have probably seen some very kind comments from Tyler and Bryan, and there have been some behind the scenes favors as well. I have a persistent feeling of guilt that I am not able to reciprocate. Thus I was horrified to recently discover that I had not even answered a question posed by Bryan a few months ago. He had asked whether investor panic might have been an independent shock hitting the markets last October. I responded, but never saw his follow-up:
In the comments, Scott graciously replied:
“As long as you define “panic” as “correctly ascertaining that the monetary authority was about to embark on a dramatically lower NGDP growth trajectory that would plunge the world into depression” then I am completely with you.”
I’m afraid I’ve got more in mind. Why can’t we think of the public’s mood as an independent – and highly volatile – causal variable?
I didn’t expect a panic in October, 2008. But when it happened, it sure didn’t seem to be due to news about nominal GDP. It seemed to be due to news about the public’s mood. A week before, the natives were calm. Then they suddenly got amazingly restless.
As long as this restlessness is unpredictable, it’s perfectly consistent with EMH. So this account seems to meet Scott’s objections to distant “root cause” theories. And it seems to fit our experience of actually living through those days, doesn’t it? So what’s wrong with blaming an exogenous panic attack?
I’d like to attack this question from several angles. I should first mention that for someone who has been linked to twice by Mankiw on EMH issues, I am actually pretty uniformed on the subject. I never studied it in school, but find it an interesting topic to think about. So I don’t know whether Bryan’s assumption about the EMH is right, indeed I think his hypothetical might violate the EMH. But that’s really a side issue, because it’s a hypothesis worth considering either way.
My first observation is that it is very hard to know what the market is thinking about, as the market is much smarter than any of us, and gets “news” long before we do. You can be sure that by the time we read that the Baltic shipping rates have plunged 90% (which I recall was in the papers last fall) the markets already knew about it. One of my visions of the stock market is Lucas’ archipelago model—people get local information before it is in the official statistics. Sort of like how the brain supposedly knows something before it knows that it knows it.
After a stock crash you will sometimes get news stories suggesting that information was creeping into the market before it was in the official statistics. And I am not just talking about “inside information” (although I have seen such cases), but also highly dispersed information. After the stock market crash of October 1929 there were suddenly a lot of very, very negative stories on various types of production. Causation could not have run solely from the crash to output, as the numbers referred to production declines that were already underway at the time. It seems undeniable to me that current and prospective output declines played a major role in the October crashes of 1929, 1937 and 2008. By “prospective” I mean information about the flow of new orders, etc. I would like to emphasize that I don’t think this fully explains any of these three crashes, but it was a factor.
A second factor is policy credibility. It may be coincidence, but right around the time of the three crashes there was a major loss of trust in the government. In 1929 and 1937, investors lost confidence in the President, and in early 2008 there was a loss of confidence in Paulson and Bernanke’s ability to manage the situation. (John Taylor makes a similar but slightly different argument.) Recall that Bear Stearns did not cause major damage to the markets in early 2008.
Also recall that although the market fell about 5% on the Lehman news, it then leveled off a bit for several weeks. The Fed statement on September 16th indicated that the threats of inflation and recession were roughly balanced. So things still looked “salvageable.”
By early October I think the markets came to the conclusion that the world economy was falling fast, and that the Fed would be unwilling or unable (take your pick) to prevent a sharp downshift in NGDP growth. The exact same thing occurred in October 1929 and October 1937. I can’t prove this, but based on a close study of those earlier crashes I am pretty sure that investor forecasts of NGDP going several years forward fell very sharply around the time of the crashes, which actually stretched from September to November in each case.
Of course it is very possible that the reason NGDP expectations fell sharply is because the stock market crashed, but I don’t like that sort of reasoning. Let’s take the worst case from my pro-EMH perspective, and assume the 1987 crash was completely irrational. Recall that the 1987 crash (comparable in size to the other three) did not cause even a tiny, tiny blip in GDP growth. Instead the economy stayed very strong for the next 32 months. Why? You can’t just pick an arbitrary reason; after all there are several hundred million consumers in America. Either their decisions are affected by stock prices, or they aren’t. If they are, there should have been at least some impact in 1987.
My theory is that stocks don’t have much independent effect on AD. When expectations for NGDP growth do not fall sharply, then we don’t see a recession after a stock crash. We often see stocks fall before a recession because the market often sees the recession looming ahead. (BTW, I know the recession had officially started by October 2008, I mean the severe intensification of the recession.) So I see the causation running from expectations of future recession to current stock price collapse.
Stocks are on a hair-trigger alert for trouble. You don’t want to be the one holding the bag when other investors have already seen trouble ahead. So it stands to reason that just as nervous police officers will occasional shoot an innocent person, the stock market will occasionally be spooked by an event that never actually occurs. So events like 1987 will occur on occasion.
