Thursday, October 30, 2008

Investment prediction holds up in Q3

In a working paper last week (available from NBER or from, Univ. of Chicago student Luke Threinen and I explained that the slump in residential investment should encourage non-residential investment. The diagram below was displayed in the paper, using data through 2008 Q2:

The BEA released its advance estimate of 2008 Q3 real GDP today, including their report that "[Real investment in] Nonresidential structures increased 7.9 percent [from 2008 Q2].... Real residential fixed investment decreased 19.1 percent...."

In terms of the Figure from the NBER wp, the orange line is higher in Q3 (115.7, as compared to 113.5 in Q2) and the blue line is lower (77.1, as compared to 81.3).

[other news from the report: real GDP overall was down 0.3%. Compare this to -0.2% for employment --> suggests that capital income is down about 0.6%]

GDP Growth is the Logical Implication of the Party Line

Shouldn't a housing bust have the opposite effects of the housing boom? The party line about the economy is that the housing boom was a time of inefficient excess. Shouldn't a period of low housing investment bring efficient prodigality: that is, MORE GROWTH FOR GDP AND EMPLOYMENT and less growth for consumption? Why then does the party line feature gloomy predictions for real GDP and employment growth going forward? Make up your mind: was the housing boom efficient, or not? Do we want to relive those years, or not? If life after the housing boom is so bad, then let's not criticize the economic performance during those years.

There is some empirical support for the housing boom party line, and therefore data that calls into question the gloomy predictions for real GDP going forward. The chart below shows that real consumption (PCE) growth was somewhat greater during the housing boom than during the previous years. Real GDP growth and employment growth were less during the housing boom than during the previous years.

A related contradiction in the party line is that it was unhealthy for there to be lending to people with bad credit scores. But now it's considered a problem that today (according to the party line) only persons with good credit can obtain loans! Which is it: does a healthy economy provide subprime credit, or not?

P.S. First estimates of GDP growth 2008 Q2-Q3 will be released later today. Obviously, one quarter does not make 7-10 year time frames like I studied above. Other than saying that employment will not fall below 134 million and that real GDP (chained 2000 dollars) will not fall below $11 trillion, I do not have any prediction about today's release (read the specifics of my predictions here).

Wednesday, October 29, 2008

Credit Crunch Fairy Tale?

Some reporters for the New York Post tried to prove the existence of a credit crunch by going out to apply for loans. Loans for housing, loans for autos, loans for boats .... One problem -- their loan applications were approved (one of the 5 was formally denied, but even in that case the banker said that the money could be obtained through a credit card application)! Read about it here: "To loan seekers in Manhattan last week, the credit crunch seemed nowhere to be found."

Tuesday, October 28, 2008

Stealthy Impotence

The U.S. Treasury has not yet actually given funds to banks pursuant to its bailout plan. Those funds are intended to "go out the door" between this week and the end of the year. The crisis began a least a year ago, and became obvious to the world in mid-September.

I have repeatedly explained that those funds are impotent, or perhaps even a bit counterproductive.

I am worried that my tone seems critical. After all, I am saying that the government's timing is bad (recall Milton Friedman's essay on counter-cyclical policy -- he thought it could be potent but was doomed to be ill-timed) and its actions impotent.

That's the wrong impression. In the midst of a panic, there is value in pretending to "do something" without actually doing anything that would affect market outcomes. Whether by accident or by intention, the U.S. Treasury and the Bush administration have impressively come close to doing exactly that. There was great fanfare about the bailout during the first week of October. Every time you saw Paulson, Bush (or Bernanke for that matter), they had very serious looks on their faces, clearly conveying the message that they were regarded the economy and their fixes with utmost seriousness.

Most economists felt better that the Treasury had big plans and had even tweaked those plans to better reflect the academics' advice. Probably the public felt better too. I am absolutely certain that, while sometimes intangible, feeling better is an important commodity. For example, brand names have tremendous value -- what are those names doing if they are not making people feel better? Although the production of good feeling would ideally be left to private enterprises, I admit that the Treasury created real value by the fanfare alone.

The Treasury has dragged their feet a month now. Hopefully they can stall further, without giving back too much of the good feeling they created.

Apparently, I am alone in entertaining the idea that the best solutions to tough problems come from the marketplace. I have repeatedly offered detailed explanations how those solutions might work in this situation. But even I obtain comfort from the fact that, when the Treasury's time for stalling has run out, it will implement an impotent solution -- that is, a plan that has minimum interference with the market's functioning (there is some interference with market, but -- aside from literally doing nothing -- the interference is less than the alternatives). So the Treasury approximates the benefits of doing nothing, without the cost (that is, the opportunity cost of making people feel like "something is being done").

Not only does the Treasury's plan have the genius of letting the market operate with minimum interference, but it allows Paulson, Bush, and Bernanke to be ultimately regarded as heroes. A year from now, when the "severe recession" has failed to materialize, they can claim full credit for avoiding it. Furthermore, they'll have a legion of economists who remember that they (the economists) supported the bailout (and who will have forgotten that they predicted severe recession) and will have to give some credit to the public servants who implemented it. Moreover, the economists themselves are protected against risk, because in the unlikely case that the economy is depressed, they can offload blame on the public servants for implementing an impotent policy, or failing to implement an allegedly potent one in a timely fashion.

Is the Treasury Impotent?

The U.S. Treasury now proposes to spend some of its $700 billion authority – $250 billion to start – to purchase equity in struggling banks. This proposal echoed the proposals of a number of academics. However, in the haste of developing this plan, few have considered the fact that Treasury capitalization will reduce private capitalization, with little net effect on the overall capitalization of the industry.

It is a known fact that the private sector has itself been looking seriously at recapitalizing banks, with some investors already committing cash. Within the past year, the Abu Dhabi group purchased a large stake in Citigroup. Bank of America announced early this month that it would issue more shares in the amount of $10 billion. Mitsubishi is acquiring a stake in Morgan Stanley. Most of us would guess that JP Morgan Chase would raise capital even without the Treasury’s help if it found additional lucrative opportunities to expand. One calculation found that banks have already raised over $400 billion.

Even if existing banks could not attract capital on their own, their inaction creates opportunities for other institutions to commit capital to funding investment projects in our economy. Walmart would like to get into the banking business. Pension funds, university endowments, venture capitalists and corporations all bring money to new investment projects. For example, a profitable corporation (there are many of them these days), could cut their dividend in order to fund projects that would have otherwise been funded by a bank.

Do not assume that the private sector funds are invariant to Treasury actions. Rather, the private sector has both the means and the motive to neutralize Treasury purchases. If, say, Bank of America gets $10 billion from the Treasury, they can change their minds about their plan to issue $10 billion in the private sector (or maybe they anticipated this purchase, and without it would have planed to raise $20 billion). Even if it were true that there were some banks that were not raising private funds because their shareholders want their money out rather than throwing good money after bad, Treasury investments could still be readily neutralized by the private sector. For example, banks could use their new-found Treasury cash to buy back shares! Or they could use that cash to raise the dividend, or to put off a dividend cut that they had planned. The Washington Post called the dividend-hike possibility “the biggest hole in Treasury's financial plan,” although basic economics suggests that there are many large holes of this character.

Yet another hole of this type is for one bank receiving Treasury cash to buy the shares of another bank on the open market. Two see how this is equivalent to dividend payments and share buybacks, consider two scenarios. In scenario A, the Treasury buys stock in Bank ABC, after which bank ABC takes the Treasury cash to buy its own shares in the open market. Scenario A ends with bank XYZ's buying bank ABC in exchange for XYZ shares. In scenario B, the Treasury buys stock in Bank XYZ, after which bank XYZ purchases bank ABC for cash. In both scenarios, the Treasury ends up with XYZ shares. In both scenarios, bank ABC shareholders end up with Treasury cash. In both scenarios, there is no impact on the capitalization rate or the loan portfolio of either bank. The only difference between scenarios A and B is that the latter makes it slightly less obvious that the Treasury cash is going straight to bank shareholders.

