Monday, March 31, 2008

More on the US's Productivity-Growth Slowdown.

I had been looking at some education data, when just by chance, Clive Crook led me to new study, The Accelerating Decline in America's High-Skilled Workforce: Implications for Immigration Policy, by Jacob Kirkegaard of the Peterson Institute for International Economics. Pretty graph, which I re-reproduce here.

Source [pdf]

Loose thoughts:

  1. Since the quality of (tertiary) education varies from country to country, static comparisons across countries might not be altogether that revealing.

  2. And this graph does not reveal by itself when differences are statistically significant, so perhaps some within-country comparisons are not what they seem to be.

  3. But having said that, within-country, unless you get (from top to bottom) a triangle, followed by a little black square, a black dot, and then a big, gray square, that country is likely headed for a productivity growth slowdown, conditional on education quality within that country and a level of impact of human capital on productivity. (34 years old is old enough to rule out the "they just take longer to get a college degree there" argument.) Germany seems particularly troublesome, although their restricted university/ widespread on-the-job training system of higher education might explain some of this inversion in a more optimistic way.

  4. Within-country and given that desirable order of symbols, a greater spread suggests good prospects of human-capital driven growth. Korea, in particular, might be a happening place to watch.

  5. Is the US headed for productivity-growth stagnation? (See here and here.) So let those H1B visas flow like rivers of honey! (And I'm being selfless here: having one already, restrictions are what's in my narrow, myopic self-interest.)

  6. Peruvians have reasons to feel within-country hopeful.

CLICK to go on reading "More on the US's Productivity-Growth Slowdown."

Thursday, March 27, 2008

BS, the story so far

The fog seems to be lifting. The blurry profile starting to be seen is this one:

  1. BS went to the Fed asking for a bailout.
  2. The Fed considered that contagion and meltdown would likely result. But it declined to open the doors to moral hazard and looked for alternatives.
  3. It might have considered nationalization, but rejected it for several reasons, sp. legal. It might have considered opening the discount window to BS, but decided it would be useless for it, pouring money into an already tainted business and boosting moral hazard in the process. (The window was later opened to other investment banks to stop contagion, specially in the case of Lehman Brothers.)
  4. Instead, it helped engineer a buyout via JP, which had access to the discount window and a solid balance sheet. While this amounts to what is now being called the "socialization of losses/risk", it would prevent contagion.
  5. JP would benefit enormously, but what was important was (a) preventing contagion and (b) that BS shareholders were publicly punished. Thus the $2 price ($0 would have delayed the deal as BS shareholders kicked and screamed all the way to the bankruptcy window, even if they'd get nothing through it).
  6. But JP was not entirely happy because it wanted to keep BS's "talent" pool and keep it happy. These employees would have fled in disgust at $2 per share.
  7. So JP pretended shock at a terrible glitch in the contract it signed, though it might have even included that glitch on purpose (at the very least, it seems to have been aware of it at the signing of the contract). This gave them the excuse to renegotiate with the aim of keeping BS employees, while the Fed could only watch since it couldn't afford to let the deal fail.

Conclusion: the Fed had the right idea given the constraints it faced, but got stiffed during the implementation. In the end, it's been duped into bailing out the JP/BS combo (it "socialized losses while keeping profits private"; I like that new catchphrase) and, perhaps, into fanning the moral-hazard fire.

CLICK to go on reading "BS, the story so far"

My bad: The Economist shows me why I was wrong about Bear Stearns.

Yet another post on the BS anti-saga. This time, to remind me that I should keep up to date with my reading before posting stuff.

The Economist's Free Exchange blog has a wonderful post that shoots down my main alternative-universe proposal for what-the-Fed-missed-to-do. They get the mix of outrage (at the retelling of the story by Sorkin in the NYT) vs cool-headedness just right. And brevity. Definitely a good read.

First, two additional pieces of info:

  1. The week this all got started, "a complacent Bear Stearns went to the feds cap in hand, saying it would be gone by last Monday if help wasn't forthcoming." Dude! Could they be this cheeky? After what they did (didn't do) with LTCM in 1998?
  2. There's no need to speculate about how much BS's shareholders would have received had they gone to bankruptcy: $0. So even $2 was mana from the skies (or, more technically, $2 is infinitely more than $0). Quoting naked capitalism:
    It was going to declare bankruptcy Monday if there was no deal; its shareholders would have been wiped out. Why am I so confident of this view? If bondholders, as rumored, were buying shares to make sure the JPM deal went through (and thus would take losses on their stock purchases when the deal closed), that meant that they thought their bonds were worth well under 100 cents on the dollar in a bankruptcy. Shareholders are subordinate to bondholders, so equity owners would have gotten zilch.

So why am I doing a mea culpa here? Because of my suggestion that BS should have been nationalized. Quoting naked capitalism again:

I can think of a host of reasons, however, why the Fed did not go the nationalization route, the biggest being that it lacked clear authority (it couldn't declare Bear to be insolvent, as it could a member bank). And letting Bear fail (and having acsounts [sic] frozen) was what the Fed was trying to avoid, so letting it fail and then seizing control (even assuming it could do that) was never an option. No doubt, the central bank also did not want to assume administrative control of an entity that it had never regulated (ie, its supervisors had never kicked its tires) that dealt actively in markets in which the Fed has little expertise. Even in an orderly liquidation scenario, that it a lot to take on.

