• James Hamilton Rejects the 'Flow View' on QE3

    At Econbrowser, James Hamilton takes issue with those who think the pending/likely/coming-to-a-central-bank-near-you tapering of the Fed's large scale asset purchases will have a large effect on the markets.  Hamilton sees any Fed action on QE3 as important because of what it signals, not because of what it means for the flow of funds.

    No one expected the Fed to announce a complete cessation of its purchases at the September meeting, only a "taper", or gradual slowdown in the pace of net purchases. Suppose for illustration that the Fed had announced at the last meeting that it was going to start reducing its net purchases of Treasury securities by $2.5 B per month beginning in October, so that it would be down to zero net purchases by November 2014 (in other words, back to maintaining a constant stock rather than allow its holdings to continue to grow further). Even though the Fed did not make such an announcement after its September meeting, there should be no doubt that a similar announcement is coming soon. Let's say that in fact the Fed is not going to begin tapering until January, with net purchases not reaching zero until February 2015. The difference between the two paths I just described is that the Fed would end up holding about $100 B more in Treasury securities at the end of 2014 than if it had begun the tapering immediately. That's a difference of less than 1% in the current stock of Treasury debt. This news is supposed to shave 30 basis points off the 10-year yield?

    Some argue that it is not the Fed's holdings as a share of the stock of outstanding debt that matters, but instead the share of the flow of newly issued debt that is purchased by the Fed. Of the $862 B in net bond sales from the Treasury to the public between June 2012 and June 2013, the Fed ended up with $277 B, or 32% of the new flow as opposed to 17% of the outstanding stock. A change in the flow of $2.5 B per month such as discussed above would represent 3.5% of last year's flow pace of $862 B/year.

    There are in any case substantial problems with the "flow" view of the importance of QE3. For one thing, it is hard to arrive at it from any economic model. Anyone who holds Treasury securities is free to sell them at any time they like, which is why the equilibrium price (or yield) must be such that the stock currently held is the quantity investors want to hold. That is a theory of the equilibrium interest rate that is based on stocks, not flows. Moreover, there's been zero change so far in the flow, meaning the entire argument comes down to a story based on anticipation of future flows. And how can anticipation of future flows matter? It only matters insofar as it leads to a reassessment by investors about whether they want to be holding the existing stock given the current and anticipated future yield. In other words, the only way to get a story based on flows to work is ultimately to reframe it in the standard way, namely in terms of finding the yield at which investors are willing to hold the current stock.

    Another and perhaps more important component of QE3 has been purchases by the Fed of mortgage-backed securities. Here it is more difficult to calculate the fraction of the total stock of such securities the Fed is holding, because there is a range of assets with similar characteristics. What I have done in the graph below (partly because it seemed the simplest thing to do given the way the Fed's Flow of Funds accounts are structured) is to look at the Fed's MBS holdings relative to the total stock of agency- and GSE-backed securities. As of June, the Fed's $1,277 B in MBS represented 17% of the total stock.

    Read Who's afraid of the big bad taper? here.

  • World Economic Forum: The Entrepreneur of Tomorrow

    In this short video for the World Economic Forum, Hua Lei urges us to consider the power of the under-30 entrepreneurs around the globe.  Young entrepreneurs like Hua--a partner at Maipu Venture in China, were born into a globalized world, and therefore are already thinking about one global marketplace.  Indeed, it seems they are not entrepreneurs of tomorrow, as the World Economic Forum labels them here, but a powerful force today.

  • NY Fed President Sees Economy in a 'Tug -of-war'

    Speaking at Syracuse University on Friday, NY Fed President William Dudley let it be known he is still seeing mixed signals from the economic data.  A lot of the recent data, he says, is promising.  Household net worth has increased.  Banks have loosened credit lines.  Consumer spending is up.  Home prices are rising and excess supply of housing is lessening.

    However, a number of risks to the outlook are evident. Long-term interest rates, including mortgage rates, have risen significantly since early May. Since then, we have seen a sharp drop in refinancing mortgage applications, a more moderate but significant decline in purchase mortgage applications and fairly flat housing starts and new home sales. Although I do not anticipate that the rise in long-term rates will lead to a downturn in housing, these developments do suggest that higher mortgage rates have cut into the upward momentum of the housing sector. We will need to monitor upcoming data closely to assess more fully the impact of higher rates on the housing recovery.