Treasury Secretary Henry Paulson has said the money was aimed at rebuilding banks' reserves so that they would resume more normal lending practices. But reports then surfaced that bankers might instead use the money to buy other banks. Indeed, the government approved PNC Financial Services Group Inc. to receive $7.7 billion in return for company stock and, at the same time, PNC said it was acquiring National City Corp. for $5.58 billion.

Remember that it is unclear whether the Treasury will vote along with the other shareholders, let alone micro-manage bank operations. If bank shareholders want cash in their pocket rather than loaning it out, there are strong market forces (not to mention fiduciary responsibility) pushing bank executives to pay out the cash.

Even if by luck or judicious micro-management the Treasury were to prevent these payouts, the flow of private sector funds toward funding new projects would still be reduced, thereby offsetting the Treasury investment. In this case, the banks receiving the Treasury investments would cede less business to new entrants to the banking industry and to alternative institutions that fund investment projects. For example, profitable non-financial corporations would no longer have to cut their dividend to finance their projects, because they could obtain the funds from one of the Treasury-partnered banks. The total amount of funds available for investment projects is just the same.

Bush, Paulson, most economists, and I agree that a nationalized banking sector is by itself undesirable. But the Treasury purchase plan is going forward because the purported benefits – a more capitalized banking industry – outweigh that cost. The purported benefits will never materialize because private capital is pulling out -- and will continue to pull out -- of the banking sector to make way for Treasury capital.

[This article is apparently not very interesting: it was turned down by the Wall Street Journal, the Washington Post, the LA Times, and Forbes.]

Flashback: How Far Will Housing Prices Fall?

Do you remember this entry from 3 weeks ago? I said that housing prices had 27% more to fall. Last Friday, Luke and I wrote " of July 2008 housing prices more to fall in order to reach the real value they had for several years prior to the boom" and that the fall would be about 30% relative to the PPI.

Today the Case-Shiller index for August 2008 was released, and its value fell 2% from the previous month and 28% from the prior year.

Chicago housing prices have fallen much less over the past couple of months: the Case-Shiller Chicago index has fallen only 2.5% over the last 6 months. Slow rates of Chicago decline are expected because Chicago prices were closer to construction costs, although the rates are so slow that it makes me wonder whether Chicago will ever get back to 1999 levels of (housing price)/(construction cost).

Monday, October 27, 2008

Boom or Crash? Actually, both

The housing crash is one of the fundamentals our economy inherits from the past. This is boom time for the nonresidential sector because, after a long wait, the housing sector no longer absorbs so many resources. If you are young with new business ideas -- good news: you no longer have to compete with the housing sector for funding.

Although business capital and GDP will grow (my detailed predictions are here), there is some crash to this economy. Bad news for older persons who planned to live off past investments: your capital will have to compete with the new projects of well-funded young people. That's part of why the stock market fell. It's not all good news for the young: they'll have to compete in the labor market with older workers who can no longer afford to retire; this is one of those rare occasions when GDP grows more than normal and so does the unemployment rate.

Univ. of Chicago student Luke Threinen and I explain these results in more detailed in a working paper (available from NBER or from This research is ongoing, so please check back here for updates, corrections, etc. For example, we would like to understand better the implications of Hypothesis G, which is not explored in the NBER wp.

Our favorite empirical result is here:

I just heard through the grapevine that University of Chicago graduate student Pedro Gete has also linked housing construction to the U.S. current account. I will report back when I learn more.

Sunday, October 26, 2008

Economic Outlook: My GDP predictions (or lack thereof)

The first estimates of 2008 Q3 GDP will be released on Thursday (four days from now). I take this opportunity to reiterate my predictions, which have been previously stated in my New York Times article and in my working paper "Market Responses to the Panic of 2008" (I hope the NBER will have that available by tomorrow). My goal here is not to convince you of my predictions, just to make it even more clear what they are.

My basic approach looks at the marginal product of capital -- that is, the profitability of each dollar invested -- in the nonresidential sector and at the wealth and substitution effects of the housing price crash. My model is not much more detailed than that, so we cannot ask it to make especially detailed predictions. In particular, I have plenty to say about how the economy will look a couple of years after the housing crash (in 2009 and 2010) but not much to say about the month-to-month or quarter-to-quarter path for getting there. Moreover, while the financial crisis was at its worst in the last two weeks of Q3, I have suggested that its adverse effects (if any) would have been anticipated in Q1 and Q2, so I cannot even say whether the financial crisis' impact (if any) would be after Q3 or before.

Because of the high non-residential marginal product of capital before and after the housing price crash, the incentive to save is strong, so the real U.S. non-residential capital stock should be significantly higher in 2009 and 2010 than it was in 2006 or 2007. Normally, three years would bring about 6% more real consumption -- and more with a high marginal product of capital -- but the housing crash had an adverse wealth on the order of -3%. So real consumption will be higher in 2009 and 2010 than in 2006 or 2007, but probably not 6% higher. Real GDP and employment will be significantly higher in 2009 and 2010, and so will unemployment, because of the shift in labor supply.

I blogged recently about questions in my own mind about sign of the wealth effect; I continue to investigate them. If the housing price crash turned out to be good news, then 2009 and 2010 employment and consumption should be closer to trend rather than reflecting the wealth effect cited above.

I don't have a model of month-to-month or quarter-to-quarter fluctuations, except that longer term changes are the accumulation of monthly and quarterly changes. With that said, the mechanisms emphasized in the medium term model do make some suggestions as to the dynamics.
My previous writing explained that the financial sector needs a major reorganization, and the auto sector needs new, green, fuel efficient products. In the short term, employment and output will fall in both of those sectors. The vast majority of people are not employed there, but nonetheless finance and autos are included in GDP so GDP and employment will grow less (or shrink somewhat) in the short term until those sectors start to participate. The wealth effect on labor supply my take longer to show itself: for example, delayed retirements will not show themselves overnight.
Early September seems like an eternity ago in economic history, but don't forget that a major hurricane landed in Texas. This by itself will cause GDP to grow less Q2 to Q3.

The medium term fundamentals point toward more real GDP, more employment, and (to a lesser degree) more consumption. Some employment and real GDP declines may occur in the short run, but they will be small by historical standards. Professor Cooley recently explained "The losses to date represent less than .5% of the work force. In the relatively mild recession of 2001 to 2002, job losses equaled about 1% of the work force. In the much more severe recession of 1981 to 1982, job losses totaled nearly 3% of the labor force--six times today's figure. And in the (truly) Great Depression--invoked, now, with an alarmist frequency--job losses between 1929 and the trough in 1933 were 21% of the labor force." Note that 21% over 3 1/2 years is an average decline of 2% every quarter for 14 consecutive quarters! If employment declines 2% in even one quarter, or 5% over a full year, I will admit well before 2010 that a severe recession is happening and that my 2010 forecasts are unlikely to be attained.

According to the BLS, national nonfarm employment was 136,783,000 (SA) at the end of 2006, as the housing price crash was getting underway. Real GDP was $11.4 trillion (chained 2000 $). Barring a nuclear war or other violent national disaster, employment will not drop below 134,000,000 and real GDP will not drop below $11 trillion. The many economists who predict a severe recession clearly disagree with me, because 134 million is only 2.4% below September's employment and only 2.0% below employment during the housing crash. Time will tell.

[Added Oct 28: I notice that's 2008 recession market gives more than a 70% probability of a 2008 "recession" -- that is, two consecutive quarters of negative real GDP growth. At this point, a 2008 recession means negative GDP growth for both Q3 and for Q4, because GDP growth was positive in Q2.

Do to the hurricane, slightly negative GDP growth for Q3 is fairly likely. Negative real GDP growth for Q4 as well is possible. I cannot tell you whether 70% is the right number, just that real GDP will remain above $11 trillion.'s 2009 recession market gives more than an 80% probability of a 2009 recession, although the meaning of "2009 recession" is unclear to me. The contract seems to discuss GDP growth as something that happens WITHIN the quarter, when in fact GDP growth is measured between quarters. So I guess that the contract would pay if real GDP growth were negative 2008Q4-2009Q1 and negative 2008Q1-Q2, but I'm not sure. In any case, 80% seems too high]

Updated. As of October 2008, I had not anticipated that the public policy response would be to pay the unemployed so generously, to the point that millions could make more unemployed than employed. Whatever ultimately depressed the labor market, it was apparently unanticipated by the chief White House Economic advisers, despite the fact that they had at least 3 months more data than I did.]

