FT.com / Columnists / Martin Wolf - It is in Beijing’s interests to lend Geithner a hand

FT.com / Columnists / Martin Wolf - It is in Beijing’s interests to lend Geithner a hand:

A recent paper from Goldman Sachs ...points to four salient features of the world economy during this decade: a huge increase in global current account imbalances (with, in particular, the emergence of huge surpluses in emerging economies); a global decline in nominal and real yields on all forms of debt; an increase in global returns on physical capital; and an increase in the “equity risk premium” – the gap between the earnings yield on equities and the real yield on bonds. I would add to this list the strong downward pressure on the dollar prices of many manufactured goods.
The paper argues that the standard “global savings glut” hypothesis helps explain the first two facts. Indeed, it notes that a popular alternative – a too loose monetary policy – fails to explain persistently low long-term real rates. But, it adds, this fails to explain the third and fourth (or my fifth) features.
The paper argues that a massive increase in the effective global labour supply and the extreme risk aversion of the emerging world’s new creditors explains the third and fourth feature. As the paper notes, “the accumulation of net overseas assets has been entirely accounted for by public sector acquisitions ... and has been principally channelled into reserves”. Asian emerging economies – China, above all – have dominated such flows.
The huge capital outflows were the consequence of policy decisions, of which the exchange-rate regime was the most important. The decision to keep the exchange rate down also put a lid on the dollar prices of many manufactures. I would add that the bursting of the stock market bubble in 2000 also increased the perceived riskiness of equities and so increased the attractions of the supposedly safe credit instruments whose burgeoning we saw in the 2000s. The pressure on wages may also have encouraged reliance on borrowing and so helped fuel the credit bubbles of the 2000s.
The authors conclude that the low bond yields caused by newly emerging savings gluts drove the crazy lending whose results we now see. With better regulation, the mess would have been smaller, as the International Monetary Fund rightly argues in its recent World Economic Outlook. But someone had to borrow this money. If it had not been households, who would have done so – governments, so running larger fiscal deficits, or corporations already flush with profits? This is as much a macroeconomic story as one of folly, greed and mis-regulation.
The story is not just history. It bears just as heavily on the world’s escape from the crisis. The dominant feature of today’s economy is that erstwhile private borrowers are, to put it bluntly, bust. To sustain spending, central banks are being driven towards the monetary emissions of which Ms Merkel is suspicious and governments are driven towards massive dis-saving, to offset higher desired private saving.

The banks are the intermediaries of the capital inflow due to the current account deficit (trade deficit). If we have a huge current account deficit, then we will have a huge amount of money for the banking system to loan out. And the effects of the imbalance have not ended; at some point we will need to pay all that money back to foreigners with interest.

Real Estate Prices To Keep Sliding?

Is it good for you if real estate prices continue to decline? What about stock prices? Robert Shiller via Mark Thoma:

Why Home Prices May Keep Falling, by Robert Shiller, Commentary, NY Times: Home prices in the United States have been falling for nearly three years, and the decline may well continue for some time.

Even the federal government has projected price decreases through 2010. As a baseline, the stress tests recently performed on big banks included a total fall in housing prices of 41 percent from 2006 through 2010. ...

Such long, steady housing price declines seem to defy both common sense and the traditional laws of economics, which assume that people act rationally and that markets are efficient. ... If people acted as the efficient-market theory says they should, prices would come down right away, not gradually over years, and these cycles would be much shorter.

But something is definitely different about real estate. Long declines do happen with some regularity. And ... we still appear to be in a continuing price decline. ... Why does this happen? One could easily believe that people are a little slower to sell their homes than, say, their stocks. But years slower?

Several factors can explain the snail-like behavior of the real estate market. An important one is that sales of existing homes are mainly by people who are planning to buy other homes. So even if sellers ... have no reason to hurry because they are not really leaving the market.

Furthermore, few homeowners consider exiting the housing market for purely speculative reasons. ... And they don’t like shifting from being owners to renters... Among couples...,... any decision to sell and switch to a rental requires the assent of both partners. Even growing children, who may resent being shifted to another school district and placed in a rental apartment, are likely to have some veto power.

In fact, most decisions to exit the market in favor of renting are not market-timing moves. Instead, they reflect the growing pressures of economic necessity. This may involve foreclosure or just difficulty paying bills, or gradual changes in opinion about how to live in an economic downturn. This dynamic helps to explain why, at a time of high unemployment, declines in home prices may be long-lasting...