    Another risk is that federal fiscal policy could exert further restraint on the economy during the rest of this year and in 2014. It is difficult to assess how much of the contractionary effects from sequestration, for example, have already occurred, or still remain ahead. A related issue is the high degree of uncertainty about fiscal policy. In coming weeks, Congress will be considering how to fund the government for the next fiscal year and will also be debating what to do about the debt limit. This creates uncertainty about the fiscal outlook and may exert a restraining influence on household and business spending.

    One other risk to highlight is the global economic outlook. Even though the euro area appears to have begun to grow again after a protracted recession, growth in that area is still expected to be fairly weak at best. In addition, growth in many of the largest emerging economies has slowed, and some of the countries with large trade and current account imbalances have seen their financial markets and currencies come under pressure. If growth abroad were to slow, this could impede the growth of U.S. exports and this could result in less strength in manufacturing production and employment in the U.S.

    Thus, returning to an analogy I have used in previous speeches, I see the economy in a tug-of-war between these headwinds and underlying fundamental improvement, with a great deal of uncertainty over when the improvement in the underlying fundamentals will prevail.

    In the end, my best guess is that growth for all of 2013, measured on a Q4/Q4 basis, will be near the post-recession average. But I believe a good case can be made that the pace of growth will pick up some in 2014. The private sector of the economy should continue to heal, while the amount of fiscal drag should subside. I also expect that, despite the near-term concerns, growth prospects among our major trading partners will improve next year. And this combination of events is likely to create an environment in which business investment spending will strengthen. However, the notion that the economy will grow more swiftly remains a forecast rather than a reality at this point.

    Read the full speech here.

  • Wharton's Mauro Guillen on Managing Expectations For Growth in the EU

    A few weeks back we saw this from Eurostat:

    Growth in GDP for the EU and the euro area.  Bravo. Magnifique.  μπράβο.  Good show (or whatever the Brits are saying these days).  Before we get too carried away, we suggest this Knowledge@Wharton interview with Mauro Guillen.  Guillen says to expect any continued growth to be slow (unlikely to top 0.5%), and, he says, a jobless recovery much like that in the U.S. seems likely. 

  • R&D Spending: 'Something to Worry About'

    John Robertson--vice president and senior economist in the Atlanta Fed’s research department--gives us "something to worry about" at the Atlanta Fed Macroblog.  This is the trend line for private R&D spending:

    Robertson writes:

    Notice the unusually slow pace of R&D spending in recent years. The 50-year average is 4.6 percent. The average over the last 5 years is 1.1 percent. This slower pace of spending has potentially important implications for overall productivity growth, which has also been below historic norms in recent years.

    R&D spending is often cited as an important source of productivity growth within a firm, especially in terms of product innovation. But R&D is also an inherently risky endeavor, since the outcome is quite uncertain. So to the extent that economic and policy uncertainty has helped make businesses more cautious in recent years, a slow pace of R&D spending is not surprising. On top of that, the federal funding of R&D activity remains under significant budget pressure. See, for example, here.

    Read The New Normal? Slower R&D Spending here.

  • Washington Post: Why We Have a Debt Ceiling

    Well, looks like we are going to have to keep reading about the U.S. debt ceiling, at least through the end of the year (if not for longer.  Are we stuck with the debt ceiling as a MacGuffin in the political theater forever?).  So we may as well learn about why it is there in the first place.  The Washington Post's Karen Tumulty explains:

  • IMF: 'More Fiscal Integration to Boost Euro Area Resilience'

    In a new paper out this week, IMF researchers call for "deeper fiscal integration" among euro area countries.   In reading the paper, it appears IMF researchers view the euro experiment as incomplete.  Despite struggles during the global economic crisis and global recession, there is confidence in the euro area, but no so much in its current "architecture."

    From the paper:

    Large country-specific shocks. While it was recognized that countries joining the euro area had significant structural differences, the launch of the common currency was expected to create the conditions for further real convergence among member countries. The benefits of the single market were to be reinforced by growing trade, and financial, links—making economies more similar and subject to more common shocks over time (Frankel and Rose, 1998). In that context, these common shocks would be best addressed through a common monetary policy. Instead, country-specific shocks have remained frequent and substantial (Pisani-Ferry, 2012; and Figure 1).