Even so, I would be the first to admit that the crash of 1987 is hard to reconcile with the EMH. I believe part of the 1929 crash is explicable from actual events, although the most intense part may have involved a bit of panic. In contrast, I think the 1937 and 2008 October crashes are some of the most “rational” that I have ever seen. The market correctly saw that the world economy was falling off the cliff, and that the Fed had misdiagnosed the problem. If the Fed had cut rates on October 6th from 2.0% to 0.5%, investors would have been electrified. Instead they made one of the most contractionary decisions in Fed history.
My colleagues can tell you that at this time I was wandering the halls of the economics department muttering what the %#&@ is Bernanke doing? Why has the Fed suddenly stop targeting the forecast? The only reason you guys are reading these words is because early October 2008 turned me into a monetary crank. I don’t see it as an uneventful period at all. There were lots of bearish stories about the economy, and I am sure that people out in the “real world” saw lots of depressing indicators at the local level. Put it all together; the local news, the knowledge investors have that markets aggregate information, the bearish news out of Washington and the picture snaps into shape. And they were right. The early October crash took the S&P down to 900. That’s exactly where it is today. There was no “overreaction” as you’d expect if there had been panic. Panic doesn’t last forever, if there was panic a recovery would be expected by rational investors. There is no evidence a recovery was expected. The problem is very real (albeit caused by a nominal shock.)
I didn’t predict the stock and commodity crashes, but as they developed and the Fed didn’t respond it all made sense to me.
What about Bryan’s theory of panic attacks? I don’t like this theory for several reasons:
1. The law of large numbers. People don’t independently all become nervous at the same time, for no reason.
2. I presume Bryan had some contagion effect in mind. But what causes the contagion? Why does it occur in some stock declines and not others? There is a lack of serial correlation in stock prices. When prices have fallen for three straight days, there is still a roughly 50-50 chance they will rise on the 4th. So if the panic was internally generated, if the beginning of the crash created panic, which led to a bigger crash, then why wouldn’t stocks that had fallen three straight days be likely to fall on the 4th day?
3. If the panic was triggered by an external news event, why wouldn’t the crash have occurred on the day after some big event like the Lehman failure. Instead it occurred in early October when there was relatively little financial news. The only news I recall during that time period were persistent reports of very bearish forecasts about real growth and steeply falling commodity prices. Put the two together and you have very bearish forecasts about NGDP growth. The other news was a growing sense that Paulson and Bernanke were in over their heads, but that fits in with my “monetary policy failure” argument.
Having said all this, I should emphasize that I try not to be an ideologue. I don’t see any reason to have an emotional attachment to theories. I have found the EMH incredibly useful. But I don’t think it tells us much about 1987, and I think it is also plausible that there are some irrational elements in other unusual market events such as 1929 and 2000. But I also believe that many economists underestimate how quickly even highly rational markets could move on dispersed information. Again, the real economy saw a severe downturn appear suddenly in late 1929, late 1937, and late 2008. Would you expect markets to react slowly to the realization of how quickly things were getting worse? Of course not. So if the theory is very useful, and the theory fits the facts of 2008 reasonably well, why look elsewhere for theories that have never shown any utility at all, i.e. anti-EMH theories?
Tags:
13. July 2009 at 23:32
I recall one other tiny little bit of news — about Obama taking a commanding lead in the Presidential polls. In late Sept. 2008 McCain “suspended” his campaign, then “unsuspended” it, and his poll numbers dropped like a rock, after coming neck and neck with Obama after McCain’s Palin VP nomination.
Scott writes:
“the only news I recall during that time period were persistent reports of very bearish forecasts about real growth and steeply falling commodity prices.”
13. July 2009 at 23:35
From the highlights of the latest econtalk podcast about EMH:
“Portfolio insurance, Berkeley professors, 1970s, launched in the 1980s, Hayne Leland: the moment he devised it–strategy for selling stocks quickly as the market falls–he knew that if everybody did this it would be a disaster, causing market prices to fall even faster. How long would it take? It took seven years, 1987 crash”
http://www.econtalk.org/archives/2009/07/justin_fox_on_t.html
14. July 2009 at 02:12
Oooh, you may annoy the WaMu paranoids with the “I don’t know what caused the post-Lehman collapse” schtick. The forced takover of WaMu happened on Sep 26, the ‘true’ collapse of the indices started on the next trading day, and lasted until November.
As much as I don’t want to admit it — that story fits. The problem is that outside of those people in financials, Lehman was better recognized and discussed more than WaMu.
14. July 2009 at 02:58
Scott:
“Investor panic” does not necessarily mean “stock market crash.” What about those investing in short term commercial paper issued by investmnet banks?
(Sometimes you seem to be writing like a business journalist. (Tight money, “the market” meaning the stock market, etc. Did your read too many thirties era newspapers? I realize that using economics lingo is probably more confusing to the rest of the world.)
I think that Bryan correctly points to a hole in your thinking. Except in your idiosyncratic way of defining things, Fed policy didn’t suddenly change. Something must have happen such that the Fed’s existing policy (as normally understood) was highly deflationary. (In retrospect, that means that its policy was inconsistent with base money rising enough to get nominal income back up to its 5% growth path in the “near” future.)