Doh! What was I thinking? The Fed can take over commercial banks, not investment banks without breaking half a million laws, right? (If anyone out there knows what the case is exactly, please drop a comment here.)

So perhaps I owe Bernanke et al and apology. I'm sure they'll be so happy to know that.

CLICK to go on reading "My bad: The Economist shows me why I was wrong about Bear Stearns."

Wednesday, March 26, 2008

Sympathy for Bear's employees

Part of the media blitz used by BS shareholders to improve their bargaining situation by twisting JP's/the Fed's arm via public opinion has centered on the effect of the bailout on the wealth of BS employees.

There are three arguments here: direct emotional impact (employees seen crying in through the windows of BS headquarters); loss of jobs/income; loss of savings (a third of BS's stock was owned by employees). The latter one sometimes gets refined into not-a-choice argument: it's not ESOPs, it's things like options, it's part of their pay tied in stocks for X years.

I find these arguments rather pathetic attempts at manipulation. Shareholders should get hurt, no matter what their other sources of income are (were). I don't see why shareholders who also happen to be employees fall under a different moral category.

I do hope that workers who had nothing to do with how recklessly BS was run and who have now lost their jobs find another one soon, hopefully an even better one. But that sorry state of affairs should have nothing to do with the terms of the deal (or whether it should have happened in the first place); if the issue is unemployment, the the direct solution goes through unemployment insurance, not through a financial bailout.

Firstly, a (likely large) subset of BS employees were part of the dealings that pushed the company into insolvency. They profited on the way up and, apart from taxes and possible mortgage-default costs, nobody will take away the wealth that they kept in safer (non-BS stock) assets. Even when it comes to things like mortgage defaults, my position is that, if they leveraged themselves in their private life like they leveraged their company, then they should have kept a close eye on how stable their jobs were and consider that as part of the risk when jumping into debt.

About having their wealth in BS stocks: I've blogged before about what I think about ESOPs: it's gambling and you do it at your own risk, specially when we're talking about stock from a bank known to be so highly leveraged bank as BS was. Be responsible, enjoy your proceeds when you win, don't come crying for a bailout when you lose.

That leaves the other reason to own BS stock: it was part of their compensation, perhaps as options, so they couldn't help but be invested in the company. Nope, I don't buy that either: it's true given you're in the job, but when you decide to accept a job in the first place, you (should) know where your compensation is coming from and have some sense of how risky its components are, at least relative to each other. Fixed vs variable pay, sales people evaluate it all the time, why can't financiers?.

Please, these people are supposed to be savvy risk-managers! If they can't cope with risk and plan accordingly, then we should shut down the markets and take all businesses under government control because there'd be no hope for anyone to make intelligent decisions under anything but total certainty.

CLICK to go on reading "Sympathy for Bear's employees"

Tuesday, March 25, 2008

The Bankers' Ball

Time for the JP Morgan/Bear Stearns/Fed shenanigan. I've delayed writing about it this long for a reason: my knee-jerk reaction was on the vitriolic, almost fundamentalist side, so I thought it best to get some perspective. And, oh my, it paid off in the defining clarity bought by yesterday's events.

This is going to be a long post, so I'll follow the consecrated rule of starting by saying what I'm going to say, then saying it, then..:

What has happened here is a bailout, pure and simple, obscured by the subsequent bargaining over the spoils between two private groups. As usual, the bill is footed by the taxpayer, directly in the form of a return-unadjusted loading of credit risk; and indirectly both in the form of increased moral hazard and as an efficiency loss. By this latter, I mean that what was achieved in terms of contagion-containment could have been achieved at a lower cost to the public purse and at lower risk of moral hazard. The windfall for the beneficiaries is the reduction in risk, leaving behind a portfolio with better risk-adjusted returns. What is perhaps different is that there is not one, but two groups of beneficiaries, two groups of bankers, bargaining over who gets to keep how much; and we have gotten to watch this process more or less live. Furthermore, all that has happened since that first salvo on Friday, March 14th, has been but distracting iterations of this bargaining process between private parties.

What happened on that Friday, ten days ago, was that a combination of recent events (Carlyle Capital et al) led Bear Stearns to suffer something akin to a bank run in the sense that its creditors wouldn't rollover its short term financing (despite rosy statements earlier that week).

The Fed took action by giving BS access to collateralised borrowing from its primary discount window. According to the rules at the time, BS was not entitled to it because it wasn't a deposit-taking institution, which is short hand for saying that investment banks were not considered of systemic importance to the retail and wholesale payment cycle. They were on the other side of the protection/regulation trade-off from commercial banks such as JP Morgan. And they had been happy for it so far.

The Fed circumvented this restriction by giving JP Morgan a $30bn non-recourse loan through the discount window, one that JP would use to give a loan on similar terms to BS. JP would be, in effect, nothing but a financial channel running a loop around regulation; the collateral would flow through JP, from BS to the Fed, at no risk to JP and all risk to the Fed.