Time to Enjoy President Obama

If you do not mind having nightmares, I recommend reading Professor Mankiw's article comparing the McCain and Obama tax plans. He calculates that, relative to McCain's, Obama's tax plan almost triples the price of his children's consumption after the good Professor is dead.

He takes the candidates' tax plans literally. Doing so is, of course, appropriate for the purposes of evaluation and debate. But taking candidates literally is ridiculous for the purposes of forecasting. Just as we know that Coke and Pepsi are far more different in marketing than they are in chemical composition, we know that Democrats and Republicans are far more different in rhetoric than in practice. The president is not a dictator (even dictators aren't dictators, but that's another story) -- the winner Nov 4 will have to deal with the same Congress, interest groups, and ultimately re-election as would the other candidate if he had won.

Second, most of the price-tripling result comes from the capital tax side. Because Professor Mankiw expects to live about 35 more years, the President during the next eight is hardly relevant. Indeed, if it were true that Obama would be a heavy taxer, Professor Mankiw and his kids might be better off if Obama gave a vivid demonstration of the harms of heavy taxation before they realized their capital gains in the year 2043.

Third, even if it were true that Obama and McCain would set labor tax rates that were consistent with their rhetoric, I am even more dubious that capital tax policy would follow that rhetoric. Look at western European countries. They have a lot more socialist talk than the U.S. does, and have some hefty labor tax rates to back it up. But their capital tax rates aren't so high. For a decade now, U.S. Republicans have been pointing to western Europe as a model of corporate taxation.

Fourth, capital taxation will likely be driven by the politics of elderly baby boomers. Unless one of the candidates plans to exterminate baby-boomers, they both will have to deal with them, as will the next several of their successors. For example, hiking the capital gains tax may work in the short run because the baby-boomers don't have any. But eventually they will (if nothing else, inflation will deliver some), and any good politician (regardless of party) will float a capital gains tax cut in order to obtain baby-boom support [I don't claim to know everything about the politics of capital taxes --- my point is that these politics are subject to the fundamental forces of supply and demand, which cannot be altered by the political party of the president].

My forecast: an Obama victory would be good for Professor Mankiw's kids ( Yes, I expect there would be an infinitesimally larger price of their consumption and, therefore, they will spend just a bit more time with Dad than they would have under McCain. Maybe kids and father can use that bit of extra time together to enjoy President Obama's eloquent and memorable (and, admittedly, substance-free) speeches!

Saturday, October 25, 2008

Was the Housing Crash Good News for America?

I am not a fan of the blame game. However, regardless of what public policy actions might follow, determining the fundamental cause of the housing price crash is necessary to understand where the economy is headed. Let me give three hypotheses, and demonstrate how each of them affects what we should be forecasting for the future.

  1. Hypothesis F ("F" for future): During the boom the housing market expected (rationally or otherwise) that housing demand would be high in the future. That is, unless housing construction were far above pre-boom rates, there would not be enough housing to satisfy demand in 2007, 2008, 2009 and beyond. Based on the expectation, housing construction proceeded at a furious pace. Once we learned that the future demand wasn't there, we were worse off because those houses couldn't be unbuilt. This ultimately false expectation cost America -- according to my forthcoming (hopefully by Monday at paper "Market Responses to the Panic of 2008" the losses were in the trillions. These losses will cause people to work more and, through that channel, will raise GDP.

  2. Hypothesis P ("P" for present): Suddenly, people no longer found housing to be an important priority. The scenario has some of the losses as with Hypothesis F (and thus the work stimulus), except that GDP may fall to the extent that actual housing/apartment rental rates are lower (recall that part of GDP is the rental value of housing) and this dominates the work stimulus. In the scenario above, actual rental rates do not fall, it's just that people revised their expectations about future rental rates.

  3. Hypothesis G ("G" for government distortion): The boom was caused by a distortion (induced by the government, or otherwise) of capital away from the nonresidential sector. It is good news that the distortion finally ended; the housing price crash is just an indicator that things are getting better. Our economy can use its resources more productively. This may ultimately raise GDP, but through different mechanisms: productivity will be higher, work will be induced by a substitution effect (rather than a wealth effect), and we may even be able to obtain the same government revenue with lower tax rates (recall that the housing sector is a major area for tax avoidance).

The housing rent data tell me that Hypothesis P is not important. Notice from the graph that the inflation-adjusted rents paid by persons living in houses and apartments are essentially as high now as they were during the boom, which themselves were not that high.

I don't yet know which of the remaining hypotheses is more important. I do not get the sense that America is saying "Finally! We can do things more efficiently!" so I have started pursuing the logical implications of Hypothesis F. But I have to start somewhere, and will report back when I have given more thought to G and/or have evidence on its relative importance.

[Update: I haven't made up my mind yet, but in the meantime I recommend Professor João Marcus Marinho Nunes' very nice article on Hypothesis G]

Parallels with the 1930s? Hardly

In today's New York Times, Professor Mankiw writes "... it’s hard to avoid seeing parallels (with the Great Depression) to the current situation." Conspicuously absent from the article are specifics about the parallels he sees (not to mention the lack of a conceptual framework -- supply and demand maybe?! -- to understand what fundamentals are even worthy of comparison, but that's another topic).

He points out that consumers are scared. I agree. Anything else?

He points out that that many banks failed during the Great Depression. But those bank failures came well after the economy was severely depressed. Friedman and Schwartz (p. 306) explain how the economy had already declined very significantly by October 1930: "Even if the contraction had come to an end in late 1930 or early 1931 ... it would have been ranked as one of the more severe contractions on record."

That's it. That's all the parallels he mentions about the two economies! He has an interesting discussion about how economists might be in a similar situation today as there were then. I'm not sure that I agree, but anyway this blog is about the economy, not economists.

I stick by my list of top ten reasons why today's economy is fundamentally different from the 1930s:

  1. Productivity is high today, and was low prior to the 1930s bank panics
  2. Nonfinancial corporations are very profitable this year, and were not prior to the 1930s bank panics
  3. GDP had grown at least through 2008 Q2. Friedman and Schwartz (p. 306) explain how the economy had already declined very significantly by October 1930: "Even if the contraction had come to an end in late 1930 or early 1931 ... it would have been ranked as one of the more severe contractions on record."
  4. The Midwest grew corn very high this year, and was a dust bowl in the 1930s.
  5. Bank deposits increased during this year's financial panic, they fell during the 1930s (Friedman and Schwartz, Chart 27).
  6. Today's banks suffer from a crisis of solvency; 1930s banks suffered from depositor-runs (see Anna Schwartz). [Prof. Mankiw acknowledges this]
  7. Today's failed banks are gobbled up by large investors from around the world. In the 1930s, many of them just failed.
  8. Today bank lending rates are falling; in the 1930s they were not.
  9. Today we have inflation (so far); in the 1930s there was deflation (both before and after the bank panics). [Prof. Mankiw acknowledges this]
  10. Today JP Morgan Chase is buying competitors; in the 1930s JP Morgan was buying competitors (OK, I admit that this hasn't changed!)

Wednesday, October 22, 2008

I am (partly) changing my mind about the stock market

I think we will see corporate earnings continue to grow. Even so, that does not mean that nonfinancial stock prices will bounce back to last year's levels; price-earnings ratios will not return to their previous levels. I will explain further in my forthcoming working paper "Market Responses to the Panic of 2008" -- using supply and demand, of course!

Tuesday, October 21, 2008

Professors Chari, Christiano, and Kehoe debunk 4 myths

I have explained in a number of places how, in theory, the banking crisis need not have much impact on the non-financial economy. I have notified readers of this blog of various pieces of evidence related to my hypothesis.