Even if there is a quick end to the recession, the housing market’s poor performance may linger. After the last home price boom, which ended about the time of the 1990-91 recession, home prices did not start moving upward, even incrementally, until 1997.

Get Your College Degree

Creative Class » Blog Archive » 16.4% - Creative Class: 16.4% is "the overall rate of unemployment, according to the Bureau of Labor Statistics’ newly released U-6 measure which includes “marginally attached workers” as well as those who work part-time for economic reasons. That’s quite a bit higher than the widely reported 9.4 percent figure also released today.

And, unemployment continues to fall unevenly by gender, race, class, and occupation.

...Unemployment is even more uneven by education or human capital level. The unemployment rate for college graduates is 4.8 percent, half that for high school (only) graduates (10 percent), and one-third of the 15.5 percent rate facing those without a high school diploma."

Calculated Risk has graphs:

Paradox of Thrift

What does the Paradox of Thrift have to do with the following graph?
Brad Setzer follows up on the previous post:

Negative borrowing by households and firms means, I think, that households paid down their debts in the fourth quarter.

It hardly needs to be noted that the fall in borrowing by households and firms in late 2008 was exceptionally rapid. A stronger economic cycle implied that the magnitude of counter-cyclical fiscal policy also needed to be ramped up....

Both charts highlight the risk that worries me the most. In both the early 1980s and the first part of this decade, both the private sector and the government were large borrowers. And in both cases, borrowing rose faster than domestic savings, so the gap was filled by borrowing from the rest of the world. The trade and current account deficit rose. In the early 1980s, the US attracted inflows by offering high yields on its bonds. More recently, it did so by borrowing heavily from Asian central banks, together with the governments of the oil-exporting countries. But now yields are low (even after the recent rise in the yield on the ten year Treasury bond), and need to be low to support a still weak US economy. And China (and others) are visibly uncomfortable with their dollar exposure; banking on their continued willingness to finance a large external deficit seems like a stretch.

The challenge this time around consequently will be to bring down the government’s borrowing as private borrowing resumes.

In a recession, the economy has more savings than it wants to invest.

Is the government's deficit spending causing problems?

Many politicians are worried that the huge increase in government deficit spending is causing problems because it will:
1. raise interest rates as demand for borrowing exceeds savings. This would hurt investment spending and reduce economic growth.
2. cause foreigners to stop loaning the US money. Foreign governments (mostly, but also private investors) have been loaning the US hundreds of billions of dollars every year (graph) and that has helped keep the dollar strong so that we can buy more imports than we export.

However, interest rates have been really low which indicates a surplus of savings over investment. How could the government dramatically increase borrowing without driving up interest rates?

Brad Setser: Follow the Money » Blog Archive » More government borrowing doesn’t necessarily mean more total borrowing: "The United States is borrowing less from the rest of the world than it was. That is true even though the US Treasury is borrowing more from everyone, including more from the rest of the world.

The amount the US borrows from the world is the gap between the amount that Americans save and the amount that Americans invest at home. That turns out to be equal to the current account deficit. And for the US, it so happens that the current account deficit is about equal to the (goods and services) trade deficit. The trade deficit — at least in the first quarter of 2009 — was way down. In dollar terms, it was about half as big as it was in the first quarter of 2008. That implies that the US is borrowing far less from the world now than at this time last year.

Why hasn’t the expansion of the fiscal deficit pushed the amount the US borrows from the world up? Simple. American households and businesses are borrowing a lot less, so the total amount of money that Americans are borrowing isn’t rising.

A picture is generally more effective than words. The following chart shows borrowing by various sectors of the economy — households, firms and the government.** All data comes from the Fed’s flow of funds, table F1.

As the chart shows, the rise in government borrowing came even as other sectors of the economy were borrowing a lot less. Household borrowing peaked in 2006. Borrowing by firms actually peaked in 2007 — remember all the leveraged buyouts then. Borrowing by both households and firms fell precipitously in 2008. As a result, total borrowing by households, firms and the government fell in 2008.
...And since Treasury rates now (even after last week) are well below Treasury rates back when private borrowing was far higher, it is pretty clear that the rise in Treasury borrowing didn’t induce the fall in private borrowing (crowding out). Rather, the rise in Treasury borrowing came in response to a crisis-induced collapse in private borrowing.

From 2004 to 2007, net borrowing by American households and firms averaged over $1.8 trillion. In q4 2008, it was less than zero. That is a rather large swing.

