The Long Journey Ahead

Wolfgang Munchau tells us that the unwinding of global economic imbalances may take many years.

Global Adjustment Will be Long and Painful
...It is no accident that our multiple crises – property, credit, banking, food and commodities – have been happening at the same time. The simple reason is that they are all part of same overriding narrative. The mother of all these crises is global macroeconomic adjustment – a rare case, incidentally, where the word “crisis” can be used in its Greek meaning of “turning point”.

It is a huge global macroeconomic shock. How long the financial part of the crisis will go on will depend to a large extent on how bad the economic part of the crisis gets.

The economic part of the story started more than a decade ago with a liquidity-driven global boom. Property, credit and equity bubbles were all part of this.

So was a Ponzi scheme that later became known as Bretton Woods II, a gravity-defying design that allowed the US to run persistent current account deficits. The dollar surplus in the newly industrialised countries was recycled back to the US and European markets, where various categories of asset prices were driven up and banks lured into excessive risk-taking. It could not last, and did not.

If excess liquidity was the ultimate cause of this crisis, the real estate sector was its most important driver. Experience shows that housing cycles are long and symmetrical: downturns last as long as upturns. We also know from the past that house prices undershoot the long-term trend on the way down, just as they overshoot it on the way up. You can see this quite easily when you look at long-run time series of inflation-adjusted house prices for several countries.

The last property downturn in the US and the UK lasted some six years. This is not a prediction of what will happen this time, more like a best-case scenario – because this bubble has not only been more intense than previous ones; it has also bubbled on for longer. But even if we take six years as an estimate of the peak-to-trough period, that means the housing downturn will last until 2012 in the US and a couple of years longer in the UK...

Read the rest here.

A Critique of Mainstream Monetary Economics

Mark Thoma points us to a speech by the iconoclastic Jamie Galbraith. In the speech Galbraith criticizes mainstream monetary economics or what he calls the "new monetary consensus."

...what in the “new monetary consensus,” led to a correct or even remotely relevant anticipation of the extraordinary financial crisis that broke over the housing sector, the banking system and the world economy in August 2007 and that has continued to preoccupy central bankers ever since? The answer is, of course, absolutely nothing.

Ouch! He continues his rant:

You will not find a word about financial crises, lender-of-last-resort functions or the nationalization of banks like Britain’s Northern Rock in papers dealing with monetary policy in the monetarist or the “new monetary consensus” traditions. What you will find, if you find anything at all, is a resolute, dogmatic, absolutist belief that monetary policy should not – should never – concern itself with such problems.

So what does Galbraith gives us as an alternative?

What is the relevant economics? Plainly, as many commentators have hastily rediscovered, it is the economics of John Maynard Keynes, of John Kenneth Galbraith and of Hyman Minsky...

I agree there is insight to be gleamed from these authors. However, the main policy prescription coming from these authors--more financial regulation is needed since financial systems tend to create their own crises--is general. How does one apply their insights in an dynamic world where financial innovations often are one step ahead of regulations? Also, how would these authors specifically implement monetary policy? Would they suggest a Taylor-like rule that had asset prices included in it?

For a more practical approach to monetary policy that takes seriously financial imbalances, I would suggest the work of Claudio Borio, Andrew Filardo, William White and others at the Bank for International Settlements. They have been thinking about these issue for some time and raised similar concerns prior to the outbreak of financial crisis in August 2007. Here is an excerpt of their work I discussed in a previous posting:

Economic historians will no doubt look back on the last twenty years of the 20th century as those that marked the end of a long inflationary phase in the world economy.... And yet, the same decades will in all probability also be remembered as those that saw the emergence of financial instability as a major policy concern, forcing its way to the top of the international agenda. One battlefront had opened up just as another was victoriously being closed. Ostensibly, lower inflation had not by itself yielded the hoped-for peace dividend of a more stable financial environment.

Is this confluence of events coincidental? What is the relationship between monetary and financial stability? What is an appropriate policy framework to secure both simultaneously?

[...]

We would like to make three points.