    Some countries experienced a specific shock through a dramatic decline in their borrowing costs at the launch of the euro, which created the conditions for localized credit booms and busts. The impact of globalization was also felt differently across the euro area, reflecting diverse trade specialization patterns and competitiveness levels (Carvalho, forthcoming). These country-specific shocks have had lasting effects on activity. And divergences in growth rates across countries have remained as sizeable after the creation of the euro as before (Figure 2).

    Deeper into the paper we start to see some proposed solutions:

    Long-term options for the euro area. Cooperative approaches to foster fiscal discipline have shown their limits in the first decade of EMU. On that basis, and in light of international experience, two options emerge to foster fiscal discipline in the euro area in the longer term. One could be to aim to restore the credibility of the no bailout clause, including through clear rules for the involvement of private creditors when support facilities are activated. But the transition to such a regime would have to be carefully managed and implemented in a gradual and coordinated fashion, so as to not trigger sharp readjustments in investors’ portfolios and abrupt moves in bond prices. Another option would be to rely extensively on a center-based approach and less on market price signals. This would, however, have to come at the expense of a permanent loss of fiscal sovereignty for euro area members. In practice, the steady state regime might have to embed elements of both options, with market discipline complementing stronger governance.

    Read a summary of the paper, and download the full paper, here.

  • Marketplace Whiteboard: Stock Exchanges as Supermarkets

    Paddy Hirsch is back at the Marketplace Whiteboard.  This time it is to explain how stock exchanges work.  He wants us to let go of the exciting scenes from films like Trading Places, and instead imagine a sort of supermarket.

  • Looking Beyond the Headline Numbers in Monthly Jobs Report

    At Project Syndicate, Mohamed El-Erian digs into the monthly employment data from the BLS and finds a lot of rich data.  Beyond the headline stats of job creation and unemployment rate, the report reveals, he says, much about the overall health of the economy.  El-Erian finds that "duration of employment," and "teenage-unemployment," are examples of statistics that help us see where the economy is heading.

    Undoubtedly, the US labor market’s uneven recovery has much to do with the structural and policy gaps exposed by the 2008 global financial crisis and the recession that followed. The economy is still struggling to provide a sufficient number of jobs for those who were previously employed in leverage-driven activities that are no longer sustainable (let alone desirable).

    Moreover, US schools, particularly at the primary and secondary levels, continue to slip down the global scale, constraining Americans’ ability to benefit from globalization. Meanwhile, existing and newly created jobs provide less of an earnings upside. And political polarization narrows the scope for effective tactical and structural policy responses.

    This combination of factors is particularly burdensome for the most vulnerable segments of the US population – particularly those with limited educational attainment, first-time labor-market entrants, and those who have been out of work for an extended period.

    So while net job creation will continue and the unemployment rate will maintain its downward trajectory – both highly welcome – the labor market’s evolution risks fueling rather than countering already-significant income and wealth inequalities, as well as poverty. Overburdened social support mechanisms would thus come under even greater pressure. And all of this would amplify rather than attenuate political polarization, placing other urgent policy priorities at even greater risk.

    If this interpretation is correct, the heightened attention given to the monthly BLS headline indicators needs to be accompanied by a broader analysis and a different mindset. After all, the report is much more than a scorecard on America’s performance in confronting a persistent economic, political, and social challenge; it is also an urgent call for a more focused corrective effort involving both government and business.

    A better mix of fiscal and monetary policies and sustained measures to enhance productivity and competitiveness remain necessary conditions for addressing America’s labor-market challenges. But they are not sufficient.

    Read America’s Labor Market by the Numbers here.