Was it a bailout? BS was so leveraged and in need of short term finance, so insolvent, that it would have gone bankrupt. Of course, the BS side will argue in the 100 years of lawsuits about to be unleashed that it was a liquidity issue born out of illiquid markets, not a solvency issue. Although I would do the same if I was them (this is business, not a morality play), that is so wrong, it gives me a headache: saying you would be fine under circumstances ideal to your investment strategies is meaningless, really. Under the market as it was, as it is, and as it will be for quite a while, BS was insolvent, period. Bankruptcy awaited.

But liquidity, solvency, whatever: the Fed was bending the rules as they existed at that point to rescue a particular company through a mechanism intended for a different set of businesses.

Even then, some important questions remained: What collateral would the Fed take from BS (the best or worst rated papers)? What was the haircut on the collateral? What was the rate JP was going to charge BS (JP is not a charity, it was in for the money)? These would define the risk being assumed by the taxpayer and the level of suffering for BS shareholders, which was needed in considerable amounts to avoid moral hazard.

But in my view, the real issue among them all was: Was it even necessary?

BS was the fifth largest investment bank. Still, it was puny compared to the market. And of course, it was not a traditionally systemic part of the payment cycle.

The problem was arose from how highly leveraged BS's assets were and, because of this, the contagion that would result if BS dropped them in a fire-sale in such illiquid markets in a last-ditch, doomed attempt to save the business.

Ben Bernanke must have been waking up from nightmares of financial meltdowns just to see them coming true.

(Aside: on Sunday 16th, the Fed extended the discount window to investment banks. While this seems to complicate the story, it's almost completely irrelevant to it. Having said that, it is probably the most important event of financial-sector regulation in ages as it might mark the beginning of a seismic change in which investment banks and private capital in general come to be recognized as systemic to the payment cycle. In other words: more support, but more regulation. But, heck, we knew they were systemic since LTCM, right? Anyway, that's a whole different issue and one likely to trigger the battle of all lobbying battles if it ever gets seriously discussed.)

So back to the core of it all: was this necessary? I'm a sucker for first-best solutions when these are available. You lose efficiency when you don't attack the problem itself, but some iteration of the problem, some incarnation down the road. The problem here was the potential contagion because of BS selling assets in illiquid markets to reduce its private damage while it rushed all the way to the bankruptcy window. It was not that BS was going bankrupt.

So what the Fed needed to do was to prevent the sale of these assets in illiquid markets, not to shore up BS.

Instead, what the Fed did was to buy credit risk into the tax payer's portfolio and to shore up a company that had played unsustainable cards (at the very least in the sense that it wouldn't have survived given the current situation).

When a private firm is insolvent, it declares bankruptcy. But if there is a public interest in preventing a desperate, chaotic sale of assets which, in the process, triggers a contagion, the business is taken into receivership. That is, it is seized and wound down in an orderly fashion like the Fed would do with a commercial bank under similar circumstance.

Yep, I said it: "seized" as in "nationalized" No: I'm not saying the the gov should run an investment bank. Instead, the business is closed and the well-valued assets sold back into private hands, while those assets that would have triggered a contagion are held temporarily to be sold at a time in which the markets have returned to fundamentals. Debtors are paid with the proceeds, guarantees for the public purse are taken. And once all assets are finally sold, if something is left then, and only then, this is given back to the original shareholders.

It's contagion-less bankruptcy. Pure and simple.

Instead, what the Fed did do was to absorb the risk with nothing in return and generating in the process moral hazard by signaling its willingness to bend the rules to save a particular investment bank. And someone was going to pay JP for its troubles, whether BS or the Fed or both.

A lot has happened since then, and yet so little has. To be frank, beyond the expanding of discount-window loans to investment banks, as mentioned above, things since then have amounted to nothing more than a cat-fight between JP and BS shareholders on how to split the spoils.

On Friday, we went to sleep with BS shares hanging there at $30. On Sunday, JP announced that it was buying BS at $2 per share through a deal brokered by the Fed. And best of all, the Fed was still lending those $30bn, but at least we now knew which assets it would get as collateral: the riskiest, most radioactive of them all. And it seems save to assume that this deal wouldn't have happened without the Fed's loan. I say this to give the benefit of the doubt to the Fed: it the deal had gone through otherwise, then the Fed had no business in what should have been a transfer of wealth (and risk) between private parties. So those $30bn must have been key. (In fact, JP's valuation went up by a little over $32bn between the 14th and the 20th.)

(Aside: BS's board agreed to issue stocks for 39.5% of the company's worth at $2 per share and that these would be sold to JP; together with the 5% the board controlled directly, JP would almost be able to impose a stock swap and absorb BS for good. Why 39.5%? A rule-of-thumb says that Delaware courts, were both companies are incorporated, will not stop the board of a company from issuing and selling stock up to this amount without consulting stockholders under an emergency for the business' survival (see here).)

In other words, the Fed was in the same situation as before, which was now revealed to be the riskiest of all possible ones. JP was getting the sweetest of all deals: to keep all the juicy assets, including the super-blogged-about BS's headquarter building (valued at >$1bn), for about 1/4 of a billion thanks to the taxpayer absorbing the worst risk. If ever there was a windfall, here it was. The open question was how much punishment did $2 per share mean for BS shareholders.