Now, once “the market” realizes that Fed policy isn’t going to do whatever is needed to keep nominal income on target, then expecations of falling nominal income start impacting the market.
However, it is almost certain that something had to happen that would push nominal income below target. What was that?
Again, some kind of sudden panic regarding stock market values is probably not the right place to look. The conventional view is that Lehman brothers failed, and so there was a panic regarding commercial paper funding financial institutions. That is, “investors” stopped rolling over their loans to them and no one would lend to them. Which meant that they could no longer fund their portfolios of mortgage backed securities. And no one wanted to buy those either, depressing the prices of MBS way down.
Now, from your (and my) perspective, none of this is particularly important. The Fed should have just raised base money whatever amount needed to keep nominal income on target. This panic may have had all sorts of implications for different sorts of interest rates. It may have impacted the pattern of investment and consumption spending. It might have caused structural unemployment and reduced productive capacity as resources shifted. The inflation rate might have increased.
But nominal income would have stayed on target–or, at least, have been expected to return rapidly to target.
But, as soon as nominal income was no longer expected to remain on target and could drop and stay low for who knows how long, then that impact began to swamp whatever panic that got the process started.
That is my answer to Bryan.
It is very impliausibe (and I hope you agree Scott) that the market was tooling along and suddenly thought that the Fed would no longer target the forecast and keep nominal income growing at 5% per year. And so, the demand for base money skyrocketed causing nominal income to fall.
No, something else changed, which showed that the Fed’s policy was something different than targetting the forecast. (Lower the Fed Fund target step by step in response to observed market conditions and then keep it low.) And when they _saw_ that the Fed didn’t switich on a dime to making sure base money rose enough to keep nominal income on target, with a willingness to purchase whatever assets necessary, then they panicked based upon that.
My view is that if the Fed had followed the proper policy, then there would have been implications for interest rates. I think you don’t care about them because they are unimportant. I agree, but they should be considered for completeness. And, I think that it would involve the Fed taking on more interest rate and credit risk as the short term and low risk nominal interest rates hit the lower bound. That is the response to the initial panick. People not willing to lend short term to invetsment banks, who then could no longer fund a bunch of long term, risky, mortgage backed securities. Only when it became clear that the Fed would not raise base money enough in response to the situtuation, so that nominal income would be permitted to fall, does the impact of low nominal income begin to impact the market. And, I have to agree that this probably swamps everything else at this point. Still, it seems likely to me that we are back where we started.
Oh.. and, I am not sure that refusing to lend to investmnet banks by purchasing their commercial paper when they are using that to fund mortgage backed securities, and the mortgage backed securities are collateralized by homes that fell in price by 30% counts as an _irriational_ panic. In my view, continuing to lend to after housing prices fell 30% was of questionable rationality.
14. July 2009 at 04:20
The discussions here seem to be centred around three inter-related problems.
Firstly, some deny that the link between money supply, inflation and interest rates is complicated. That is they support a model that links interest rates, money supply and inflation quite directly. We can point at King Henry VIII and Zimbabwe to demonstrate the problem with this view.
Secondly, there is the problem of the monetary base. M1 doesn’t accurately represent money that is held, neither really do the other M figures. The commercial paper mentioned here is used in a manner very similar to money – this is an old point Post-Keynesian’s often make.
Thirdly, we have the problem posed by the two issues above. How can money demand be accommodated and at what price? Interest rates can’t tell us that much about it in unusual times, and nor can measures of money, though they are better. So, this is where Scott’s NGDP targeting comes in. I don’t really understand the logic of it.
However, I think that Scott and Bill have identified here what the big problems are.
(There is also lots of other issues about how recessions start, whether NGDP transactions or all are to be considered, what money holding is for, etc. These are reasonably separate though.)
14. July 2009 at 04:30
Greg, Good point. Unlike some of the other factors we have very accurate data on the impact of presidential elections. A win for Democrats knocks about 2% off stock values. I imagine that the odds of Obama winning rose by less than 50 percentage points in late September, meaning that the negative impact (although real) was less than 1 percentage point of stock values.
malavel, I’m not saying you are wrong, but I think a lot of people underestimate just how mysterious October 19, 1987, really was. The Dow has never fallen 14% in all of history, except on that date when if fell more than 22%. Here’s the problem: whatever theory you come up with, why does it just happen once?
Having said that, I wouldn’t strongly oppose the view that during the 1980s a flawed model was put into lots of computer trading programs, and after the crash the problem was “fixed”, which is why we haven’t seen even a 10% daily drop since. It could have happened. My only point is that any explanation for the 1987 crash also has to account for its rarity. We are not good at developing models for one time events. So you might be right, it’s just hard to tell.
Sean, I seem to recall the next day was when Congress voted down the bailout. Is that right? On the other hand when Congress finally passed the bailout stocks fell as well. So who knows?