Professors Chari, Chrisiano, and Kehoe have now looked a variety of Federal Reserve Bank data. From the data, they conclude:
  1. "The claim that disruptions to the banking system necessarily destroy the ability of nonfinancial businesses to borrow from households is highly questionable."
  2. The data show no decline in bank lending to nonfinancial business.
  3. Nonfinancial business are issuing commercial paper at quite low interest rates.
  4. The volume of interbank loans continues to be quite high.

As I noted in an earlier post, I am wondering whether (2) is bank-driven or customer-driven. Nevertheless, it seems at odds with the simple view that banks are just cutting off credit.

I would not have guessed (4), which raises an interesting question: if we ultimately conclude that the banking crisis did not impact the nonfinancial economy, is it because (a) the banking sector does not significantly impact the nonfinancial sector, or (b) the crisis is not even a big deal within the banking sector, or (c) both?

Please note that Professors Chari, Christiano, and Kehoe and are affiliated with the Federal Reserve Bank of Minneapolis. They are more qualified than I (or, if not, have ready access to Fed personnel who are) to appreciate the intricacies of Federal Reserve data. Their findings should be given significant weight.

Wanted: Credit Crunch Anecdotes

I have given some multi-billion dollar examples of how businesses continue to fund new projects despite the so-called credit crunch. There are remarkably few counter-examples.

I have a friend who has some lake property, against which he took out a callable loan and has faithfully made the payments. The loan was just called. I'm not sure this is a counter-example (is there a good project he can't fund because of the loan call?), but I mention it because it's one of the only anecdotes I have that might suggest that the bank crisis is even trickling out to the wider economy. has a story of 12 small businesses during the credit crunch. I was really eager to read this one, anticipating that I'd learn about real-live small businesses that are unable to fund good projects because of this month's banking crisis. Well, I was disappointed. Of those 12 businesses, many reported that their troubles began a year ago. Others report that they are doing great, and are just worried that, someday, a credit denial will get in the way of their continued success. One business owner had been continually denied credit for the last four years -- so this month was nothing special! Only the boogie board shop owner provided a possible counter-example: he said that his sales would be $2 million/year rather than $1 million/year if his credit line had not been frozen.

If all I can find to counterweight my multi-billion dollar examples is a boogie-board entrepreneur and one called lake property loan, I'm going to have to conclude that the credit crunch is not significantly impacting the real economy. Given that the news media hungers so intensely for such examples yet still cannot produce them, what else can we conclude?

Do you have any examples?

Ricardian Equivalence Again Recognized

You heard it here first. Then the Washington Post. Now Professors Scharfstein and Stein explain how the Treasury Bailout Plan is less potent than you might think.

My editorial "Is the Treasury Impotent?" on this topic is still sitting at at a newspaper op-ed page for their consideration. I will post it here soon.

The Rhetorical Gap far Exceeds the Policy Gap: Further Evidence and Interpretation

Democrats are supposedly the ones who "help" the poor. Measured in terms of the fraction of people who are not obligated to pay income tax, hardly any progress was made during the Clinton years. It was two laws passed under the current administration that exempted large numbers of poor from the income tax.

Professor Mankiw reminds us that Democrats renege on campaign promises too (see here for Republican examples): President Clinton changed his mind about "middle class tax cuts."

By the way, the phenomenon that Democrats and Republicans have essentially the same public policies is evidence that our political system is pretty efficient. If Democrats and Republicans actually differed as much as their rhetoric does, public policy would wildly shift every time there was a change in the party in power. Wild policies shifts would be bad for the economy.

If instead Democrats and Republicans were blunt and said "Ultimately, I'll do essentially the same thing as my opponent does" (McCain and Obama are almost this blunt when it comes to policies related to the financial crisis), the political process would lose its value to many people. I might call it "entertainment value," but that sounds pejorative. It's more like the difference between Coke and Pepsi -- they might be chemically indistinguishable, but consumers would not be well served if Coke said "our drinks are essentially like Pepsi's" and Pepsi said "our drinks are essentially like Coke." Indeed, I wrote an earlier post to cheer up the November 4 losers, but it may have the opposite effect because there is value to imagining that your favorite brand is unique. Many people look at the Democrat and Republican brands that way.

Monday, October 20, 2008

An Obama Victory Would be Good for America

Candidates Obama and McCain often sound different when it comes to describing their public policy plans (although not always: both sounded the same -- that is, silent -- when Congress took $700 billion from Americans to bail out Wall Street). I like McCain's sound better than Obama's, because Obama more often talks about policy proposals and policy philosophies that don't make a lot of economic sense.

But it would not be good for America to have a president chosen merely on the basis of how the candidate's rhetoric sounds to Casey Mulligan. I think it is clear that a lot of people -- probably less than half, but still a lot -- like Obama's sound better. Moreover, the Obama fans are INTENSE about their preference. That intensity ought to count in the political marketplace.

You might say that Obama's nice (to many) sound should not outweigh the bad policies he will implement. That's a good point, but irrelevant. Just because Obama more often talks about bad policy proposals and policy philosophies does not mean that he would actually implement them. The Democrat-Republic rhetorical gap is vastly wider than their policy gap.

I estimate that an Obama presidency would, relative to a McCain presidency, reduce economy efficiency by less than $50 per person per year (you can read about the details here, but please wait until Nov 5). That small loss in economic efficiency is almost outweighed by Oprah Winfrey's enthusiasm alone! Seriously, judging from campaign contributions and rally-turnouts, I think it is likely that the intensity of preference felt for Obama by a significant minority of America is worth $50 per person per year.

P.S. Let me add that Professor Goolsbee is a good economist (being a good economist got him in trouble in Canada). So Republicans do not have a monopoly on having good economists in house.

[update Oct 27: The Financial Times endorses Obama, emphasizing "Mr Obama, on form, is as fine a political orator as the country has heard in decades."]

Do Not Read This Until Nov 5

If your candidate lost yesterday, I'm sorry. If you lament because you assumed that your candidate would have implemented superior public policies, then you can feel better already because your sorrow is based on a false assumption.

Democrats and Republicans clearly have different rhetoric. But rhetoric is not policy. Republicans talk a great game when it comes to cutting government spending, but President Clinton's administration had one of the lowest ratios of government spending to GDP. President Bush added immensely to Medicare spending with the Prescription Drug Act. Democrats talk a great game about helping the poor, but they pushed through a bill to tax America in order to bail out Wall Street fat cats. FDR started Social Security, but Nixon did the most to increase its spending. Democrats talk about limiting the power of the state when in comes to the death penalty, but a Republican Governor (Ryan in IL) put a moratorium on the death penalty.

Do you remember when Democrats were devasted because Roe-v-Wade would be overturned once President Reagan made his Supreme Court appointments? Well, those appointments happened and Roe-v-Wade still stands. I could go on and on with examples.

Economic theory suggests that political party might not affect policy, but instead merely reflect public policy preferences of the citizens. With some exceptions (see below), political parties compete with each other. Obama was one of the most liberal U.S. Senators because he faced little contest in Illinois, but became quite middle-of-the-road when it came to the Presidential race. Politicians are politicians first and (at best) ideologues second. A public opinion shift may give one party or another a small advantage and thus create a correlation between public policy and party-in-power, but this does not mean that political party itself has a significant impact on policy. Indeed, it would be inefficient if it did.

A number of economic studies have failed to find a correlation between party-in-power and public policy. Others have found a correlation (Professors Besley and Case have a nice survey in the JEL), but even there the implied impact is quite small. For example, Besley and Case look at state governments (where spending is about 1000 1982-dollars per capita per year) and find that governor's party is not correlated with spending and that a 10 percentage point increase in the Democratic party's share of the state legislature is associated with additional state government spending in the amount of $10 per capita per year. $10 per capita per year could be less than the cost of voting itself! Furthermore, effects at the state level may be larger than they would be at the national level because state-legislature elections are often uncontested and the whole economic logic cited above presumes competition.

Professors Snowberg, Wolfers, and Zitzewitz tried to look at situations in which party-in-power was significantly different even when citizen preferences were not. They found some effects, but they were also quite small. Eg., a Bush administration (rather than Kerry or Gore) was expected to increase stock prices by 2-3%. That is pretty trivial, given that the stock market fluctuated that much in the 20 minutes it took me to type this entry.