That last question became the main distracting issue in this whole affair. BS's shareholders were getting $2, which, after all, is infinitely more than $0. So was this a bailout or enough punishment to wipe out moral hazard? Although some shareholders would still take millions home, it'd be hard to deny it was a harsh drop from the $30 per share of the 14th: how much less could they have gotten from bankruptcy or from receivership? Not a lot less than $2 less for sure! (Although apparently someone thought that more; see below.) In fact, I'd like to think that the Fed's estimates for the return per share through bankruptcy were $2; I really hope that was the case.

While that could have been the end of the story, instead we saw BS shares trading at >$5 and even >$6 in the subsequent days. This highlights yet another failure of the Fed's approach: it gave agents much more leeway to try to game the system when compared to a definitive seizing of assets.

(Aside: What was going on? Two hypothesis: (1) The current shareholders refused to sell because they thought they would get more through bankruptcy. (2) The current debtholders wanted to buy stock to make sure the deal would pass since they would get more from having JP take over their otherwise almost worthless BS debt.)

But who cared for those valuations, right? The deal was signed, JP only needed about 5% more of the stock; the bottom line: the Fed had intervened to transfer BS's assets to JP and the taxpayer. The best ones went to JP at no cost; the worse, the riskiest, went to the taxpayer. I sincerely fail to see the public interest in that.

(Aside: In the following days, the markets went up, the dollar went up, etc. Some analysts have argued that this shows the Fed did the right thing. What? Why would a transfer of wealth such as this encourage the markets? Because it signaled more bailouts to come? Moral hazard, here we come! But even at my most cynical, I cannot buy that as the main explanation: it must have had a lot more to do with the expansion of the discount window's lending, and the positive (less negative than expected) results from Lehman Brothers and Goldman Sachs.)

So this should have been the end of the story, except... Except that the lawyers for JP really screwed up. Massively. Someone must have been banished from private practice for six hundred and sixty six years. A clause in the signed contract meant that JP had agreed to back all BS trades for a year, even if the deal didn't go through. Now BS shareholders had some real bargaining power here and they knew it. JP had to get the old contract thrown out and a new one brought in. That's how we got the $10 per share yesterday.

But what does this change? Nothing from the public's perspective. Not fair: to be exact, there is a token change. The Fed now guarantees "only" $29bn and JP assumes the first $1bn in losses. Same-difference for the tax payer, but not quite: it's worse as there is greater scope for moral hazard in the future. The rest is just a redistribution of the windfall from JP back to BS shareholders. JP is, of course, still making a killing. And now, BS shareholders are getting five times more than before and a third of what the company was worth when we all found out how worthless it was.

Because of this latter, the discussion of whether this is a bailout for BS shareholders has again intensified. But this is still as misguided as before, it's still the wrong question: it was and remains a bailout plus a redistribution between private actors. The tax payer footed the risk, the juicy assets were distributed among the private parties in some bargaining game.

Moral hazard: Here we come.


Background reading, just in case you've been living in a cave: the FT offers a summary of the current state of affairs here (just ignore the first comments on the home data and the "rally") and a longer term perspective here; the NYT has the juicy tidbits of what happened Monday here.

CLICK to go on reading "The Bankers' Ball"

Thursday, March 20, 2008

The next bubble?

So I'm being facetious. Or am I? Bear with me if you're of the school of thought that loose monetary policy was behind the dot com bubble, then behind the housing bubble, and now behind...

The outstanding Econbrowser posted two weeks ago this little jewel. In essence, the Fed's pushed "risk-free" real interest rates into the negative (we've all seen that plot of the real return on the 5-year TIPS , right?) and now all that money is pouring into commodities. He presents this table:

Percent change in commodity prices since Jan

At a time of global slowdown, I call it scary (I still believe in decoupling, but as I said here, that perfectly compatible with the world slowing down because of an adjustment in the US's housing market). Nah, I call it bubbly: some investors might have gone in looking for a safe haven, but I'm sure lots more are going in just because of a believe in on-going asset appreciation. Look at those numbers! Let's hope there's a soft-landing for that one too. Wait: "too"?

CLICK to go on reading "The next bubble?"

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Saving in employer's stocks

Megan McArdle blogs:

* One-third of employees eligible to invest in company stock through their 401(k) have more than 20% in their company's stock.

* Almost 9% of them have more than 80% invested in their employer.

* For employees in their 60s, almost 20% hold half of their 401(k) savings in company stock.

(This, in regard to a report that Bear Stearns' employees' 401(k) plans were heavily invested in the company's stock. The thread of comments then discusses whether BS offered or did not offer stock-purchase options in their 401k's (it seems they did not, but had an ESOP for it).)

Should I feel sorry for Enron/Bear employees who put 20 or 80 percent of their pensions on Enron/Bear shares? There was plenty of advice out there to NOT do that. I certainly don't feel sorry for traders/analysts/executives etc who did it: they are financially savvy. Perhaps some employees who are not expected to have known better? OK, I feel sorry for that hypothetical lot.

Thaler and Goolsbee must be having a melancholy-tinged chuckle. Is this more evidence that we're all irrational (or so bad at dealing with risk or so prone to mistaken beliefs) that we need to be protected from our own failed instincts? (Like whether to have the option to sign in or to sign out of 401k's to start with.)

