From "'Created or saved' doesn't add up", by Joseph Lawler:

...[t]he "created or saved" numbers are meaningless. The administration purposefully devised the metric to be nebulous. Without a counterfactual, showing the trend of unemployment in the absence of the stimulus, it is impossible to know how many jobs the stimulus saved.

But this is completely counter to what I learned in economics, and how, for instance, the CBO conducts analysis. I assume Mr. Lawler doesn't dispute the impartiality of the CBO (but who knows?). Here's the way real macroeconomists conduct analysis:

As the President has discussed, analysis done within the Administration has shown how his tax cuts have substantially offset the series of adverse shocks that have been buffeting the economy. Simulations of a conventional macroeconomic model show that, without the tax cuts, the level of real GDP would have been about 2 percent lower in the middle of 2003. About 1.5 million fewer people would have jobs today. The job market is not what we would like it to be right now, but it would have been worse without the Administration's actions.

One can view the short-run effects of these tax cuts from a classic Keynesian perspective. The tax cuts let people keep more of the money they earned. This supported consumption and thus helped maintain the aggregate demand for goods and services. There is nothing novel about this. It is very conventional short-run stabilization policy: You can find it in all of the leading textbooks.

The writer is Greg Mankiw, discussing in 2007 a particular fiscal measure, namely the 2003 tax cuts (h/t, Brad Delong).

So let us return to how the Congressional Budget Office (CBO) conducted analysis. In their February analysis, they presented this set of results, based on a range of multipliers in the literature.

So GDP is estimated to be between 1.4 to 3.8 percentage points (ppts) higher than baseline in 2009Q4, due to the stimulus bill. The midpoint of this range is 2.6 ppts. Relatedly, the range of employment gain relative to baseline is 0.8 to 2.3 million; the midpoint of this range is 1.55 million.

Interestingly, taking the CEA's model based approach (Table 2, Joint Economic Committee testimony of 22 October), and assuming the same incremental growth rate in 09Q4 as in 09Q3, the implied deviation from baseline is 2.56 ppts, or right in the midpoint of the CBO's range.

Now using the error correction model that I estimated in last Tuesday's post (where the cointegrating relationship between log GDP and log nonfarm payroll employment is 0.37), I find the range of increased employment relative to baseline is between 0.68 and 1.84 million, slightly lower than the CBO range of 0.8 and 2.3 million. The estimated employment impact is 1.26 million, using the midpoint of the CBO range for impact on GDP.

I know counterfactuals and math are hard to fit on a bumper sticker. But one would hope that in an 800-plus word essay on economics (even if in Politico), some economic content could be included.

By the way, Jeff Frankel debunks a similar misapprehension in National Journal.

...recent research questions the claim that the financial panics themselves contributed to their contemporaneous and severe employment downturns.

The post continues:

The timing was different in this recession -- the largest employment drops seemed to come immediately after the financial panic -- but a recent paper by Ravi Jagannathan, Mudit Kapoor and Ernst Schaumburg of Northwestern argues that the coincidence is just as misleading. They argue that the changing global economy -- with more employment of residents in developing countries like China -- created a glut of savings in those countries, and was destined to reduce employment in developed countries regardless of whether there had been a financial panic.

This paper was discussed earlier on this weblog, and Professor Jagannathan provided some clearly exposited counterarguments to my criticisms in his comments. Indeed, I think there's a lot more subtlety to that paper, and the posited causal chain, than is related above, even if I disagree with the main thesis (see [1]).

But even if you believe the Jagannathan, Kapoor, Schaumberg thesis in full, this does not invalidate the idea that banks provide useful intermediation services, and that failing banks, insolvent banks, or banks that are retrenching in terms of their lending will exert a contractionary influence on the economy. (After all, if one reads Bernanke's 1983 paper (AER 73(3)), you'll see him focus on the declining ratio of loans to the sum of checking and savings deposits, shown in his Table 1) It's just that you think that what caused the banks to overleverage is the "saving glut". (Another way to put it is you think the financial system is the proximate cause, and Beijing the ultimate cause, a la "Blame it on Beijing"). This interpretation is suggested to me by this passage in the conclusion to Jagannathan et al.:

...History might have taken an entirely different path with better risk management controls in place in the US but then again, financial innovation might just have found a different way of getting highly leveraged deals done off-shore or through creative accounting. The root cause of the excess liquidity in the global financial system must be addressed, otherwise we are just squeezing the proverbial balloon only to see it bulge out somewhere else. However, this does not negate the need for the development of improved risk management in the broadest sense in order to ensure financial stability and prosperity going forward.