The Federal government currently spends about $9000 per capita per year. Even if I applied the estimates from the states (which I think are too big because national elections are more competitive), that means a victory for Obama (McCain) AND the Congressmen of his party will increase (decrease) federal spending by $90 per capita per year. Regardless of whether you like or dislike public spending, $90 is not worth much worry.

I am aware that I wrote an article showing how women's relative wages increased over the years, but essentially did so only during years of Republican presidents. But I don't know (yet) whether or how that progress can be attributed to public policy (more on the women's wage issue here).

P.S. How much would did (would have) an Obama victory cost? The $90 upper bound pertains to both executive and legislative victories by Democrats. Obviously, Obama is only part of that. Furthermore, some of the $90 would be a pure transfer. On the other had, deadweight costs may be created both from the taxation and the spending of the $90. I would say less than $50.

Top 10 Reasons Why This is not the 1930s

  1. Productivity is high today, and was low prior to the 1930s bank panics
  2. Nonfinancial corporations are very profitable this year, and were not prior to the 1930s bank panics
  3. GDP had grown at least through 2008 Q2. Friedman and Schwartz (p. 306) explain how the economy had already declined very significantly by October 1930: "Even if the contraction had come to an end in late 1930 or early 1931 ... it would have been ranked as one of the more severe contractions on record."
  4. The Midwest grew corn very high this year, and was a dust bowl in the 1930s.
  5. Bank deposits increased during this year's financial panic, they fell during the 1930s (Friedman and Schwartz, Chart 27).
  6. Today's banks suffer from a crisis of solvency; 1930s banks suffered from depositor-runs (see Anna Schwartz).
  7. Today's failed banks are gobbled up by large investors from around the world. In the 1930s, many of them just failed.
  8. Today bank lending rates are falling; in the 1930s they were not.
  9. Today we have inflation (so far); in the 1930s there was deflation (both before and after the bank panics).
  10. Today JP Morgan Chase is buying competitors; in the 1930s JP Morgan was buying competitors (OK, I admit that this hasn't changed!)

Please let me know if you see any further similarities or differences.

Bank Lending Rates over Time

It has been alleged that banks these days are unable to loan to their business customers. A reduction in the supply of bank loans to businesses should decrease the quantity of bank loans to businesses and increase the interest rate on those loans. Whether most of the bank-loan-supply shock shows up as higher rates rather than lower quantity depends on the elasticity of demand for bank loans (I think that the elasticity of demand is high because there are good substitutes for bank credit, but put that aside for the moment).

I just posted information on the amount of bank lending, which shows evidence of bank customers' hoarding liquidity, but does not suggest that banks have reduced lending (a reduction might be hidden in the data somehow, but if the effect were hidden you have to wonder how big it really is).

Now take a look at banks' prime lending rate. It rose during the housing boom and was flat or falling since the housing crash. It was just cut another half percentage point less than two weeks ago. That tells me that major bank customers had to compete with residential loans during the boom, and now they no longer do (the prime rate also follows the fed funds rate -- I'll leave it to another day to discuss whether supply and demand determines that rate, as opposed to the fed itself).

If a bank does not intend to lend, why doesn't it at least charge more on the loans it does make? You might say that it has to compete with other banks, but that's both true and proves my point. Banks DO intend to lend: they cut their rate to retain and attract customers.

Commercial Banks are Lending More than Ever?!

During the 1930s bank panics, banks:
  1. lost deposits and
  2. tried to increase their short-term assets rather than make loans.

During the last week of September 2008 (at the height of today's banking crisis), large commercial banks:

  1. increased deposits by $232 billion (normally, this is like 9 months increase)
  2. increased borrowing from "others" (ie., the Federal Reserve) by $150 billion
  3. increased ownership of "Treasury and Agency securities" by only $24 billion
  4. increased ownership of home equity loans by $41 billion
  5. increased ownership of residential mortgages by $102 billion (this is a normal one year's increase)
  6. increased ownership of commercial real estate loans by $46 billion
  7. increased ownership of commercial and consumer loans, although by less massive amounts than those cited above

The small commercial banks (in the aggregate) had much smaller balance sheet changes. I am still digesting this (you can read it at the Federal Reserve www site), but I suspect that much of the loan increases are "passive" -- that is, banks had already committed to customers that they could have access to credit and those customers took full advantage (i.e., it is the bank customers who are hoarding liquidity). Likely that is why deposits increased so much: bank loan customers just turned around and made deposits. Nevertheless, it is notable that banks honored their commitments, and then stand to make an easy profit as their customers receive less interest on the deposits than they pay on the loan.

Interest rates are also coming down (see my next post). Thus, it is difficult to see any effect on the supply of bank loans to the nonfinancial sector in either the quantities or in market prices. If this financial crisis were such a big deal for the nonfinancial sector, why is it so hard to see in the banking statistics?

Charts forthcoming.

Sunday, October 19, 2008

It's Just a Question of Exit and Entry: Look Who Agrees with Me!

Anna Schwartz and Milton Friedman wrote A Monetary History of the United States, in which they blamed many economic contractions (or at least the persistence of those contractions) on a failure of the government (esp. the Federal Reserve) to sufficiently expand the money supply. They did not think that letting banks fail was a good public policy for the 1930s.

I admire both authors. I deeply admire Milton Friedman's work in a wide range of areas. So I thought long and hard as to whether I should speak out about my conclusion that today's problem is "merely" one of entry and exit in the banking industry. But the more I thought about it, the more I became convinced that (among other things) the 1930s were different, and today the logic of supply and demand clearly point toward the exit-entry solution.

So I was pleasantly surprised, to say the least, to see Anna Schwartz quoted as saying "They should not be recapitalizing firms that should be shut down" in October 2008!

Rockin' Like a Hurricane

U.S. factory production was very low in September. It is important to recall that two major storms hit the U.S. in that month -- Gustav and Hanna -- and that there was a strike at Boeing. Significant events like these are unlikely to occur in 2008 Q4, 2009 Q1, or 2009 Q2. Furthermore, the economy quickly rebounds from these events.

Thus, we should be careful not to extrapolate the rate of economic growth measured through September 2008 into the future. We should also be careful to evaluate economic growth measured FROM September 2008 with the understanding that some "rebound" is to be expected as factories clean up after a hurricane or strike.

This story suggests that most of the measured drop August-Sept in industrial production should be attributed to the hurricanes and the strike.

Saturday, October 18, 2008

Professor Mankiw's Taxing the Uninsured Neglects Trejo's Dissertation

Professor Mankiw has a great supply-demand-based discussion of Obama's health plan tax. I hope Greg is correct, but he may not be. Republicans, please do not read what is written below unless you want to have nightmares.

Obama plans to tax employers who do not offer health insurance. Professor Mankiw rightly points out that employers may want to react by paying their employees less. However, the law may get in the way of having wages lower than they would be in the absence of the tax because those wages were already at minimum wage (this was the point of Steve Trejo's dissertation written at Chicago about 20 years ago).

You might say that most jobs already pay above the minimum wage, so that Trejo's analysis rarely applies. However, I bet that the jobs without health insurance coverage are much more likely to be minimum wage than would be the average job. Furthermore, don't forget that Obama and a Democratic Congress could raise the minimum wage, and thereby invalidate your claim that most jobs already pay above the minimum wage.

Yes, I did let my six-year-old son watch "Jaws" before we went fishing.

P.S. There is also the question of, under Obama's plan, how many employees would be without employer coverage. This depends on the size of the tax as compared to the employer cost of obtaining and administering health insurance. Every employer has some critical value of the tax above which she would provide insurance to all of her employees (of which she could have zero) -- in this case the proper analysis is Professor Summers' "Some Simple Economics of Mandated Benefits." (cliff notes: mandated benefits are like a tax equal to the amount (if any) by which the benefit costs EXCEED the employee's valuation of them)

Squeezed: Venture capitalists curtail investments

I have mentioned that venture capitalists are one of the substitutes for banks. So it is a problem that their 3Q startup investment activity is down 9%?