(And please, let's not get started with the argument that employees have better info that non-employees and so their decision is rational. To start with, ESOPs don't work that way: they cannot let employees react to privileged info quickly as it would smack of insider trading; by the time they can do something, the market already has the info (for example, you announce your intent to buy at the beginning of a quarter and the purchase is done at the end of it). What really matters are the incentives given to the purchase (matching purchases, discounts on the price, choosing the lowest price over the following quarter, etc). Also, a case could be made that there is an illusion of having "better information" that will allow you to beat the market after controlling for the special incentives and that the apparent irrationality stems from that, from mistaken believes.)

Hmm. If some smart behavioral econ can show that people do have an irrational tendency to over-invest in their employer's stock (which my experience in companies that offer ESOPs suggests is the case), does this mean a cap should be placed on how much of one's retirement savings can be in the current employer's stock?

Since my knee-jerk, libertarian reaction is to say "no" to more regulation, let me make a modest policy proposal that operates through education (indoctrination?):

Some high-school course should work hard at driving-in a three-step lesson:

  1. Out of each paycheck, first deal with expenditure needs; then with long-term savings; and only then, if you want to gamble, allocate a percentage of the remaining income to it. Stick to that percentage as an iron-clad max (and never as a min!).
  2. Dealing in individual shares is gambling, no matter what, period.

  3. Corollary: if your employer offers stock-purchase incentives, that is nothing but subsidized gambling. Allocate accordingly, given the shift in relative returns. But do so out of gambling money.

  4. 401k = LONG term savings = BROAD index funds, where you can park the money and forget about it until retirement starts getting close.

Then victims of ESOPs-gone-bad cannot claim to not have known better. And we don't need to feel guilty about their despair. Which will avoid creating perverse incentives through the political process.

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Monday, March 17, 2008

Are we already experiencing slower trend-growth?

What if the expansion of the long-run aggregate supply curve through productivity growth has slowed down already? Not right now, but a few years back, say around 2002. And say that the expansion of expenditure managed to keep on going thanks to a wealth bubble, deficits, and cheap credit; and that inflation managed to stay down thanks to cheap imports of both goods and inputs?

What are the policy implications?

Forget about whether you believe or not in an upward-sloping short-run aggregate supply, whether you're a New Keynesian, an RBC-er, or a microeconomist playing the macro game (like yours truly); if the expansion of the long-run AS curve has slowed down, then we should bite the bullet and accept that those GDP-growth numbers will be slower for a while and be grateful if we avoid inflation catching up and staying with us.

And we should definitely be wary of policy measures, whether monetary or fiscal, attempting to return us to the growth rates of the 1990s: these would instead quickly morph into inflation boosters with little to show for real income (and with the usual redistribution effects).

Oh! But isn't that what we've been seeing since January?

My "evidence" for the trend-productivity slowdown since 2002: A short while ago, I blogged around this graph by Robert Gordon, showing trend productivity dropping since perhaps 2002; EconWeekly has a similar one, together with a lot more analysis on the sources of growth and an explanation on the methodology.

Again, some basic dynamic (and expectations-augmented) ADAS will help here. This is a graphical representation of the expansion of the (static) aggregate demand and aggregate supply curves (represented by their "dotted" counterparts), with inflation in the vertical axis and GDP growth in the horizontal (and all the hand-waving this requires).

In the graph below, we start from point A, the long-run equilibrium. We shock the system so that the dynamic long run aggregate supply growth curve (LRAS) contracts (to LRAS'): point A is no longer a long run equilibrium and long-term growth will have to slow down to that given by LRAS'.

I am arguing we were in a point like A until the very end of 2007, with inflationary and "slow-down" pressures being kept at bay by the factors mentioned above (bubbles, deficits, cheap credit, cheap imports) and perhaps also some of the usual rigidities/inertias. But we cannot stay out of long-run equilibrium in the, well, long-run.

How will the system return to equilibrium if policy cannot magically increase long-term growth to what it was before? Suppose we let the market economy work its impersonal magic:

  1. This overheated economy puts pressure on input prices. When this pressure finally gets passed onto input prices, the dotted AS curve contracts and slides along the AD curve, causing inflation to pick up just as the growth rate decreases. This seems like what we've been seeing over the last few months.
  2. At the same time, expenditure could contract not just because of price increases for consumption and investment goods (which cause a movement along the AD curve), but because of the decrease in wealth produced by the bursting of the housing-bubble and by the collapse of credit markets.

This is shown in the graph below and the move from point A to point B:

Of course, the curves don't need to contract by the same amount. We might end up with higher or lower inflation in B than in A depending on whether aggregate expenditure/demand or aggregate production/supply contract faster. Keep in mind that growth will be given, in the end, by the position of the dynamic LRAS curve and is the same whether the adjustment happens with any mix of SRAS or AD contraction; the only difference is how high inflation will be.

For example, say that the adjustment happens with NO contraction of the AD curve, but only SRAS slowdown. In that case, the AS curve must contract more and the equilibrium will "slide" up the AD curve until they meet over the LRAS curve; the end result will be the same growth rate with higher inflation and likely a longer adjustment time.