One truly odd aspect of Professor Mulligan's discussion is the treatment of the banking system as the financial system. I've been hearing a lot about the "shadow financial system" for quite a while -- and I have some inkling there was trouble brewing there somewhat before the plunge in employment and output in September 2008. Below, I graph one aspect of the broader financial system.

So in my view, the financial system problems preceded the initial decline in employment and output. That doesn't preclude the possibility of the subsequent declines in employment and output causing further financial system problems. That I believe is what is called an adverse feedback loop.

More graphs from the real world in this post and the IMF's GFSR.

Postscript: Brad Delong also appears to find this post befuddling.

First, I agree with Mark Thoma that Mr. Posner apparently has little understanding of macroeconomics, either of old-style Keynesian type, or the new(er) real business cycle type, or certainly New Keynesian approaches. His charge that her current pronouncements are at sharp variance with her earlier academic work really makes me wonder if he's read any of Dr. Romer's previous work. I suspect that he's taken at face value the conservative mis-apprehension that her tax cut paper contradicts the view that government expenditures can have an impact on growth. As I've explained in my responses to reader comments here, Romer and Romer (2008) provided estimates of tax cut multipliers, but no spending multipliers. Hence, a comparison of instrument efficacy is not feasible (comparing multipliers across methodologies can be done, but would be inappropriate).

Second, I would not pass a student out of intermediate macro who wrote in an exam:

The impact of the public-works program on investment is more complicated. But suppose, plausibly in a serious economic downturn such as the one that we're in at present (and that was even more serious back when the stimulus bill was enacted), that a great deal of investment is in the form of passive savings, such as demand deposits and Treasury securities, because people and companies are anxious about their economic prospects, and they want safe savings, rather than savings that would be at risk because invested in entrepreneurial projects.

As Mark Thoma points out, this is confusing a financial investment with physical investment in a NIPA sense.

This confusion tells me that anybody writing far outside their area of expertise should think twice, consult a textbook or two, before committing virtual pen to virtual paper. (I'm not saying one shouldn't write outside of one's area of research expertise on a weblog -- just one has to be careful).

Third, before he pontificates on what economists who work in the government should or should not be doing, I think Mr. Posner should read Martin Feldstein's discussion of how the CEA works ("The Council of Economic Advisers and Economic Advising in the United States," The Economic Journal, Vol. 102, No. 414 (Sep., 1992), pp. 1223-1234 [JSTORE pdf]; excerpt here). Here's a quote:

Although the CEA is physically as well as operationally part of the White House complex (CEA offices are in the Old Executive Office Building adjacent to the White House and within the same security cordon), the economic staff functions in a completely professional and nonpartisan way. My very able and distinguished staff included Larry Summers, who was prominent as chief economic adviser to presidential candidate Michael Dukakis.

The tradition of professionalist is so strong that even in a presidential election year the CEA chairman appoints members of the staff for the coming academic year with the clear understanding that they will continue to serve even if the party in power loses the presidential election. ...

My limited observations, having been a staff economist in the situation mentioned in the last paragraph, is that CEA members (nominated by the President and confirmed by the Senate) do not "leave behind their academic scruples" when they move from academia to government service. That doesn't mean that I think they're correct in their analyses -- just that what they believed when they came in is pretty close to what they say in public. (After all, silence is also an option.)

Fourth, I think any blog post (let alone paper) should be internally consistent. Consider Mr. Posner's (approving) statement:

Most economists, however, believe that it is unrealistic to suppose that people have enough information about the future to adjust their current behavior to expectations of higher taxes, inflation, devaluation, or other possible consequences of an increase in the national debt. There is too much uncertainty.

Then, he says two paragraphs later:

But Romer actually gives some credence to the unrealistic picture of the far-sighted consumer or businessman by arguing that recipients of tax credits authorized by the stimulus bill will spend rather than save the tax-credit money because they will assume that the credits are permanent.