Yes, I would like to see venture capitalists expand their role. But not necessarily in funding startups, but rather to expand their role in funding investments that would have traditionally funded by banks. The story cited above does not discuss whether venture capitalists are doing, or considering, such a new role.

I have already discussed how savers are less willing to hold the same dividend streams. In other words, maybe savers want to invest less in risky activities. If so, startup funding (of which venture capital startup funding is part) would be down regardless of what happened to banks. The question is whether the decline of banks has caused venture capital to decline less than it would have.

I have noticed that the NASDAQ is down about the same as the S&P 500. However, the proper comparison would be the market value of S&P 500 capital as compared to the market value of NASDAQ capital -- that is, including the market value of the bonds of these companies. It is my impression that NASDAQ capital is less leveraged, so an equal percentage decline in NASDAQ and S&P means that the market value of NASDAQ capital fell by a greater percentage.

Professor Krugman is right: "Now is not the time to worry about the deficit"

In this case, Professor Krugman is right for the wrong reasons. First of all, the markets are thirsty for Treasury Bills (recall that the government runs a deficit by selling Treasury Bills, Notes, or Bonds) -- if you doubt me, just look at how low are their yields and how high are their prices. If the Treasury has a product that the market likes, than it should supply it until those prices and yields indicate that the markets have had enough. [This is Milton Friedman's Optimum Quantity of Money, applied to interest-bearing government liabilities. See also an AER paper by Professor Woodford called "Public Debt as Private Liquidity"]. I don't know whether liquidity will stimulate the economy, but even if it didn't, it's still efficient to provide liquidity when its cost of production is less than the market's valuation of it.

Second, it's time to cut taxes. Actually, it's always time to cut taxes! Cutting spending is politically more difficult. So you cut taxes first and let the growing interest payments on the public debt be your partner in the crusade against public spending [Reagan ran this program well].

Professor Krugman's argument (New Keynesian, and by no means novel) for running a deficit is to stimulate the economy with higher spending and/or lower taxes. This argument is either wrong, or absurd, or both. In the interests of brevity, I will deal with the absurd side of it and discuss the rest later. The New Keynesian argument why deficits would stimulate the economy is that the economy is perpetually depressed by excessive monopoly, especially during recessions (the so-called counter-cyclical markups), and that fiscal (or monetary) stimulus is a roundabout way of forcing monopolists to reduce their prices. But that's the Justice Department's (aka, DOJ) job, and the Justice Department has tools that are much better suited for dealing with monopolists' anti-competitive practices. I repeat my Query to New Keynesians -- What do You Have Against the DOJ?.

Friday, October 17, 2008

Banks Admit Bailout Won't Work

See this story. I have to admit that I didn't predict this -- more specifically I didn't predict that bankers would be so quick to admit what supply and demand predicted from the beginning!

Thursday, October 16, 2008

Japan's Crisis began with a Low MPK

Japan's banking crisis began no earlier than 1993, because Japanese banks were making profits prior to that, and were taking losses 1993 through at least 2001 (Kashyap, 2002, Table 1).

I am still double-checking this, but it seems to me that non-financial capital was already in sorry shape by then. The attached graph shows non-financial sector net operating surplus per dollar of capital in the non-financial sector (seasonally adjusted by taking residuals from a regression on quarter dummies). It reached its lowest in 1993 and 1994.

In the U.S., by comparison, banks began taking significant losses in 2007. The non-financial sector was quite profitable then, and continues to be. The high U.S. marginal product of capital not only raises the growth rate forecast from which to subtract any adverse impact of liquidity crisis, but also reduces the expected magnitude of that impact.

The Washington Post quickly discovers and applies Ricardian Equivalence

The Washington Post calls dividend freedom "the biggest hole in Treasury's financial plan." Good work! Ricardian Equivalence can work through a variety of mechanisms, but dividend policy is a great example.

Tino -- thanks for this citation and several others related to the dividends paid by the financial sector!

The Imperfect Information Excuse

Imperfect information plays a role in our economy. For example, a person diagnosed with a fatal illness may like to purchase life insurance for his family even if he had to pay an actuarially fair (thereby, high) price. But life insurance companies will not sell insurance to such a person because the cost of verifying exactly how fatal is his illness (expensive doctors and testing would have to be hired) exceeds the patient's willingness to be insured.

Imperfect information cannot stop a transaction with billions of dollars of benefits unless the costs of verifying that information is even greater than that.

Professor Kashyap and Diamond are blaming lack of troubled bank equity sales on imperfect information. Specifically, they say that a fairly strong bank would fail to raise equity because investors fear that the bank is actually quite weak (i.e., have some hidden troubled assets). They error both in fact and in logic. In fact, troubled banks have raised some equity from the private sector, which demonstrates that information problems have been overcome in this situation.

Regarding the logic, their story has some sense to it if it were a story about a small bank. But they are applying that story to the large banks (such as those receiving the "equity injections" from the U.S. Treasury) who have hundreds of billions of dollars in assets. Whatever private information those bank managers have could be made sufficiently public (or revealed to a single large scale investor) or sufficiently incentivized for far less than billions of dollars.

I suppose that the Professors would say that "it takes too long to make those discoveries." Where is the evidence for that claim? How many hours did the bank managers currently (and allegedly) holding the private information take to acquire it in the first place? Haven't some of these banks known for months that they would need more equity -- why weren't those months long enough to sufficiently publicize the private information? Why can't some of the managers in-the-know be made part of a new investment group and thereby given an incentive to blow the whistle? A lot of problems can be sufficiently solved in short order when there are billions at stake.

A more coherent story for the lack of equity sales is that the cost of capital is too high (many investors do not want to own bank stock regardless of what a detailed audit would show) and, even if it weren't, subsidized public capital is on the horizon and raising private equity would make them less eligible for the subsidy.

Wednesday, October 15, 2008

Economic Outlook: Anticipation

Until Lehman failed, I and most of the world had not realized that Fall 2008 would be the time when commercial paper markets would freeze, some major commercial banks would fail (or be gobbled up moments before failing), or that the once-libertarian economist Bernanke would propose spending circa $1 trillion of taxpayer funds helping the banking sector. One story commonly told after the Lehman failure is that banks would cease lending, and this would take a sharp bite out of national investment, which in turn would bring down the economy. Since then, we have been waiting with anticipation to see what would happen to the economy as a whole.

It is quite possible that we do not have to wait. Suppose that, while most of the world did not anticipate these events, the troubled banks themselves understood this much earlier this year. I cannot guarantee you that the troubled banks knew this, but it seems very likely that they did. After all, they were involved in the daily operations in a way that most of the world was not. So let's pursue this possibility to its logical conclusion.

If the soon-to-be-troubled banks understood in 2008 Q1 and 2008 Q2 that they were flirting with bankruptcy, wouldn't they cease lending in 2008 Q1 and 2008 Q2 in order to improve their short term asset positions? Why give a loan to a mediocre customer in Q2 when you recognize that you likely will be cutting off your best customers in Q3 and Q4?! In other words, we should have already seen much of the lending and investment impact of the bank troubles already in Q1 and Q2. [recall my blog entry from yesterday where I explained how the 1930's economy suffered well before the banks actually went broke]

We already have data for Q1 and Q2. Residential investment was down, of course, following the downward trend that began mid-2006 when housing prices peaked. But non-residential investment was UP (a bit), not down. In 2008 Q3, gross nonresidential investment was 4.64% of the capital stock, as compared to 4.55% a year earlier and 4.58% two years earlier.

Economic Outlook: Indicators of the Marginal Product of Capital

Corporate profits per dollar invested were very high through 2008 Q2. Indicators of 2008 Q3 are coming out now:

NonFinancial Corporations

Financial Corporations

I see no evidence here that a credit crunch is getting in the way of important business. In case you want to weight these items, note that total earnings for the quarter are $2.8 billion (IBM), $1.89 billion (Coke), $0.12 billion (Hershey), -$0.24 (Contin), $2.7 billion (Nokia), $1.35 billion (Google), $1.53 billion (Sch), $0.92 billion (Honey), $0.53 billion (JP), $1.64 billion (Wells), -$2.8 billion (Citi), $0.92 billion (UnitedHealth), -$5.2 billion (Merrill). I never said that it would be pretty for the FIRE industry!