  • Case Shiller: Home Prices Continue Steady Rise

    Home prices kept rising in July, but at a slower rate than previous months, according to the latest Case-Shiller Home Price Indices release.  Average home prices rose 1.9% for the Case-Shiller 10-city composite and 1.8% for the 20 city composites.  On an annual basis, prices rose 12.3% for the 10-city composite index and 12.4% for the 20-city composite.  Prices rose in all 20 top metro areas, with Chicago, Atlanta, and Detroit all posting monthly growth above 3%.  Here's a look at the long term trend:

    From the release: 

    “Home prices gains are holding their 12% annual rate of gain established by the two Composite indices in April,” says David M. Blitzer, Chairman of the Index Committee at S&P Dow Jones Indices. “The Southwest continues to lead the housing recovery. Las Vegas home prices are up 27.5% year-over-year; in California, San Francisco, Los Angeles and San Diego are up 24.8%, 20.8% and 20.4% respectively. However, all remain far below their peak levels.

    “Since April 2013, all 20 cities are up month to month; however, the monthly rates of price gains have declined. More cities are experiencing slow gains each month than the previous month, suggesting that the rate of increase may have peaked.

    “Following the increase in mortgage rates beginning last May, applications for mortgages have dropped, suggesting that rising interest rates are affecting housing. The Fed’s announcement last week that QE3 bond buying will continue for the time being may have only a limited, though favorable, impact on housing.”

    Read the full release here.

  • Simon Johnson on Getting the Financial Sector on Safer Tracks

    Simon Johnson is required reading at The Watch, especially at the Baseline Scenario blog. For years now, Johnson has been speaking out against the failure of policy makers to adequately oversee the finance sector.  His warnings did not steer us clear of the near meltdown five years ago, and he remains dissatisfied with the overall response to the global financial crisis.  He recently sat down with Marshall Auerback of the Institute for New Economic Thinking to discuss what he believes needs to be done to protect citizens and economies (as opposed to the banks themselves) from future crises. 

  • Confidence and the Continued Success of Hedge Funds

    Hedge funds seemed to recover rather quickly when compared to other parts of the finance industry.  Writing at The Guardian, Timothy Spangler chalks that up to confidence.  The confidence of the traders at hedge funds.  And the confidence in those hedge funds by big investors.  And by "big investors" Spangler doesn't so much mean personal estates of the super wealthy as much as he means big pension funds.

    As has been well reported, although many hedge funds perished on the rocks of the market volatility and the liquidity crisis that followed on from the Lehman bankruptcy, several funds profited from the ensuing chaos. Similarly, although much hand-wringing occurred when the credit crunch shut down the flow of leveraged finance that was a mainstay of private equity buyouts for two decades, many funds continued to engage in successful investments and divestments as buying opportunities presented themselves in the economic wreckage that ensued. Even America's beloved Twinkies and Ding Dongs were ultimately saved by private equity.

    The reason for the continued success of hedge funds and private equity funds is actually quite simple – investors love them!

    Of course, there were doubts and recriminations that surfaced again and again at the end of 2008 and the beginning of 2009. Of course, there were investors that suffered eye-watering losses on their fund investments who would require some coaxing (and a little TLC) before their would allocate money again.

    But when fund after fund continued to post high investment returns, and the rest of the financial markets seemed to oscillate between pessimism and indifference, investors began writing checks again. With replenished war chests, hedge funds and private equity funds were back in business.

    So long as these funds can credibly promise high returns, there will be a steady flow of investors willing to back them. Once accumulated, the money is deployed wherever the men and women running them feel there is an opportunity to profit. This industry is driven, first and foremost, by the confidence level of these investors.

    Read Hedge funds and private equity are thriving … thanks to pension funds here.

  • Markit Economics: Euro Zone Business Activity Picks Up

    Business is picking up across the Euro Zone, according to the latest Purchasing Managers Index release from Markit Economics.  An upturn in new business activity, combined with increased activity in both the service and manufacturing sector, drove PMI to its highest level in 27 months. In fact, the survey shows increases pretty much across the board, with one notable exception.  Employment continues to lag.  Here's a look a the trend:

    Comments from Chris Williamson, Chief Economist at Markit, in the release:

    “An upturn in the Eurozone PMI in September rounds off the best quarter for over two years, and adds to growing signs that the region is recovering from the longest recession in its history. “It is particularly encouraging to see the business situation improved across the region. Although the upturn continued to be led by Germany, France saw the first increase in business since early-2012 and elsewhere growth was the strongest since early-2011.

    “Employment continued to fall, though it is reassuring that the rate of job losses eased to only a very modest pace, suggesting that employment could start rising again soon.