* Technically, a current deficit can be financed by selling equity rather than debt, so equating the current account deficit with the amount the US borrows from the world isn’t quite right. But in general the US has financed its deficit by selling debt not equity, so it isn’t a bad rough approximation.
** Firms are defined as non financial corprate businesses and nonfarm noncorporate businesses in table F1 of the flow of funds data. government includes state and local government.

Macro Should Split Off From Micro

Macro models are generally founded upon micro models in economics. Perhaps it is time for a split of the two topics into separate disciplines. Macroeconomics is a mess and the problems are compounded by brilliant microeconomists like Becker spouting off nonsense about it.

Matthew Yglesias » Home Page: "As a general principle for investigating the world, we normally deem it desirable, but not at all necessary, that researchers exploring a particular field of inquiry find ways to “reduce” what they’re doing to a lower level. To make that concrete, in the modern day we have achieved a decent understanding of how principles of chemistry are grounded in physics’ understanding of the behavior of atoms. But it’s just not the case that advances in chemistry were made by demanding that chemists ground all their models in subatomic physics. On the contrary, chemistry moved forward in the first instance by having chemists investigate issues in chemistry and see which models and theories held up. Similarly, though psychology is intertwined with the detailed study of the biology of the brain, it’s not deemed illegitimate to research psychological issues in the absence of a specific neurological theory. Nor, for that matter, do microeconomists generally deem it necessary to explore in detail the psychological foundations of their models. The models are, rather, judged by whether or not they produce fruitful insights about economics. Trying to enhance models with better information about psychology isn’t against the rules, but it’s not required either. What’s required is that the models do useful work."

Alex Tabarrok on how ideas trump crises | Video on TED.com

Alex Tabarrok on how ideas trump crises | Video on TED.com: "Alex Tabarrok argues free trade and globalization are shaping our once-divided world into a community of idea-sharing more healthy, happy and prosperous than anyone's predictions."

The number of banks in the US had been increasing until the mid 1980s whereupon the number began declining again despite growing population and wealth. A few banks became extremely large: "too big to fail." Super large institutions suffer from more moral hazard and take on too much risk due to the implicit government guarantee. There are two options to avoid moral hazard. 1) we could prevent banks from getting too large to fail. The government regularly takes over ('nationalizes') small failing banks and liquidates them but huge banks would be much more difficult to do this with. 2) we could impose additional regulations upon big banks to prevent risky behavior. Canada has this kind of system and it has worked well for them so far.

Too Few Banks, Too Many Giants: I have repeatedly mentioned Too Big To Succeed as a cause of the most recent crisis, but have you ever wondered HOW we got that way?

One obvious suspect has been the easy M&A environment of the past 20 years. Instead of a very competitive market where mergers for sheer size sake is discouraged, the opposite occurred. The number of bank acquisitions skyrocketed, and the number actual banks got slashed. Where there were once over 18,000 banks in early 1980s, today, the number is less than half, to under 8,500.

Recall that the big acquisitions and mergers in the 1980s were so banks could be competitive with Sumitomo and Mitsubishi and other big Japanese banks. (Why was that again?)

Hence, we end up with a few Superbanks. Ask yourself why Citibank, Bank of America, Washington Mutual, and Wachovia got to be too large to manage. And once again, I am compelled to ask why it is in the country’s interest that 65% of the depository assets are held by only a handful of banks.

To put this into context, consider the chart below, courtesy of banking analyst Dick Bove:

chart courtesy of Rochdale Securities

(click on graph to enlarge)

According to Ken Rogoff, the stagflation of the 1970's was caused by monetary expansion [plus the oil price shock] due to the "political business cycle". That is the increase in spending (decrease in taxes) and increases in money supply that often happen just before elections.

In theory, the U.S. Federal Reserve is independent of the executive branch. But just listen to the 1972 White House tapes of Nixon’s blistering exchanges with then Federal Reserve Board Chairman Arthur Burns. Historians can debate whether Nixon intimidated Burns or if the chairman simply succumbed to faulty economics. Regardless, Burns certainly delivered the goods. In the run-up to the 1972 election, he printed money like it was going out of style, wreaking havoc with global price stability and exacerbating worldwide inflation.