As an aside: should we care about inflation being higher or lower? In this model, not really; but if the LRAS curve has a negative slope because of all the inefficiencies inflation brings on the price system (plus its distributional issues), then higher inflation leads to lower the long-term growth. I will talk a little more about this later.

What would expansionary policies achieve in this case? In the tamest case, expansionary policies like those given by the Fed and the White House/Congress since January will achieve what was described above as "keeping the AD curve in place", forcing the adjustment to take place solely through the SRAS.

This could be the case if policy makers have accepted that the economy has slowed down so that the discussion hinges only around the speed of adjustment and what tolerable inflation is, not about the growth (and employment) level.

I'm not sure what the advantage of that would be beyond showing voters that the government is "doing something."

What happens if we have not accepted this slowdown and instead try to keep returning to the previous level of long-term growth through expansionary policies? That is when things get scary.

We start again from point A. Rising input prices contract the SRAS curve; however, as it begins to contract, expansionary policies expand the AD curve so that we move to point B: same short-term growth, but with higher inflation.

Point B becomes the new point A for the "next" period! In this "next" period, policy either sends another expansionary boost to the system (to counter the continuing contraction of the SRAS as input prices keep rising), thus moving the economy from B to a point above it; or the contraction finally begins then, the same thing but delayed.

But is it really the same thing? No, it's even worse: the contraction would begin from a higher inflation level. When we finally make it to the long-term equilibrium, we will have the same growth rate as in the previous (pure market adjustment) scenario but with higher inflation.

No, no: it really is even worse! To keep the short-run equilibrium above the long-run equilibrium, policy must be unexpected. The economy is already expecting last period's inflation and that is precisely what will contract the SRAS curve: real prices returning to equilibrium. Policy must surprise contracts, catch them unaware, with an even higher inflation to keep the real price of production inputs (including real wages) below equilibrium levels. That's what makes producing above the long-run equilibrium possible. In other words: inflation must spiral upwards at an accelerating pace to keep us producing above the long-run equilibrium.

(Of course, at this point, we need to tip our hats in Milton Friedman's direction: inflation is a monetary phenomenon. Fiscal policy can result in price shocks, but a process of sustained price increases must feed from the expansion of the money aggregates. Appropriately for this argument, it's the Fed that's doing most of the heavy expansionary lifting these days.)

One might ask: but can't the government simply keep inflating the economy to keep us moving vertically from A to B (to C to D) each period? Of course not: economics would not be called "the dismal science" if that was the case!

What is not captured in this simple model is how the underlying mechanics of the system begin to break down as inflation accelerates (the negative slope of the LRAS referred to above). Eventually, the real side of the economy, production and income, enters free-fall: negotiating contracts (whether for goods, labor, or credit) becomes the art of divining future inflation and how to compensate for it, since the higher the inflation rate, the greater the penalty for failing to adequately account for it. In other words, transaction costs go up and we all end up spending more time trying to figure out how to work our way around inflation than in being productive. And the poor get harder hit as more of their wealth is kept in assets closer to cash: inflation is a tax on money holders.

So eventually, keeping us above long-term growth is unsustainable and we return to the long-run growth at a higher inflation level. Which, when we add detail to the model, actually means lower long-term growth than otherwise.

And once inflationary expectations settle in, they become little nasty self-fulfilling prophecies. To get rid of them, policy makers need to create recessions until they are beaten down like whack-a-moles through slower growth. A government-induced slowdown like in the early 80s: not nice at all.

The morale of the story: If productivity growth is slower, so is long-term growth; accepting this means letting short-term growth slow down and prices adjust; not doing so means entering a losing fight which would only result in higher inflation and, very possibly, even slower future growth.

UPDATE: Gabriel points out that total factor productivity (TFP) is endogenous and thus not policy-independent. Although I completely agree with him (since I dare call myself an institutional economist, I can't do otherwise!), I don't think this affects my argument unless the expansionary policies implemented to fight the slowdown also increase TFP. While I don't have any particular endogenous-growth model in mind, I don't think that what the Fed or the White House/Congress are doing these days would be among the arguments in one. So with that caveat, I'll still stand behind my post... for now.

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Monday, March 10, 2008

The opportunity cost of listening to Eliot

Spitzer's hypocrisy aside, isn't anyone hrmphing that our limited law-enforcement resources, oh-so strained trying to stop terrorists from blowing us to smithereens (so we are told), are instead being diverted to monitoring high-end prostitution rings? Are there no better targets for their bugging interests? Or, perhaps, we should see this as redistributional justice in action: by monitoring the affluent and their games, they leave the rest of us bloody well alone?

Update... and apologies? From The Economist: "(r)eports indicate that the FBI initially suspected that Mr Spitzer was involved in a case of public corruption because of movement of money in and out of accounts controlled by him. This led federal agents to investigate the prostitution ring and begin electronic surveillance of his phone calls, texts and e-mails." OK, corruption: if that's what triggered the investigation, then the FBI's choice of where to assign its resources is much more reasonable, at least in my book, than if this all but a moral crusade which happened to catch Spitzer with... nah, too easy.

Update (March 12th): The NYT clears up the story and leaves me high and dry. The investigation was triggered by Spitzer's suspicious transactions as reported by his bank. Alas, my peeve got deactivated.