    “The overall rate of growth signalled by the Eurozone PMI remains modest, however, consistent with gross domestic product rising by a meagre 0.2% in the third quarter. While rising inflows of new business bode well for a further upturn in the fourth quarter, policymakers at the ECB will no doubt view it as too early to change their stance on keeping policy on hold for an extended period.”

    Read the full release here.

  • Fall 2013 Brookings Panel on Economic Activity

    The Brookings Panel on Economic Activity is under way in Washington today.  You can take a look at the agenda hereJustin Wolfers and his colleagues have managed to put together a tempting mix of topics.   Wolfers introduces two of today's discussions in these short videos.  First, declining U.S. labor share:

    Second, seasonal data:

    Read more about the conference, and download the conference papers, here.  And follow the conference via Twitter by using #BPEA.

  • A Call to Consider More Women to Lead Central Banks

    Janet Yellen has emerged as the most likely replacement for Ben Bernanke as chair of the Federal Reserve Board of Governors.  This prompted Caroline Freund, senior fellow at the Peterson Institute for International Economics, to do a little counting.  In an op-ed for the Washington Post, Freund points out that, of the 34 members of the OECD, only Finland, Austria, and Poland have ever had a woman as top central banker.  And those women no longer lead their respective central banks.  Freund:

    There is a bright spot for women in the developing world. Of the 36 non-OECD countries with populations greater than 20 million, seven have had female central bank chairs. Here, the trend is positive, with five in office in 2013.

    Why is it that nearly all central bank leaders are men? One possibility is that relatively few women study economics and finance, which tend to be prerequisites. This leaves a very small pool of qualified candidates. But being a finance minister has similar requirements, and six OECD countries had female finance ministers in 2011. Four are in office today.

    A more troubling explanation is that women may still not be part of the tight-knit clubs from which central bank heads are chosen. Because central banks are independent, trust that the chairman’s goals are aligned with the administration’s interests is more critical than for other appointed positions. Bankers want someone they know and trust, the administration wants the same, and the independence of the institution means you’d better be pretty darn sure. In contrast to Cabinet positions, the Federal Reserve head cannot be fired if he or she strays from administration goals or fails to meet expectations.

    As an example, consider that a stellar publication record, a pedigree as former chairman of the Princeton economics department and service on the Fed board were initially not enough for Ben Bernanke to be asked to replace Alan Greenspan. President George W. Bush brought Bernanke in to head the Council of Economic Advisers and got to know him better before naming him Fed chairman. The lack of relative outsiders in this position suggests it is about not only what you know but also whom you know and how well. Women may perform less well in areas traditionally populated by old boys’ clubs.

    Read Where are the women in central banking? here.

  • Laurence Meyer on Fed's Holding Pattern, and Possible Janet Yellen Appointment

    As you may have noticed, we have been spending much of the last 24 hours reading and watching analysis of the Federal Reserve's moves.  Between the latest FOMC meeting and speculation over Ben Bernanke's pending departure--and coming successor--there is no shortage of material.  David Wessel, Wall Street Journal Economics Editor, pulled in an interesting guest to discuss the Fed issues.  Laurence Meyer served on the Board of Governors for the Fed in the late Clinton and early Bush 43 years.  In this interview, he offers up a past-insider's perspective into the decision to hold firm on bond-buying, and looks ahead at a possible Janet Yellen leadership. 

  • DeLong on Perceived Risks in Quantitative Easing

    Brad DeLong is "at a loss."  Following the Fed's decision to keep with its bond-buying program at least a little longer, the cries of dismay can be read all across the econoblogosphere.  And DeLong takes issue with the idea that there are great risks involved with quantitative easing.  To our benefit--whether we are inclined to initially agree with him or not--he neatly lays out the reason he is disturbed by those who suggest that all serious economic thinkers must see big risk. 

    Yes, the Federal Reserve has taken some domestic risky assets off the table. Yes, U.S. financial intermediaries and savers will respond by buying foreign assets to so deploy some of their now-undeployed risk bearing capacity. Yes, they will now bear some exchange-rate risk. But, once again, the fact that QE pushes interest rate spreads down is very powerful evidence that these capital flows are not "outsized"--that the extra exchange-rate risk U.S. financial intermediaries have now taken onto their books is less than the duration risk that QE took off of their books.