Grasping Reality with Both Hands

Grasping Reality with Both Hands: "financial markets have six useful purposes:

*to aggregate the money of people who ought to be savers into pools large enough to finance large-scale enterprises. [This permits economies of scale without requiring that one person finance each large-scale enterprise. Even Bill Gates couldn't finance Microsoft by himself and it is a relatively small enterprise.]
*to channel the money of people who ought to be savers to institutions and people who ought to be borrowers.
*to spread risks so that no one individual finds herself ruined by the failure of any one investment or the bankruptcy of any one company or the slow growth of any one region. [Individual small investors can enjoy high return investments that are diversified so that although each part is risky, the whole is much safer than each of its parts.]
*to keep managements efficient by upsetting and replacing teams and organizations that have outlived their usefulness. [If share prices plummet, managers get fired and/or companies get liquidated.]
*to encourage savings by creating liquidity—the marvelous fact that one can own a piece of an extremely illiquid and durable piece of social capital (an oil refinery, say) and yet get your money out quickly and cheaply should you suddenly have an unexpected need for it.
*to take the money of rich people who like to gamble and, by providing some excitement for them as they watch their gains and losses, use it to buy capital equipment that raises the wages of the rest of us (at the price of paying a 20 percent cut to the Princes of Wall Street). This is a superior use for the rich—and for the rest of us—than, say, taking their wealth to the craps tables of Vegas.

Wall Street innovations and practices are useful only insofar as they promote these six useful purposes. Call them aggregation, accumulation, diversification, efficientization, liquiditization, and casinoization.

By these standards, the current compensation scheme on Wall Street—large annual bonuses based on annual marked-to-market results—is absurd. It helps achieve none of these six goals, and it greatly increases the chance of a crash by providing everyone with an incentive to help their friends by marking up value, marking down risk, and ignoring the impact of their actions on the long-term survival of the enterprise. Silicon Valley compensation schemes seem much better: no large payouts until assets have reached maturity and portfolio strategies have proved their value in all phases of the business cycle.

...In the future, we need to change the culture of Wall Street by changing how top-earning financial professionals are paid, changing the assets they trade to make the markets less opaque, and changing the risks they run by taking capital requirements very seriously once again.

"

Economics and Politics - Paul Krugman Blog - NYTimes.com

Economics and Politics - Paul Krugman Blog - NYTimes.com: "What seems clear is that the nature of monetary policy leading up to recessions has changed dramatically. Pre-Great Moderation, recessions were preceded by tightening policy, presumably to control inflation; the combination of policy tightening and a high underlying inflation rate meant high rates going in, giving lots of room for policy loosening. Increasingly, however, recessions have been the result of bursting bubbles, with monetary policy getting looser even before the recession begins."

Economist's View

Reagan Did It, by Paul Krugman, Commentary, NY Times:

For the more one looks into the origins of the current disaster, the clearer it becomes that the key wrong turn ... took place ... during the Reagan years. ...

Federal debt as a percentage of G.D.P. fell steadily from the end of World War II until 1980. But indebtedness began rising under Reagan... The increase in public debt was, however, dwarfed by the rise in private debt, made possible by financial deregulation. The change in America’s financial rules was Reagan’s biggest legacy. And it’s the gift that keeps on taking.

The immediate effect of Garn-St. Germain, as I said, was to turn the thrifts from a problem into a catastrophe. The ... fact is that deregulation in effect gave the industry — whose deposits were federally insured — a license to gamble with taxpayers’ money, at best, or simply to loot it, at worst. By the time the government closed the books..., taxpayers had lost $130 billion, back when that was a lot of money.

But there was also a longer-term effect. Reagan ... essentially ended New Deal restrictions on mortgage lending ... that, in particular, limited the ability of families to buy homes without putting a significant amount of money down.

These restrictions were put in place in the 1930s by political leaders who had just experienced a terrible financial crisis, and were trying to prevent another. But by 1980 the memory of the Depression had faded. Government, declared Reagan, is the problem, not the solution; the magic of the marketplace must be set free. And so the precautionary rules were scrapped. ...

We weren’t always a nation of big debts and low savings: in the 1970s Americans saved almost 10 percent of their income... It was only after the Reagan deregulation that thrift gradually disappeared..., culminating in the near-zero savings rate ... on the eve of the great crisis. ...

All this, we were assured, was a good thing: sure, Americans were piling up debt,... but their finances looked fine once you took into account the rising values of their houses and their stock portfolios. Oops.

Now, the proximate causes of today’s economic crisis lie in events that took place long after Reagan... — in the global savings glut..., and in the giant housing bubble that savings glut helped inflate.

But it was the explosion of debt over the previous quarter-century that made the U.S. economy so vulnerable. Overstretched borrowers were bound to start defaulting in large numbers once the housing bubble burst and unemployment began to rise.

These defaults in turn wreaked havoc with a financial system that — also mainly thanks to Reagan-era deregulation — took on too much risk with too little capital.