Bill, You said:
“I think that Bryan correctly points to a hole in your thinking. Except in your idiosyncratic way of defining things, Fed policy didn’t suddenly change. Something must have happen such that the Fed’s existing policy (as normally understood) was highly deflationary. (In retrospect, that means that its policy was inconsistent with base money rising enough to get nominal income back up to its 5% growth path in the “near” future.)
Now, once “the market” realizes that Fed policy isn’t going to do whatever is needed to keep nominal income on target, then expectations of falling nominal income start impacting the market.
However, it is almost certain that something had to happen that would push nominal income below target. What was that?”
I don’t quite follow this argument. Suppose the Fed’s only mistake was errors of omission, which I think is your view. Why wouldn’t that also cause stocks to fall? Obviously the financial crisis had something to do with the crash, but it is important to remember that the financial crisis was already priced into the market BEFORE THE CRASH. What was news was that the Fed wasn’t going to use monetary policy in an aggressive way as they had in January. The markets had no reason to anticipate that. The Fed cut rates by 125 basis points in January in just 10 days in response to a MUCH SMALLER CRISIS. And it worked. So why wouldn’t investors have expected an even more aggressive move by the Fed to avert a looming liquidity trap during a severe financial panic? I think the stock market didn’t collapse in September because investors still had some confidence in the Fed. Bernanke had written articles arguing that it was important to be very aggressive in heading off deflation. I don’t know why other economists don’t find the Fed’s passivity in early to mid-October to be very strange, indeed almost bizarre. Can someone tell me why there wasn’t outrage at the Fed’s passivity?
On my equation of “the markets” with stocks, that’s just shorthand. I also look at commodity prices, real estate prices, TIPS spreads, forex prices, etc. It’s just that many readers follow stocks closely and its easy shorthand for what’s going on more broadly when AD falls sharply.
You said:
“It is very implausibe (and I hope you agree Scott) that the market was tooling along and suddenly thought that the Fed would no longer target the forecast and keep nominal income growing at 5% per year. And so, the demand for base money skyrocketed causing nominal income to fall.”
Yes I agree that the financial system problems were creating more demand for base money. I agree that the Fed had to take affirmative action with its policy levers. I think of policy in terms of targeting expectations. From that perspective it was an explicit Fed policy change. But most people think of Fed policy as the ff rate or the MB or M2. I’m fine with that. By the conventional view of policy the problem was Fed errors of omission during a financial crisis that had created a need for bold action. Thus the financial crisis was a sort of “root cause.” Is that your view?
You said:
“My view is that if the Fed had followed the proper policy, then there would have been implications for interest rates.”
I actually agree. Recall I mentioned in the post that a bold cut from 2.0% to 0.5% in early October would have been helpful. I saw that as addressing the issue you raise here. Or am I missing something?
You said:
“Only when it became clear that the Fed would not raise base money enough in response to the situation, so that nominal income would be permitted to fall, does the impact of low nominal income begin to impact the market. And, I have to agree that this probably swamps everything else at this point. Still, it seems likely to me that we are back where we started.”
This is exactly my view of early October. I can’t tell whether you disagree with me here, or are just clarifying your views. But I agree.
14. July 2009 at 04:43
Current, I agree with your first point, but don’t agree with the Post Keynesian view of near money. I don’t consider CP a close substitute for cash. I never carry CP in my wallet when I go shopping.
Because the demand for cash is separate from CP, by controlling the supply of cash the Fed can control its value.
14. July 2009 at 05:13
ssummer:
“Because the demand for cash is separate from CP, by controlling the supply of cash the Fed can control its value.”
Not as accurately as you may want, unless the Fed can also control velocity. You’ve said this yourself. If people are holding money as a store of value to insure against events like job loss, and other stores of value (e.g. assets) are viewed as “risky”, then demand for holding money can be quite high even as supply is quite high.
There is, of course, some point at which the Fed can print enough money to disincent people from holding too much cash as a store of value, but the problem is that velocity can move rapidly… So if the Fed prints enough money that all the sudden everyone decides cash is going to start losing value, then everyone rapidly shifts out of cash causing rapid inflation.
It’s a tipping point problem, which is easily described as a coordination/expectations game among businesses/households. The smooth-curve models simply don’t capture this.
14. July 2009 at 05:14
This is a bit of a tricky area. For normal purposes amongst normal people commercial paper is not like cash. Cheques though are for some purposes. For a business though some sorts of credit note may fulfill a similar role.
So, like commodities some of the demand for money comes from those who can choose to use money or other things for their purposes.
This doesn’t mean that the Fed can’t control the value of cash, they can. But it does mean that the monetary magnitudes aren’t necessarily as useful as they look. What they mean depends on the institutional arrangements of the time.
14. July 2009 at 07:17
Scott:
I think I am less interested in explaining the stock market crash than you appear to be. I am concearned about the drop in nominal income. The “panic” that caused it had to do with “runs” in the shadow banking system.
By “implications for interest rates” I am not discussing Federal Reserve targets for the FF rate. Rather, I am talking about what happens to market interest rates to allow for market clearing in the context of the Fed expanding base money whatever amount needed to keep nominal income on target.