First, posing the question in terms of the desirability of a monetary response to "bubbles" per se is not the most helpful approach. Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions. Booms and busts in asset prices... are just one of a richer set of symptoms...

Second, while not disputing the fact that low and stable inflation promotes financial stability, we stress that financial imbalances can and do build up in periods of disinflation or in a low inflation environment. One reason is the common positive association between favourable supply-side developments, which put downward pressure on prices, on the one hand, and asset prices booms, easier access to external finance and optimistic assessments of risk, on the other

Third, achieving monetary and financial stability requires that appropriate anchors be put in place in both spheres. In a fiat standard, the only constraint in the monetary sphere on the expansion of credit and external finance is the policy rule of the monetary authorities. The process cannot be anchored unless the rule responds, directly or indirectly, to the build up of financial imbalances. In principle, safeguards in the financial sphere, in the form of prudential regulation and supervision, might be sufficient to prevent financial distress. In practice, however, they may be less than fully satisfactory...

Read more here.

Preview of 1st Quarter GDP Growth

This week we learn what happened to the U.S. economy in 2007:Q1. The folks at Real Time Economics argue the numbers do not add up for an outright Q1 contraction. This conclusion is supported by the coincident indicator from the Philadelphia Fed which grew on an annualized basis about 1% in Q1. Below is the same coincident indicator over Q1 plotted for the 50 states:

In words, "for the past three months, the indexes increased in 31 states, decreased in 14, and were unchanged in the other five." Not bad, but wait... things look different over the last month, March: "The indexes increased in only 19 states for the month, decreased in 22, and were unchanged in the remaining nine..."(Source). So even though we may have escaped negative growth in Q1, economic conditions may be getting worse going forward if March is any indicator of things to come. This is consistent with what famed investor Mohamed El-Erian thinks as well as those observers who believe we are only 1/3 of the way through a $1 trillion dollar loss. Hang in there America.

Macro Reading List

1. The changing housing cycle and its implications for monetary policy.
2. Could IMF have prevented this crisis?
3. How much do we understand about the modern recession?
4. Don't blame China for the rise in inequality.
5. How to spend it.
6. Ut-oh! Is China starting to blame the US for its currency losses?
7. Surplus countries depreciating when they should be appreciating.

Getting Real

In a previous posting I reprimanded Paul Krugman for not being more cheery about the future of commodity prices. I argued human ingenuity in the face of increased scarcity has been the source of many innovations over the past couple hundred of years and this commodity price crisis should be no different. However, I was probably too sanguine about the transition to this new world--it is and will be a painful ride. The Economist did a good job last week documenting the pain and the dynamics behind the transition: surging demand from growing Asia, possible speculation due to loose monetary policy, and diversion of farming capacity to biofuel production. This last factor is particular frustrating since some of the biofuel production is more about special interest groups than cleaning up the environment (e.g. ethanol). I would encourage you to take a look at The Economist article on this issue as well as Trade Policy for a New Deal on Hunger.

Update: Josette Sheeran, executive director of the U.N. World Food Program, on the food crisis via Foreign Policy:

I’m optimistic because the world knows how to beat the cycle of hunger and the world knows how to produce enough food for the global population. A lot of global hunger is an infrastructure and distribution problem—maybe half. We see up to half the food lost in developing countries simply because there’s no way to get it from farm gates to markets. We see virtually nonexistent agricultural markets, so there’s no place for buyer and seller to meet. These are things that can be solved. They don’t require a new scientific breakthrough or a Nobel Prize-winning team to find out how to produce enough food for the world. So, we need to focus our attention on a green revolution in Africa that will help break this cycle. In a way, the higher food prices may inspire more people to stay in farming as they see that it’s a good investment. But there will be a lag between what I hope will be a pretty robust response to world demand, and what I know will be a pretty difficult three to four years.