Tuesday, October 14, 2008

The Profit Rate during the 1930s Era Bank Panics

As recently as 2008 Q2, corporate earnings were quite high by historical standards. This by itself predicts high rates of economic growth -- the baseline from which we can subtract any adverse growth effect of the today's so-called credit crunch. Moreover, corporate profits are an important substitute for bank loans (see my earlier posts). So an economy with high corporate profits is probably more resilient to banking sector failures than would an economy with low corporate profits.

According to Friedman and Schwartz' A Monetary History of the United States, the first (short) banking crisis of the Great Depression was in November 1930 and, in Professor Lee O'Hanian's words, "The first banking crisis of any national significance didn't occur until the fall of 1931." Regardless of which date you choose, the economy was already in bad shape. Friedman and Schwartz (p. 306) explain how the economy had already declined very significantly by October 1930: "Even if the contraction had come to an end in late 1930 or early 1931 ... it would have been ranked as one of the more severe contractions on record."

The marginal product of capital was above average in 1929 (although not nearly as far above the average as we are today). Maybe that means that, absent crop failures, etc., the economy might have grown well otherwise. Maybe that means that the 1929 economy would have been resilient to a severe bank panic. But I see 1931 as the more relevant comparison, because in the fall of that year the serious bank panics began. The 1931 marginal product of capital was 2.5%/year less than it was in 1929. By 1931, there were not extraordinary corporate profits that could be rolled back into corporations as a substitute for bank funding. The low 1931 marginal product of capital was by itself predicting a low rate of subsequent economic growth.

In summary, the marginal product of capital in the months prior to today's liquidity crisis was much higher than it was in the months prior to the 1931-3 bank panics. This not only raises the growth rate forecast from which to subtract any adverse impact of liquidity crisis, but also reduces the expected magnitude of that impact.

Query to New Keynesians -- What do You Have Against the DOJ?

Last week, the Treasury proposed spending some of its revenue purchasing equity in struggling banks. This proposal echoed the proposals of a number of academics. However, none of the academics have discussed whether Treasury capitalization would crowd out private capitalization (one caveat noted below). This irritates one of my pet peeves with New Keynesian economics -- that they propose to use macroeconomic policy to deal with industry-level problems. Even if public policies were generally potent, I cannot imagine that such an oblique approach to a problem would have much impact.

Let's begin with the proposition that the proposed Treasury transactions will be fully neutralized by private sector transactions in the opposite direction, and explore how New Keynesians might attempt to refute it. In the simplest model, future taxes are lump sum (with a known incidence) and the economy is closed – i.e., that all potential bank stockholders are also U.S. taxpayers. In much the same way that taxpayers behave in Barro’s (1974) model, taxpayers will recognize that the Treasury has invested more in bank stocks, and has implicitly done so on their behalf because the taxpayers will reap the gains and pay the losses of those investments. As a result, taxpayers will attempt to reduce their holdings of bank stocks by the same amount that the Treasury increased them.

A number of “realistic” modifications to Barro’s (1974) model have been proposed, but they do not necessarily weaken the basic result that public transactions are at least partly offset by private transactions, and may strengthen it. Consider first the possibility that taxpayer portfolio decisions are at a corner solution, so that taxpayers desire to reduce their holdings of the equity of existing banks but cannot.[1] If bank management were responsive to shareholder demands, banks would use the cash they obtain from Treasury investment to buy back bank shares from the public. In this case, the Treasury purchases put the cash into a revolving door, without boosting bank capital. [I saw a comment by Professor Stein that seemed to suggest that bank executives would raise dividends in order to enrich themselves at the expense of other bank creditors. This may be a concern too, but I think that the Ricardian force is at least as fundamental as corporate governance issues.]

Again for the sake of argument, suppose that Treasury purchases were accompanied by (perhaps implicit) regulations restricting share repurchases and dividend payments.[2] Investors still desire to hold equity in new banks or in alternative institutions that would compete with banks and likely view that equity as (imperfectly) substitutable for equity in existing banks. In other words, the portfolio-at-corner-solution view may explain how Treasury transactions would not be precisely neutralized by private sector transactions, but it predicts that the Treasury plan reallocates capital from new entrants to the banking industry and toward the existing (and struggling) banks. Tino pointed out that smaller banks are resentful of the bailout, because it props up their larger competitors. This reallocation harms the future efficiency of the banking industry.

Another modification to the Barro (1974) model assumes that taxpayers are unaware of what the Treasury is doing, and therefore have no motivation to offset Treasury transactions. This modification may be applicable in some situations, but seems quite inapplicable today when (a) the entire country is focused on the financial crisis and public sector responses to it and (b) taxpayers have loudly voiced their displeasure with the tax liabilities they perceive to be created by the Emergency Economic Stabilization Act of 2008.

One reply to all of this might be to have the Treasury invest in the bank equity across-the-board. At worst, Barro’s model applies and the Treasury investment does nothing. With enough Treasury investment, all of the private capital will be crowded out so that Treasury investment can have a real impact at the margin. Is that amount too much even for the U.S. Treasury? Can we trust that the Treasury will locate all possible competitors to existing banks? Should the Treasury invest in Walmart too (Walmart wants to operate its own bank)?

The Role of Complementarity in the Neutrality Result
By this point, I have pushed New Keynesians to start telling me about details of the banking industry. Unfortunately, the logical escape route in this direction is narrow and unpleasant.

How might industry detail trump Barro’s analysis? Suppose that, when industry capitalization rates become low, each bank’s output is complementary with the others.[3] In this case, the most direct public policies for raising bank output would facilitate cooperation among banks by encouraging mergers or the formation of other private-sector institutions such as clearing houses or commercial paper exchanges to align each bank’s incentives with the industry-level complementarities.[4] Once banks were the proper size, the industry could otherwise be analyzed as if the complementarities were absent (with the same neutrality or non-neutrality results).

Suppose for the sake of argument that mergers and other private sector efforts were insufficient to internalize the complementarity, and that banks can be prevented from buying back shares or cutting dividends. Even so, the impact of Treasury equity purchases depends on the terms of the purchase. Professor Mankiw has proposed that the Treasury co-invest (on a non-voting basis) with private investors who decide “on their own” to make a purchase of a bank’s stock. If (some subset of) taxpayers wanted to invest, say, $20 billion in bank ABC absent the Treasury plan, then there is nothing to stop them to investing $10 billion in the presence of the plan, thereby bringing the total ABC equity sale to $20 billion. In this case, other banks in the industry are unaffected by the Treasury’s purchase, because bank ABC sells $20 billion regardless of whether the Treasury participates. Professor Mankiw’s plan does nothing to align the incentives of the private co-investors with those of the industry as a whole, and is premised on two of the mechanisms that can deliver Barro’s result (that private investors are willing to invest even absent Treasury action and that bank managers are free to make dividend decisions, etc., to the shareholders’ advantage).

In order to use complementarity to predict a significant effect of Treasury purchases on bank capitalization, we must also assume that private investments are at a corner solution. In this case, a judicious and carefully micro-managed choice of Treasury investment will raise the marginal product of capital throughout the industry, and presumably stimulate private investment.

In summary, economic theory reminds us that Treasury transactions are at least partly offset by private sector transactions. Each Treasury dollar spent on bank equity will reduce private ownership of bank equity by some multiple. More research is needed to determine whether the multiple is close to zero, close to one, or even larger.
[1] This logical possibility probably does not accord with the facts, because Bank of America announced in early October 2008 that it would issue $10 billion worth of stock.
[2] Note that these regulations are counter to the spirit of many of the academic proposals, which are to keep the public sector out of bank business decisions.
[3] Presumably the complementarity was not significant at normal capitalization rates, or else banks would have merged or cooperated with each other by contract.
[4] Among other things, I owe these examples to Fernando Alvarez.