Suppose we had index futures targetting. Presumably there would be interest rates on T-bills, various sorts of FDIC insured bank deposits, and overnight interbank loans. These would not be targetted by the Fed.
Now, let us suppose that people who had be holding commercial paper to fund investment banks to hold mortgage backed securities “panic.” Immediately, they accumulate balances in checkable deposits. But, maybe they spend them on T-bills. Or maybe they buy FDIC insured CDs. The commercial paper held directly or through a money market mutual fund seemed safe enough before, but not now. There is a rush to safety.
If we actually hit the zero nominal bound, then this is going to turn into an increase in the demand for base money.
The Fed expands the quantity of base money to accomodate this growing demand with nominal income remaining on target.
So, any market process that is based upon higher expected inflation or higher income income really is beside the point. Nominal income remains on target.
Because we are at the zero nominal bound, no longer is the demand for currency related to its use to make transactions. It is demanded because it has a zero yield. Any excess demand for T-bills, CD’s, etc. at the slightly negative rates reflecting their lower storage costs, is shifted over to zero interest currency.
If the Fed buys low risk, short assets and issues currency, then it reduces the quantity of those assets for people to hold at the same time it provides the currency for them to hold. The demand for currency rises to meet the demand.
Any intuition you have about drug dealers flush with cash buying bling is just wrong. We have a new class of currency holders. (Really, just letting banks story currency in vaults and letting people keep money in deposits at slightly negative interest rates is better than printing up the currency. So, the interest rate charged on reserve balances should be no lower than the cost of storing vault cash and trying to charge banks for vault cash is a waste.)
What is happening to the Fed’s balance sheet as it accomdates the increase in the demand for base money when the safe and short assets have hit the zero nominal bound? (The real bound is -2% in your version and it is zero with my price level stablity version.)
I think it is “obvious” that the Fed is going to have to accumulate risky and longer term assets, lower the real and nominal yields on them, and so compress the interest rate structure. The Fed is taking on more risk–both interest rate risk as it compresses the term strucutre and more credit risk as it holds riskier assets.
As long as the Fed is going to issue zero interest currency on demand, then it has to do this if there is such a rush to safety that the save assets (like T-bills) hit the zero nomiminal bound. It must take the risk by purchasing longer term and higher risk assets.
My view is that by paying interest on reserves, the Fed is causing the excess demand for base money to develop and something higher than it needs to. That is shouldn’t do this. And, by doing so, it increases the amount of interst rate and credit risk it must bear.
My view, however, is that the zero bound is a bad thing. And so, I look forward to the day when the Fed stops issuing zero interest rate currency on demand.
14. July 2009 at 07:26
Scott:
Let me try one more time.
I don’t know what Caplan meant, but when I read the original exchange, I think you were way to quick to interpret “panic” with the stock market rather than with the financial problems that occurred before. You know, the difference between LIBOR and T-bills jumped by 300%. Crisis!!! The Great Depression is coming if we don’t bail out Wall Street. No one is goign to be able to get any loans. No car loans. No loans for small business. So, Congress needs to let us borrow $900 billion to jump start the market for mortgage backed securities. That panic.
Not the rapid drop in the stock market that happened next.
14. July 2009 at 07:29
On defining “panic”:
the notion that “Panic” is an exogenous event is odd when panic did not really seem like much of a panic in retrospect. The November stock market trough (7800) wasn’t actually the low of the lows. Both consumers and the stock market correctly anticipated that the economy was going to H3ll, and the government/Fed had no intention to do anything about it.
Here’s a (parochial) summary of events:
1) There was a financial crisis due to fear of bank failure, interbank lending stopped, and credit markets froze. Loans were called in.
2) The big brokerage houses saw opportunity and madly short-sold all financial institutions (including each other, thus helping recoup losses from bad loans), and they shorted every company that had a high debt load that was coming due (figuring they would have trouble refinancing).
3) Standard consumers saw the stock market and virtually all asset values plummetting. They interpreted this as signalling that those who “knew” what was going on had lost faith in the system. They sold.
4) The stalwart “buy and hold” group of investors held on, believing the market had already seen a correction at 10K (down nearly 40% from peak).
5) But, toward the end of September, stocks were highly volatile while everyone watched Treasury and the Fed complete their bumbling. They plummeted in early October. WaMu actually failed Sept. 26th, a Friday, but the next Monday and Tuesday weren’t too bad. Oct 2nd marked the beginning of the plummet – when buy and hold investors started giving up (and net mutual fund outflows, along with forced selling, spiked).
http://finance.yahoo.com/echarts?s=%5EDJI#symbol=%5EDJI;range=1y
This plummet was ended by a coordinate international rate drop on Oct. 8th, and the reason for the end was not that the rate drop did enough, but rather that it showed the world was aligned in using monetary policy to aggressively ease conditions.