    At least, that is the case as long as the supply curve for risk-bearing capacity slopes up, like a good supply curve should.

    Perhaps those who claim that there are big risks to quantitative easing regroup. Perhaps they claim that financial intermediaries are perverted, and that the lower is the price of risk the greater is the amount of risk-bearing capacity they supply to the market because they lose their jobs if they don't make at least three cents on every dollar of assets in a normal year in which risk chickens come home to roost.

    In that counterfactual world, the supply-and-demand graph would look like this:

    And in that counterfactual world, the Federal Reserve's adoption of quantitative easing policies triggered an enormous expansion of the quantity of risk-bearing capacity demanded by firms and households and a huge private-sector lending boom as firms issued enormous tranches of risky bonds and as firms and households took out risky loans. In that counterfactual world, employment in bond underwriting tripled as $85 billion a month in QE was more-than-offset by an extra $120 billion a month in private-sector bond issues. In that counterfactual world, we saw a rapid recovery of housing construction and a thorough equipment investment boom as far across the U.S. as they eye could see.

    That didn't happen.

    Read What are the risks of quantitative easing, really? here.

  • FOMC: We are Not Yet Ready for the Easing of Quantitative Easing

    The taper that was supposed to come, in so many people's minds, this week has been delayed.  At the close of the Federal Open Market Committee meeting this week, Federal Reserve Chair Ben Bernanke let us know that the Fed will not be dropping its bond buying program.  The easing of quantitative easing has yet to start, and will not start until, as Bernanke put it in his news conference, "we can be comfortable that the economy is, in fact, growing the way we want it to be growing." 

    From the FOMC release:

    Taking into account the extent of federal fiscal retrenchment, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee's dual mandate.

    The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective. Asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's economic outlook as well as its assessment of the likely efficacy and costs of such purchases.

    Here is the full Bernanke news conference:

  • Interactive Graphic Spreads the Blame for 2008 Crisis

    Barry Ritholtz brought an interesting infographic to our attention.  This is from Asset International's Chief Investment Officer site, and it may serve as a nice teaching tool, or at least conversation starter, for understanding how different sectors and players in the financial system were involved in the near-meltdown five years ago.  We have an image of the interactive graphic tool below, but you'll need to go to AI CIO's site to play with it.  Click here.

  • Andrew Ross Sorkin Looks Back at the Response to the Global Financial Crisis

    In this short video at the New York Times, DealBook columnist Andrew Ross Sorkin gives his take on what we've learned five years on from the near-meltdown of the global financial system.  His conclusion: that if (when?) the next giant financial crisis hits, the same response options will not be on the table. 

  • Jeff Frankel Cautions Japan's Leaders to Take it Slow

    Jeff Frankel is looking at Japan as that country's top bankers and elected officials appear set to increase the consumption tax rate in an attempt to increase the rate of GDP growth.  Frankel argues that Japan's leaders should be mindful of the long game, and not rush through any quick fixes--"Slow and steady win the race."  Either way, there will be lessons from Japan for other economies.  Frankel:

    For Japan, I like a proposal of Koichi Hamada (a Yale economics professor who has advised Abe) and others: the planned jump in the consumption tax rate should be replaced with a gradual pre-announced path of increases, of 1% per year, for five years. (The annual increases should probably even continue for more than five years). A steady pre-announced set of small increases is a better path for fiscal policy than one jump, or two. Because it establishes long-run fiscal discipline, it will not crash the bond market, as an outright cancellation of the tax increase might. Yet it does not inflict damaging fiscal contraction in the short run, at a time when the economy is already weak. Indeed, the expectation that tax-included prices will go up in the future can stimulate households today to buy autos, household appliances, and other consumer goods and thereby help speed the recovery.

    The gradual path also has good implications for monetary policy too. In normal times central banks want to get inflation down. Pre-announced paths for taxes or administered prices can have the undesirable effect of building annual price increases into public perceptions, thus making it more difficult for the central bank to control inflation. But current conditions are very different in this regard. Interest rates and inflation rates in Japan lately have been, if anything, even lower than in the United States. The most important cornerstone of Abenomics this year has been efforts by the Bank of Japan to ease money further, despite already-zero interest rates, and thus end the threat of deflation. Under those circumstances, expectations of inflation are not worrisome. Positive expected inflation would reduce the real interest rate, which is not a bad thing under current conditions.