P.S. The DOJ is short for the Department of Justice. Most Industrial Organization economist believe that it is the appropriate public forum for alleviating industry malfunctions.

Monday, October 13, 2008

Congratulations Professor Krugman!

I don't know much about international trade theory, so it is a testimony itself that I have known about and admired Professor Krugman's work on that subject. Take a look at Professor Glaeser's explanation of why Professor Krugman is a highly deserving recipient of the prize.

Your comments help advance economic science!

My goal is to make the application of supply and demand be both accurate and accessible. Time does not permit me to respond to the comments individually, but I read them. A large fraction of the comments have helped me make improvements in that direction -- thank you!!

Sunday, October 12, 2008

Economic Outlook: An Analysis of Two Shocks

There are two shocks supposedly hitting the non-financial sector (which is most of our economy) as a result of the banking crisis. One of them is an adverse saver-investor intermediation shock. That is, the return to saving is low even while the cost of borrowing is high. The second shock is one of "confidence" (and also recognition that the stock market has crashed) -- an adverse wealth effect on consumption and leisure. These two shocks have exactly the opposite effects, which is why I am much less confident than the rest of America that GDP will fall as a result of the last month's events.

Intermediation Shock
I have argued that the intermediation shock is not that large, and at worst short-lived, because the entry motive pushes toward reducing that shock. Nevertheless, I will analyze it as if it were quantitatively important. By itself, this shock INCREASES consumption, because the alternative (saving) does not look as attractive. It decreases investment and raises the marginal product of capital because the cost of capital is temporarily high.

Capital is fixed in the short run, so any effect on GDP has to come from labor supply or productivity. Labor supply should fall due to an intertemporal substitution effect (i.e., working hard is one way to save, but now is, according to the theory, not a good time to save). This effect may not be large, because there are other intertemporal substitution effects to worry about (e.g., Obama's winning the election and eventually hiking tax rates). Productivity will be down somewhat, only because the banking sector is terribly unproductive and the banking sector is part of the aggregate. So the intermediation effect will reduce output in the short term, but increase output post-crisis above what it would have been absent the crisis.

Wealth Effect
Owners of equities are undoubtably poorer now than they were a year ago. Even persons who do not own equities may fear an eventual reduction in their labor income. This INCREASES labor supply, DECREASES consumption, and increases investment (with an ambiguous effect on the marginal product of capital). For example, baby boomers may delay their retirement because their 401k values no longer afford them as comfortable a retirement. This increases output now, and post-crisis compared to what it had been absent the crisis.

You may have read in the newspaper that consumption is 2/3 of GDP, so that a reduction in consumer confidence reduces GDP by reducing consumption. But, not surprisingly, that analysis ignores supply (that's why I call this blog "Supply and Demand (IN THAT ORDER)"). Baby-boomers are productive, knowledgeable people. If they stay in the workforce rather than retiring, that will result in more output, not less.

Combined Effect
These two shocks have exactly the opposite effects. The intermediation shock favors current activity (consumption and leisure) over the future. The confidence shock does the opposite. The lesson here: this is yet another reason why the intermediation shock's effect will be muted. I have already explained why I don't think the intermediation shock is very big. But even if it were, it has the wealth effects pushing in the opposite direction. These are two reasons why I am much less confident than the rest of America that GDP will fall as a result of the last month's events. [but note that the effect on efficiency and welfare is clear: the economy is less efficient and people are worse off -- ie, they'd rather live in a world without these shocks. But that doesn't mean less GDP]

Flashback: How Washington Helped Decapitalize the Banking Industry

Do you remember way back in 2005 when Walmart tried to enter the banking industry? They ran into one little problem: the Washington buzz-saw operated by banking industry incumbents to create barriers to entry. You do not have to believe my version of the story: just read it at Business Week or, among other places.

Do you think the banking industry would be poorly capitalized today if Walmart were a major player?

Do you think Treasury policies today will suddenly reverse this course? At least ONE economist needs to join me in reminding the public of the virtues of free entry.

Saturday, October 11, 2008

Professor Barro - Where Are You?!

This week the Treasury has proposed spending some of its revenue purchasing equity in struggling banks. This proposal echos the proposals of a number of academics, including Professor Mankiw. But not this academic!

I voiced some objections in an earlier blog post about the Profitable Government Enterprise Myth. I omitted another caveat -- that Treasury capitalization would recapitalize the banking industry MUCH LESS than each dollar expended by the Treasury. I was hoping Professor Barro would voice this opinion, because I learned it from him (not in 2008, but back in 1989 when I enrolled in his courses). Quite simply, Treasury capitalization will crowd out private capitalization.

To see this, assume for the moment that future taxes are lump sum (with a known incidence) and the economy is closed -- i.e., that all potential bank stockholders are also U.S. taxpayers. Professor Barro has explained that taxpayers will recognize that the Treasury has invested more in bank stocks, and has implicitly done so on their behalf because the taxpayers will reap the gains and pay the losses of those investments. As a result, taxpayers will attempt to reduce their holdings of bank stocks by the same amount that the Treasury increased them.

You might say that taxpayers cannot reduce their investments in bank equity, because those investments are already zero. If you say this, you err both in fact and in logic. In fact, Bank of America announced this week that it would issue $10 billion worth of stock. Even if we ignore that fact and accept the premise that taxpayers have no intention to invest in the equity of existing banks, I cannot believe that investors would not invest in new banks, or would not invest in alternative institutions that could compete with banks. Thus, at best, the Treasury plan reallocates capital FROM new entrants to the banking industry and TOWARD the existing (and struggling) banks. What a plan for strengthing an industry -- to take from the young and strong and give to the weak and old! As I have written many times, public policy needs to ENCOURAGE entry, not discourage it.

We cannot assume that taxes are lump sum, or have a known incidence. But recognizing taxation deadweight costs and uncertain incidence only increases taxpayer exposure to bank stock risk, which might cause them to reduce their bank industry investments MORE than the Treasury increases them! What a plan for strengthing the banking industry -- to decapitalize it!

Another concern of this type: that banks could use the cash they obtain to buy back bank shares from the panicking public. After all, those shares look pretty cheap! In this case, the Treasury purchases literally puts the cash into a revolving door, without boosting bank capital. I have seen no economist account for this concern.

This analysis also needs to relax the closed economy assumption ... more on that later today. But this is a good example of why I call this blog "Supply and Demand (in that order)" -- supply is too often ignored in public policy analysis. Proponents of Treasury bank stock purchases are guilty of a superficial analysis of the SUPPLY of private capital to the banking sector. That supply very much depends on public policy.

Institutions are Over-Rated

Economic institutions are not the same as economic functions. "Saving" and "investment" are economic functions. A bank is an economic institution that provides an economic function (bringing savers and investors together). But the function can occur without a particular institution, because alternative institutions can take its place.

The retained earnings of corporations are an example of an institution that could substitute for a bank in bringing saving and investors together. When banks were operating well, corporation ABC earning profits would often pay out some of those profits to its shareholders as a dividend. The shareholders would deposit those dividends in a bank, who would lend them out to corporation XYZ, who would undertake an investment project. Would the economic function be fundamentally different if corporation ABC reduced its dividend and loaned the funds to corporation XYZ directly? Or merged with corporation XYZ? Or invested internally?

You might observe that banks have close substitutes from competing institutions in some areas, but not others. You might say, for example, that banks are the only institution lending money for home purchases. But even if your observation were not exaggerated (employers often make home loans to employees), it comes from a time period when banks were functioning well. The real question is whether alternative institutions would bring funds to home purchases EVEN IN THE ABSENCE OF WELL-FUNCTIONING BANKS. I think they would. That's not to say that the world would be completely the same without banks. But the basic economic functions would still happen.

Democracy is another institution with an impact that has been good (I kinda like this free speech thing), but highly exaggerated. Operating the monopoly on force, and mediating between competing groups served by that monopoly, is a very important function. But a political institution such as election is only one way to serve that function. The possibility of ready institutional substitution for democratic political institutions is why democracies and autocracies have similar public policies in so many areas. It is critical that the basic economic function be performed, but there are multiple institutions that can perform it.