6) Things started to turn up in late october/early november due to the election – possibly in time to help avert a pre-holiday-season collapse of consumer demand. BUT then we had a lame duck congress decide to exact revenge for the election by getting into a p1ssing contest over the auto-sector. Which, all told, was a PITTANCE next to the financial bailout (which was run by a corrupt and incompetence Hank Paulson). The unbelievable public display of cronyism and incompetence – and Obama’s failure to say anything because he wanted to be viewed as non-partisan – gutted confidence, and clinched the recession.
The secondary November plummet stopped when Obama finally took charge and released a press clip indicating an aggressive stimulus plan. But as this faltered in Congress prior to Jan 20th (when seats turned over), this led to a secondary dip that was re-inforced by Fed action, Geithner’s monumental display of incompetence in outlining the asset “plan”, and utter failure of Bernanke to live up to his pledge, until FINALLY things started to turn around in March when Geithner gave an only slightly-pathetic review of the plan (hey, low expectations are easy to beat…) and Bernanke committed to some level of QE.
Overall, much of the “panic” was rational, self-reinforcing, and endogenously created.
I would hypothesize that the volatility from Sept. 17th to October 2nd was largely around whether or not the government would in fact respond. When it became clear it would adopt a “punish the transgressors” hard money policy, at least until Goldman Sachs came under threat, the market duly noted who had won the political battle, and tanked. (The political battle played out elsewhere too, as signalled by the controversy over the naked short selling ban and uptick rule – the results of this were rightly interpreted by investors as a signal of who was running the show.)
The CONSUMER phase of the panic (and the phase in which companies began mass firings) did not begin in September either – it began in mid-october, AFTER the dow dropped. This huge wealth shock signalled a household balance sheet crisis. It’s arguable whether this was panic, or a rational response to wealth loss (combined with general awareness among everyone in the press of what the likely consequences of millions of households suddenly cutting purchases would do to the economy).
http://www.marketobservation.com/blogs/media/blogs/Statistics/RetailSalesOct2008.jpg
Note that the auto-data is low in september because of massive incentive programs in august (that front-loaded demand). The non-auto data is only marginally lower than in august. But in October it drops massively (in spite of a super-aggressive black friday campaign).
14. July 2009 at 07:45
Surely Caplan has to be wrong in suggesting that exogenous public panic is compatible with the EMH. “Public mood” is just public expectations for future economic performance. On the EMH this cannot be an “independent variable.” The EMH says public expectations are rational, given the available information. So public expectations are determined by–are a function of–the available information; there is no room for variation.
14. July 2009 at 08:55
Scott,
Next time we should have an MD as the chairman of the Fed instead of a PhD. If panic attacks are the problem then the Fed could prescribe lorazepam to bankers and stock brokers and everything would be fine (perhaps too good). If the crisis is too big then the Chairman could ask the FDA for a temporary permit to sell Valium OTC through the discount window so banks could distribute it among its depositors.
Alex.
14. July 2009 at 09:05
Alex, Philo,
I’ve read about Shackle’s kaliedoscope. I feel I would understand it a whole lot better after a few tokes from Shackle’s bong.
14. July 2009 at 09:31
Bill:
“I think it is “obvious” that the Fed is going to have to accumulate risky and longer term assets, lower the real and nominal yields on them, and so compress the interest rate structure.”
Why is this obvious? Obvious they should do it, or obvious they will?
14. July 2009 at 09:58
Bill, Scott,
I just did some searching in the Cato journal. I see that you two have been debating partners for a long time.
http://www.cato.org/pubs/journal/cj10n3/cj10n3-8.pdf
http://www.cato.org/pubs/journal/cj12n2/cj12n2-11.pdf
http://www.cato.org/pubs/journal/cj12n2/cj12n2-12.pdf
That gives me some reading to catch up on.
14. July 2009 at 10:04
Bill, Scott,
I just did some searching in the Cato journal. I see that you two have been debating partners for a long time.
http://www.cato.org/pubs/journal/cj10n3/cj10n3-8.pdf
I see Bill replied too. That gives me some reading to catch up on.
14. July 2009 at 14:07
“Unlike some of the other factors we have very accurate data on the impact of presidential elections. A win for Democrats knocks about 2% off stock values.”
If you believe that, you might as well believe in the Super Bowl Indicator and the January Effect!
This is another example of a hypothesis which cannot be tested because it was derived from data-mining. A hypothesis needs to be tested on fresh data.
15. July 2009 at 01:51
Statsguy: “Unlike some of the other factors we have very accurate data on the impact of presidential elections. A win for Democrats knocks about 2% off stock values.”
Also, an election isn’t really an event in the sense EMH proponents mean. The likely outcome of the election is quite well known before election day. The precise deviation from that likely outcome is what drives the change in price on that day.
Statsguy: “The unbelievable public display of cronyism and incompetence – and Obama’s failure to say anything because he wanted to be viewed as non-partisan – gutted confidence, and clinched the recession.”
What did you expect? I don’t think that cronyism and incompetence had that much effect. Those who are major investors don’t have delusions about the state.
15. July 2009 at 05:18
Statsguy, You said:
“It’s a tipping point problem, which is easily described as a coordination/expectations game among businesses/households. The smooth-curve models simply don’t capture this.”