    There are useful analogies for policies in other countries. The US could legislate a pre-announced path of slow but steady increases in energy or carbon taxes (accompanied by immediate short-term offsets such as a reduction in the distortionary payroll tax or an end to the damaging spending sequester). The same arguments regarding the time profile apply as to Japan: enhancing long-run fiscal sustainability without imposing more fiscal contraction at a time when the economy has not yet fully recovered from the Great Recession. In addition, the environmental and national security arguments in favor of discouraging fossil fuel consumption work better if the increase in energy prices is phased in over a long period of time, allowing people to plan ahead in making effective decisions about choice of automobiles, installation of home heating systems, construction of power plants, research into new technologies and so forth.

    Emerging market countries like India and Indonesia are now being threatened with possible financial crises. Part of the problem is large budget deficits, of which a major component has long been food and energy subsidies. Trying to keep domestic prices for food and energy artificially low relative to world market prices has proven ruinously expensive, while yet very ineffective in the supposed goal of helping alleviate poverty. Some leaders in these countries are aware of the need to reduce the subsidies (and the arguments that they can be accompanied by better-targeted anti-poverty innovations such as Mexico’s conditional cash transfers and India’s Unique ID system). A credible pre-announced path of gradual phase-out in food and energy subsidies would provide much-needed immediate reassurance to skittish global investors, without imposing immediate hardship on the poor. At the same time, the ability to plan ahead in anticipation of the price increases would allow more effective responses in decisions by farmers to plant new crops, energy-users to switch to more energy-efficient equipment, and so forth.

    Read Japan's Consumption Tax: Take it Slow and Steady here.

  • McKinsey Insights: 'How to Make a Great City'

    Forget the political rhetoric.  It is cities that drive the global economy.  And the healthier and more attractive a city is as a place to work, do business, and live, the more it will help drive economic growth.  That is why we have been hearing so much about the need for innovative cities for the last decade. 

    McKinsey has a new report out called How to make a great city.  The full report is worth attention.  To put it succinctly, McKinsey researchers have come to the conclusion that effective urban leaders "do three things really well:

    They achieve smart growth.

    They do more with less.

    They win support for change.

    You can download the full report here.

  • Glenn Hubbard: Avoiding Next Great Financial Crisis Requires Clear Policy Framework

    Writing at The Atlantic, Glenn Hubbard gives his assessment of efforts to fix the financial sector and avoid a crisis like the one that peaked five years ago.  Hubbard, now dean of the Columbia Business School, was chairman of the Council of Economic Advisers for President George W. Bush.  He points to monetary policy during the Bush presidency as the primary cause for the crisis.  In fixing the crisis, he argues for a response that is not simply technical, but rather provides a "policy framework."  Hubbard:

    Five years ago, a massive failure on the part of financiers and financial regulators precipitated the fall of Lehman Brothers and nearly crashed the global economy. Today, investors, taxpayers, and elected officials are entitled to ask: Are we safer now?

    At one level, yes. We are both healthier and smarter. We are healthier because both banks and households have repaired their balance sheets, improving the economy’s ability to withstand future shocks. We are smarter, because we have discarded the myth that the Federal Reserve can easily clean up the fallout from financial excesses and replaced it with an attitude of vigilance and caution about financial excesses.

    This raises another question: have we created public policies that make us safer?

    It is hard to say. We know more today about how Washington can inflate bubbles. Government-sponsored enterprises encouraged excessive risk-taking in housing finance. Easy monetary policy in the early 2000s not only kept mortgage interest rates low, but also encouraged investors to reach for yield and amplify that reach with leverage. If investors perceive low rates to be lasting, the incentive for leverage is particularly great. Fed officials focused on low rates as coming from a global savings glut, without emphasizing large flows in to the United States from global banks, particularly European banks. The Fed did not restrain the housing bubble, and it was not alone. The European Central Bank stood back as credit surged in peripheral European economies. And, of course, tax policy encouraged leverage.