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Goolsbee-gate and Obama's heel

"I think Austan innocently went over there, half as a professor, half as a campaign adviser," said Obama campaign manager David Axelrod. "He's basically a volunteer. He's one of the economists Barack talks to. He's not in close and constant contact with the candidate." (source)

It is undeniable that Goolsbee has been a decisive influence in pre NAFTA-repudiation Obanomics, from health to the environment. It's something akin to a born-again miracle to see the former most-liberal Senator speak econ sense (relative to the other candidates, at least). In fact, as much as one shouldn't vote for advisers, whose job security is not exactly awe-inspiring, I would bet most pro-Obama economists really are pro-Goolsbee-behind-Obama groupies.

That this distancing is worrisome to such a crowd denotes one distinguishing characteristic of Obama's campaign: his main personal asset is his charisma and the credibility this gives to his promise to do things "differently," in particular to listen to other voices, rather than the content that comes directly from him. The complement, running in parallel to the touching speeches, are the interesting proposals in econ and foreign policy which can be traced to his advisers. More than the other candidates, Obama is a moderator of and a conduit for good ideas.

And that, I think, is the crux: if Goolsbee is set aside, who will walk in to provide the econ context behind the charisma? Specially when this distancing is the result of and part of playing politics the "old fashioned way."

In terms of the information content we can derive from Obama's campaign, we've suffered a double loss: a shift of expectations towards damaging populism plus increased uncertainty around this new position.

Let's hope that this is all temporary, a "keep your head low while it dies away," that Goolsbee comes back or is quickly replaced by an economist of similar caliber. Fingers, be crossed.

p.s. I once went to an Obama-event, a small-scale affair way back then, way before the primaries. I was not impressed: his speech was given with his usual skill and passion, sure, but perhaps because I've lived most of my life in a developing country, I'm turned off, not on, by pretty speeches lacking content. I know, I know: this country now needs a unifier; but this country also needs a leader who can process facts and act based on sound analysis (whether his/her own or wisely picked from others). So the kind of things that sparked my interest in this campaign are articles like this one (what turns it off are articles like this one). I guess this makes me particularly sensitive to events that reduce the content behind this particular campaign.

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Friday, March 7, 2008

Slowing productivity growth: the AS curve again

This is, admittedly, "old stuff" (a month old when the numbers came out), but I just came across it, bouncing around the blogosphere. And if it truly measures the trend it claims to be measuring, then a month does not make much a difference.

The ultimate source is Robert Gordon, the Northwestern University productivity econ head, but I got it from Michael Mandel's "Economics Unbound", in turn via Mark Thoma's "Economist's View", where I stumbled back after a while after reading something in Megan McArdle's "Asymmetrical Information". (I told you I was bouncing around... sometimes my guilt-prone self makes me think I'm single-handedly responsible for the drop in productivity shown above. Oh, well.)

Slowing productivity slows down the expansion of the aggregate supply curve which, given an aggregate demand now expanding faster in relative terms, leads to price increases and slower GDP growth.

This is just the kind of evidence I was looking for in my earlier post (and, to a lesser degree, this one). The message remains the same: if what lies behind slowing growth (and rising prices) is a slowdown of the AS curve because of slower productivity growth and higher input prices (including credit), then policies aimed at expanding the aggregate demand will soon be fueling inflationary expectations while at best providing temporary GDP-growth relieve.

And if that happens, we will end up with resilient inflation slowing down growth in the longer term and a Fed in need of recessing the economy to lower those pesky expectations.

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Thursday, March 6, 2008

Decoupling, The Economist version

You can say you read it here first, almost point by point (you did, didn't you?)... But my, oh my, The Economist says it so much more nicely (and with all those numbers and pretty graphs). In a nutshell: decoupling is not only alive and compatible with globalisation, but is, in fact, an offshoot of globalisation, of its effects on domestic consumption and investment in developing economies, and on the new trade relationships this growth in domestic demand allows between these economies. The part I missed was the one about increasing domestic productivity. Oh, well, thankfully I kept my day job.

It's not just me, now: it's The Economist. I feel in good company!

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Tuesday, March 4, 2008

Gary Gygax...

A colleague sent me this a minute ago. A sad day for geeks and gamers all over.

GG failed the ST we'll all fail and moved onto the next rulebook.

I know: so many people, all great in their own ways, die each day, so I don't want to exaggerate.

But what Gary did was not just innovate RPGs out of wargaming, creating a juggernaut industry that has morphed over the decades from books to desktop gaming to MMORPGs; nor was his achievement to bring to the masses the idea that complex systems could be simulated through simple rules (though some people will argue that AD&D is anything but); nope, his real achievement was to popularize the idea that these rules could be used to interact with complex systems in real time. And that it was fun both to design them and to use them.

And thus he helped pave the way that geekdom would follow from then on, adding a fun side to probabilities, computer programming, mathematical simulation, etc.

For me, personally, the discovery in high school of D&D (the Basic set in the red box) marked one of those before-and-after points in life. While my productivity (and my stock of "real" books read) would undoubtedly have been a lot higher without RPGs, some crucial aspects of who I am today have to do with the self that developed from playing those games, starting from with whom and how I spent my leisure time during high school all the way to some basic professional choices.