This is exactly why we need futures targeting. It eliminates this tipping problem. Because you can target expectations in real time, and indeed peg expectations, you don’t need to worry about nasty surprises from sudden shifts in expectations. The market determines the quantity of money that they think will best stabilize prices. Because inflation is stable (or NGDP growth) velocity also tends to be much more stable.
Current, I completely agree that the monetary aggregates can be misleading.
Bill, I actually agree with almost everything you say, so we were partly talking past each other. Your logic is impeccable, but I would like to comment on this quotation:
“I think it is “obvious” that the Fed is going to have to accumulate risky and longer term assets, lower the real and nominal yields on them, and so compress the interest rate structure. The Fed is taking on more risk-both interest rate risk as it compresses the term structure and more credit risk as it holds riskier assets.”
If you mean that in the theoretical hypothetical you gave me something like this could occur, then I agree. If you mean that under a 5% NGDP futures targeting regime last October it actually would have occurred, then I strongly disagree. I don’t think risk free rates would have fallen to zero, because I think the actual liquidity trap mostly reflected the expected fall in NGDP, not the financial crisis that would have occurred IF 5% NGDP GROWTH WAS EXPECTED. In my view that hypothethical financial crisis would have been much smaller—on par with late 2007 and early 2008. And rates did not fall to zero during that time.
But this is a quibble. I freely admit that my supposition might be wrong, but as you say you could still do futures targeting even in a liquidity trap, it’s just that the Fed would have to buy more than T-bills, they’d also need to buy T-notes. (I can’t imagine a scenario where they’d need to get into T-bonds.)
Bill, Bryan did specifically refer to the stock market. Indeed he talked about his own stocks falling during that period. But even if you are right, I view the financial crisis as a separate issue. I have never claimed expertise there. Over time I have become skeptical that a bailout would have been needed if we had NGDP targeting, but I may be wrong. In any case, whatever they did or didn’t do in terms of bailout, the stock crash was caused by falling AD, not financial problems. Even manufacturing company stocks fell sharply. Asian stock markets also crashed. That was clearly due to falling AD. If there was a run on the banking system, then I suppose the Fed can dig out their Bagehot, and see if he has any good ideas. One year later it’s pretty clear that they didn’t know what they were doing when they tried to stampede us into hasty bank debt purchase plans with predictions of doom. Once the plan was finally put into place, it turns out that the banks said “no thank you.” Is that right? That’s the impression I got reading the papers, but I’m sure some of you know more than I do about banking.
Statsguy, I agree with much of what you say. But I have two issues.
1. The first step is not the financial crisis, it is the fall in AD due to tight money in August.
2. You said:
“This plummet was ended by a coordinate international rate drop on Oct. 8th, and the reason for the end was not that the rate drop did enough, but rather that it showed the world was aligned in using monetary policy to aggressively ease conditions.”
This is completely wrong. The crash continued after these rate cuts. It lasted until the 10th of October. The reason is that the markets understood these rate cuts (a measly 0.5% after a huge collapse) was pathetically inadequate. Krugman’s always harping on the zero bound. The Fed target was still 1.5% AFTER the cut. The ECB rate was 3.75%!!! This is exactly how central banks responded in the Great Depression. Timidly. It was pathetic.
Otherwise a very nice summary of events.
Philo, Yes I tried to hint that I think he is wrong. I’ve never studied the EMH in school, but that certainly goes against my interpretation. Otherwise why would it be generally agreed that the 1987 crash seemed to violate the EMH?
Alex, How about a variable tax on anti-depressants? Then the Fed could vary the tax as a countercyclical device. More animals spirits needed? Cut the tax on uppers. Housing getting frothy? Cut the tax on downers.
Current, The Shackles reference went over my head. The articles you dug up from 20 years ago seem like from another life. I had forgotten about them.
Rob, No, it was testing by comparing real time movements in betting odds with real time movements in stock prices. It is highly significant, if my memory is accurate. Check out a graph of the Intrade election odds in the two Bush elections. They swung wildly on the day of the election. You couldn’t ask for a better natural experiment. BTW, I am not a Republican.
Current, The first quote is mine, not statsguy. And see my response to Rob. The two percent refers to a 100% change in election odds. A 50% change would move the market 1%, etc.
15. July 2009 at 06:48
Scott: “The Shackles reference went over my head.”
What Philo is talking about, though he may not know it, is something called “Shackle’s Kaliedoscope” after the subjectivist Keynesian G.L.S. Shackle.
The idea is quite simply that everything depends upon expectations. If expectations are high then outcomes will be good, if not then they will be bad. Keynes’ ideas of economic feedback explain why. He described the economic process as being like a kaliedoscope. One with many possible equilibria.
What Alex suggests, Shackle’s bong, solves many problems. Firstly it may make Shackle’s ideas makes sense. Secondly, it may make investors confident enough to continue investing.
There could be mandatory drug tests for banker and investors to make sure that they are taking their prescribed dose.