    Since the crisis, the Dodd-Frank Act increased transparency in many derivatives – a good thing. But it also made a complex system of bank and nonbank regulators more complex and created a class of systemically important banks (and even non-banks), codifying “too big to fail.” It did not – nor did other legislation – seriously address reform of housing finance or direct the central bank to focus more on financial stability. Writing the Act’s web of rules will take years. Globally, an emphasis on higher capital requirements leaves open questions of how one measures the risks taken against that capital – recall the sovereign bonds were deemed “riskless” for that purpose before the crisis – or how to limit the incentive for “shadow banking” forms of intermediation to grow outside more heavily regulated sectors.

    Read How to Stop the Next Financial Crisis: The Fed Might Be Our Last Great Hope here.

  • Marketplace: Remembering the Biggest Consumer Bank Failure in US History--Washington Mutual

    Five years ago a major financial institution failed.  No, not that one.  Washington Mutual, was one of the largest consumer banks in the country.  But it went under just 6 days before Congress set up the Troubled Assets Relief Program (TARP), which they went on to protect other institutions like WaMu that had overextended themselves in the credit bubble years. 

    Kai Ryssdal and his Marketplace producers have not forgotten WaMu.  They invited Kirsten Grind onto the air yesterday.  Grind has written the book on the WaMu collapse.  And the book is titled, The Lost Bank: The story of Washington Mutual and the Biggest Bank Failure in American History

  • The Looming Slowdown in Latin America and Structural Issues for Commodity-Dependent Economies

    After a strong several years for many merging economies, the last few months have brought some troubling signs.  In Andrés Velasco's analysis, the biggest problems of the moment seem to be large external deficits and investors in advanced economies anticipating higher interest rates, and then pulling some investment from emerging economies.  Velasco, a past president and finance minister of Chile, sees some all too familiar dark clouds across Latin America.  While he doesn't think the coming slowdown will be as catastrophic as past regional crises--"the question is not whether these countries’ financial sectors will explode, but whether their growth trajectories will implode"--he argues that the region's policy makers have not done enough to change basic structural weaknesses.  From Project Syndicate:

    When commodity prices are sky-high and money is cheap and plentiful, economic growth is almost inevitable. In Latin America over the last decade, countries with sound macroeconomic policy frameworks, like Colombia, Peru, and Chile, grew rapidly. But so did Argentina, a country whose government seems to start every day wondering what more it can do to weaken economic institutions and damage long-term growth prospects.

    Now that nirvana is over, where will growth come from? To answer that question, it helps to note, as Harvard University’s Ricardo Hausmann has done recently, that some of the emerging economies’ recent growth was illusory. Wall Street became enamored with the rapidly rising dollar value of these countries’ national income, but that rise had more to do with strong commodity prices and appreciating exchange rates (which raised the value of their output when measured in dollars) than with sharp increases in actual output volumes.

    During the boom years, structural transformation in many emerging economies, particularly in Latin America, was limited. Countries like Ireland, Finland, and Singapore – and also South Korea, Malaysia, and Indonesia – export different goods (and to different markets) than they did a generation ago. By contrast, Chile’s export basket is pretty much the same as it was in 1980.

    There is nothing wrong with exporting copper, wine, fruit, and forest products. But economic history suggests that countries seldom – if ever – get rich by doing just that. Commodity-rich advanced economies like Canada, Norway, or Australia export lots of natural resources, of course, but they also export many other goods and services. That is not true of Chile, Peru, or Colombia – or even of Brazil, with its much larger population and more developed industrial base.

    To make matters worse, unlike their Asian counterparts, Latin America’s economies are not integrated into regional and global value chains. A producer in Indonesia, Malaysia, or the Philippines can easily take advantage of the local currency’s depreciation to sell more electronic components to an assembly plant in China with which it has a long-standing and well-developed supply relationship. A business in Concepción, Arequipa, or Medellín, by contrast, must seek new customers in new countries, which takes time and money – and may not succeed.

    Latin American governments could have used the opportunities afforded by the global commodity and liquidity booms to diversify their economies, working with local business communities to move into new products and sectors. They did not.

    Read Emerging Markets’ Nirvana Lost here.