Economic Conditions and Religiosity

Andrew Gelman graciously takes note of my research on the business cycle and religiosity over at Statistical Modeling, Causal Inference, and Social Science. One of his blog readers emailed me and requested I explain more thoroughly how macroeconomic shocks could affect religiosity. Below is an excerpt from a forthcoming article where I attempt to explain the relationship in less technical terms :

The first thing economic theory says is that the cost of being religious can change over the business cycle. During an economic boom individuals may find increased opportunities for higher earnings. The potential for higher earnings, in turn, make time-intensive religious activities like church attendance costly for these individuals. Consider, for example, a Southern Baptist from a low-income family being offered the opportunity of getting overtime pay to work at a retail store on Sunday morning. For this Southern Baptist, going to church suddenly becomes a lot more costly and thus, increases the likelihood of him opting for work instead of church. On the other hand, during an economic downturn, time-intensive religious activities become less costly as opportunities for earnings decline. Here, the overtime opportunity for the Southern Baptist disappears and church attendance suddenly becomes more affordable. This idea that higher earnings lead individuals to substitute out of leisure activities, like going to church, into more work and vice versa is called the substitution effect. It implies there should be a countercyclical component to religiosity.

There are, however, two countervailing forces against the substitution effect. The first one is called the income effect and says that the higher earnings also mean individuals can work fewer hours than before and still get the same pay. They, therefore, have more time for leisure activities, like church attendance, without a loss of income. Consider, for example, an Episcopalian whose consulting business was able to increase its fees because of the increased demand for its services during an economic boom. The Episcopalian can now afford to take on fewer consulting projects, without a loss of income, and enjoy more time at church. During an economic downturn, however, the consulting fees would drop. The Episcopalian would now have to work more hours to maintain his income, leaving less time for church. The second countervailing force is something called the wealth effect. The wealth effect says that as individuals’ wealth increases from valuations gains in their homes, stocks, and other assets they have less need to save and thus less need to work. In turn, there should be more time for church attendance and vice versa. Imagine now that the Episcopalian had a large amount of funds in the stock market during a stock market boom. His wealth would increase dramatically and make leisure activities like church attendance more affordable. Both of these effects imply there could be a procyclical component to religious activities.

Economic theory is generally silent on which of these effects dominates the decision to work. Research has shown, however, that evangelicals Protestants typically fall into a lower socioeconomic grouping than mainline Protestants (Pyle, 2006). This suggests that the substitution effect should be more important for evangelical Protestants. In other words, since evangelical Protestants are starting from a lower income level, like the Southern Baptist above, they should be eager to take advantage of higher earning opportunities, whereas mainline Protestants, like the Episcopal above, who already have relatively high income levels may see less need to do so. Moreover, mainline Protestants have more wealth and should therefore be more sensitive to the wealth effect compared to their poorer evangelical Protestant brethren. A priori, then, the changing cost of being religious perspective points to evangelical Protestants being more countercyclical in their religiosity than mainline Protestants.

The second thing economic theory had to say about this issue is that individuals generally desire to have a steady stream of housing, clothes, food, and other consumption over the business cycle. During a recession individuals may become unemployed or find their earnings fall. To prevent these developments from being disruptive, individuals may turn to churches for consumption needs such as shelter and groceries. Individuals may also turn to churches for less tangible consumption needs such as a sense of certainty and divine guidance in a job search. Such a response implies there should be a countercyclical component to religiosity. Note, however, that the wealthier mainline Protestants are in far less need of churches to provide consumption for them. In addition, mainline Protestant denominations often place less emphasis on absolute truths than evangelical ones and, as a result, are not able to create the same sense of certainty or appeal to an all powerful, job-providing God. Individuals, therefore, may choose to join an evangelical Protestant denomination rather a mainline one during a recession.[1] Consequently, the consumption smoothing ability of churches also points to a stronger countercyclical component for evangelical Protestants.

[1] Conversely, these same individuals may find a mainline Protestant denomination more appealing than an evangelical one during an economic upturn when the need for certainty and employment are less pressing concerns.

Update: If the SSRN link to my paper is not working, try this one.
Update 2: WSJ's Real Time Economics the Economist's View also take note of my research.

What the Fed is Fighting