So thanks, Gary.

p.s. I profoundly dislike the level-based system!

p.s.2. A nice tribute from Slate.

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Monday, March 3, 2008

You say potato...

Here's something about Peru's little big "gift" to the world.

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What took you so long? Mismatched incentives and price-less risk

From the FT this morning:

“It seems that equities are finally becoming aware that all other asset classes are in risk aversion mode,” analysts at BNP Paribas said. “They are also recognizing that the prospects for profit growth in the near term could be constrained, given the procession of economic data highlighting the fragile state of the US economy.”

Analysts get paid to stay informed, process the information efficiently, and act accordingly. So it's amazing, ain't it, what they come to find only at the start of March? At least they didn't wait for the ides.

One can no longer be surprised by the capacity of analysts/traders/fund managers to cover the totally obvious through a mystical invocation of a new set of laws for the Universe of Vanishing Risk. Housing bubble, dot-com boom, this time, at least, we're being spared the justifications: US stocks had simply been doing quite well since January relative to other domestic and foreign assets in the face of worsening domestic econ news (even housing stocks have had their rally). If anything, I would venture it's the conviction that bad news are merely triggers for the Fed to shoot down rates further so the party can go on.

The magic spell of the moment is really irrelevant: it will happen again, we will recover and then, a few years from now, the experts will claim they've again discovered a new universe beyond the laws of economics ("this time it's for real!"), will forget to account for risk, and will try to pull us along with them. The irony is that we know it will happen precisely because it's all laid out there by those very same laws of microeconomics, most basic of all: people react to incentives.

What we ought to do is look at what the incentives facing analysts, traders, and fund managers (specially hedge fund managers) are. And the constant has been, as far back as we care to go to understand today's financial architecture, that these incentives are skewed towards short-term horizons and divorced from the downside-risk the agents' actions generate. The results are rewards virtually unlimited on the upside and limited on the downside to, in the worst case scenario, temporary unemployment (has anyone tracked the career paths of hedge fund managers whose portfolios tanked?).

To go back to my leitmotif: a lot of the risk gets priced close to zero because the agents making the calls are essentially not facing it.

With that in mind, there's no mystery left to explain: it's not stupidity and there certainly is nothing irrational (nor evil) at play; it's plain self-interest on the parts of both these market-movers as well as the institutions who hire them, at the expense of clients with (rationally?) limited information (who are also acting on their info-constrained best interest).

(In a darker angle: Kerviel's defense in the SocGen scandal boils down to "SocGen knew what I was doing and didn't care as long as I was making money for them.")

So if it's all about self interest, should we care? Isn't it what markets are all about? My pet peeve here is the considerable negative externality (and the perverted incentives) exerted on others by these actions when they find fertile ground in enough actors on the other side of the fence to tilt the markets. Those who do get informed and "do the right thing" (in this case, those on both sides of the market who follow the path given by fundamentals up to the existence of a bubble) not only miss the unsustainable gains on the upswing, but even worse, when things inevitably come crashing down, end up suffering the adjustment just like those who played hard'n'reckless, and worst of all, have to bail out those who bet and lost.

But no, the point here is not that the government should step in and regulate the life out of markets: please, I'm an economist! Indeed, I think federal and state governments have contributed to the mess in the housing market through their tax incentives in favor of house ownership (or, rephrasing this, against renting). And I really don't see how the government could improve on the reasons causing the market to fail to self-regulate.

On the contrary, it is conceivable that the mismatches in the planning horizons and allocation of risk could be eliminated so that private contracts and compensation schemes would suffice to produce better results.

For this to happen, stakeholders in the financial markets need to find a way to overcome their collective action issues and design better incentives for themselves, by which I mean more closely aligning their corporate interests and that of its market-informing/moving employees with those of the clients they inform and for whom they act as agents. In particular, this means incorporating into compensation schemes a sense of the risk, both on the upside and the downside, that their employees' decisions generate on clients' returns, and to extend the horizon of this effect on compensation over a few years.

In fact, both things work together nicely: smoothing earnings over a longer period provides incentives to think in terms of risk over the longer-term while allowing compensation to be based on realized risk, including a bigger downside. On average, agents' compensation would better track their record.

Easier said than done: the coordination problem starts when investment banks, hedge funds, etc. grow afraid they will chase talent away if they move away from immediate, limited-liability returns in favor of time-smoothed contracts that load more risk. It grows deeper when imperfectly informed clients believe the illusion of risk-less returns coming out from the "experts" and demand such returns. More generally, there are too many stakeholders (on both sides, but so many more on the clients' side) for transaction costs to allow spontaneous Coasian bargaining to get to the efficient result.

So yes, perhaps some (public) institution might be needed to provide a forum that allows this coordination to take place in. Not to blurt out even more complex regulations that will inevitably be ran loops around, but to help the parties involved overcome the costs of re-starting the system from a more efficient equilibrium. Unfortunately, the financial markets have consistently proven their inability to stop these "misalignments" (I won't call them all bubbles) from happening over and over again on their own.

Otherwise, the rational thing will be for all of us to play dumb and go for broke every few years when markets spin out of control because of some screwed up incentives scheme. Not a good equilibrium.

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