It’s not the silliest idea I’ve ever heard.
Scott: “The articles you dug up from 20 years ago seem like from another life. I had forgotten about them.”
But, they seem very similar to what you are saying today.
Scott: “The first quote is mine, not statsguy. And see my response to Rob. The two percent refers to a 100% change in election odds. A 50% change would move the market 1%, etc.”
I see, that makes sense.
15. July 2009 at 08:19
What would the economic effect be if all the Wells Fargo customers filed a complaint about the bank using usurious fees to sue itself, and asking nicely for the OCC to ask the Fed to start charging for instead of paying interest on excess reserve balances.
I am going to find out the economic effect of one person asking just that.
15. July 2009 at 13:21
I don’t think the election had much to do with the meltdown. I think the relationship went the other way.
All sorts of crazy things were happening in the market after Lehman’s bankruptcy. Remember the money market funds that suddenly were in trouble? The banks ponied up a lot of scarce capital fix this. Add to this another cash market complication–securities lending and the loss of value in cash collateral pools–and we had a real panic in the short term markets. Corporations really were wondering if they could get a normal short term loan to meet payrolls. Seriously, people were seeing the prospect of their cash accounts decline in value.
I have a client that the banks have leaned on heavily since October. If they want credit, they have to do other business in the bank–place some pension assets with their trust department, use the bank as a custodian–I thought this stuff had disappeared in the 1990s.
The dominos after Lehman were real–Merrill and Morgan Stanley were the next to fall and Citi and BoA live on due to the graces of the Fed and Treasury. You academics just don’t know how interrelated this leverage and exposure was. I hate it, but it is real.
I don’t like TARP–I think the Fed should have stepped in under some receivership relationship and wacked off a couple hundred billion of the debtholders claim and given them equity stakes. But TARP did eventually stablize the system. Keith Hennessy estimates that TARP will cost the taxpayer $170 billion or so (with far more given to support FNMA and FHLMC).
17. July 2009 at 05:18
Current, Thanks for the info. Regarding my consistency, in an earlier post I said that I discovered all my good ideas in late 1986, and I’ve simply been refining them ever since. One thing you can say about monetary cranks is that they are consistent.
Thanks James, BTW, in another post someone sent me a recent article in the FT by Willem Buiter calling for negative rates on reserves.
Elvin, You said;
“I don’t think the election had much to do with the meltdown. I think the relationship went the other way.”
I agree, the data suggests that the election probably only explains about 1% of the fall. I think the economy hurt McCain a lot.
I agree in once sense about the dominoes, but not in another. One problem did lead to another, but the transmission effect was falling asset prices and worsening balance sheets. An effective monetary policy would have reversed that process. These big banks didn’t get in trouble because people suddenly woke up and realized subprime loans were a problem, they got in trouble because the steep fall in AD dramatically worsened their balance sheets for all sorts of assets. That’s the effect of tight money.
4. September 2009 at 23:43
Dr. Sumner,
In response to
“1. The law of large numbers. People don’t independently all become nervous at the same time, for no reason.
2. I presume Bryan had some contagion effect in mind. But what causes the contagion? Why does it occur in some stock declines and not others? There is a lack of serial correlation in stock prices. When prices have fallen for three straight days, there is still a roughly 50-50 chance they will rise on the 4th. So if the panic was internally generated, if the beginning of the crash created panic, which led to a bigger crash, then why wouldn’t stocks that had fallen three straight days be likely to fall on the 4th day?” I have some comments.
On point 1, I’m not sure what you mean here, but peole can certainly independently panic over what seems like nothing. The latter is the point. Stimuli we often dismiss as relevant to rational decision making and memory functioning can make the difference between panic and calm. All responses are contextual, and many contextual elements are often missed. I refer again to the example of school children performing better on tests in classrooms they learned the material in than those tested in different classrooms. Rationality needs a new definition for economists.
On the 2nd point, contagion is a complex, nonlinear issue. AGain, I refer to a seemingly irrelevant context and subtles signs and signals that also are under-estimated in importance and lead to feedback loops.
With respect to three straight periods of declines and a 50% chance of gains in indexes on the fourth day, I’ve always imagined investors moving in to take advantage of asymmetric risk caused by market tendencies to over-react. If an individual stock falls from $10 to $2 over three days, and significant enough bounces occur about 50% of the time, it makes sense to trade on those prospects. Then, after the market adjusts and the price stabilizes or again goes down, those investors flee, adding to other factors causing volatility.
I made such volatility plays. They are very easy to make, and sometimes you can make money even when wrong more often than right.
9. September 2009 at 02:08
Mike, You are correct that it is theoretically possible for a contagion effect. I simply see little evidence. I won’t say no evidence, as October 19, 1987 looked like panic. But one trading day out of the past 30,000 is not a lot to hang a theory on. I’d want to see some evidence. It still seems highly implausible to me that panic would happen for no good reason. And if it was an important factor in stock prices, wouldn’t we see lots more October 19th, 1987s? But it is unique in all of American history.