But if in fact consumers do not look forward (as Mr. Posner argues, not as Dr. Romer argues), they will only respond to current changes in disposable income, and in fact the multiplier will look pretty big.

(Actually, I find the biggest problem with Mr. Posner's argument here is that the failure of consumers to respond in a fashion consistent with unencumbered intertemporal optimization w/perfect certainty is not due only to uncertainty, but also liquidity constraints, as well as possibly more exotic utility functions.)

Fifth, Mr. Posner should read a bit more widely. He states:

Romer argues in her talk that by the end of the second quarter of this year, $100 billion of stimulus money had been spent. That is a suspiciously round number, and it is unclear how it was arrived at; but let us assume it is accurate. She then argues that this small expenditure--about two-thirds of one percent of the Gross Domestic Product--is responsible for the fact that the decline in GDP fell (on an annualized basis) from 6.2 percent in the first quarter of the year to 1 percent in the second quarter (though the latter figure is likely to be readjusted upwards).

This assertion is groundless. No one has the faintest idea what effect the stimulus has had.

As someone who had to "fact-check" numbers going into White House policy documents and speeches on occassion, I can say that the numbers are verifiable regardless of Administration (whether they are interpreted in an appropriate fashion is a fair question).

But the more substantive question is whether the math is so nonsensical. As I showed quite clearly in this post, the number Dr. Romer obtained was easily calculated and plausible.

Sixth, my impression is that former CEA staffers and members that have become bloggers are pretty careful with the numbers and analytics -- certainly more so than Mr. Posner. These include Jeff Frankel, Paul Krugman (notwithstanding Mr. Posner's barbs), Andy Samwick, Diane Lim Rogers, and Nouriel Roubini. (see this post for former gov't/Fed economists who became bloggers.)

The objective facts are far easier to handle in the models than the shifting, subjective expectations of people trying to deal with radically uncertain futures. This is what may get reflected in financial markets. Attempting to understand all of this requires conceding that some knowledge will be imprecise and will lie outside of the box (model). The model is simply a toy that can be thrown out when it no longer suits. This means that it is indeed possible to have valuable knowledge outside of hyper-models (although, of course, all thinking proceeds in terms of assumptions and simplifications).

But this will give the "scientists" among us headaches. As John Maynard Keynes famously said about the econometrician Jan Tinbergen, "[H]e is much more interested in getting on with the job than in spending time in deciding whether the job is worth getting on with."

As long as this is the dominant attitude, macroeconomics will remain "other-wordly." Instead, the way to greater realism is through more attention to the methodology of science and to whether "the job is worth getting on with." Paradoxically, greater philosophical sophistication would put economists is closer touch with the real world. (Or so I hope.)

Lean, mean DSGE machines?

Reading the recent characterizations of Ph.D. education in our top departments, one would conclude that all one ever learned in a program is how to write out and calibrate dynamic stochastic general equilibrium (DSGE) models, or for the older among us, calibrate a real business cycle model. I have to say that this all seems a little like an all too convenient caricature (and, as I have said repeatedly in the past, these types of models have led to important insights for issues besides crises [4]).

I won't deny that in the past 20 years, I haven't seen more than a few models that struck me as pretty irrelevant for analysis of real world issues. But I think that some mathematical training, and the use of models, is essential to economic analysis. After all, one can think of completely irrelevant frameworks for looking at the world even without a model, just as one can with a model.

Furthermore, perhaps my experience in a Ph.D. program is atypical but I don't remember being forced into a particular mode of analysis in writing my dissertation (University of California, Berkeley, 1985-1991). In macro/international/econometrics, my teachers included Roger Craine, George Akerlof, Jeffrey Frankel, Andy Rose, and Richard Meese. We studied Euler equations as well as the market for lemons. We knew what Arrow-Debreu markets were, but we also learned about the Great Depression (from Bernanke's paper as well as Friedman and Schwartz). The time series econometrics taught did not presuppose optimizing behavior. We even studied models with sticky prices (gasp!). Doesn't sound too doctrinaire to me.

So what was a common theme in the curriculum? For me, the defining feature in thinking about what model to use was whether the analysis answered the question posed, and whether the question posed was of interest. Now, whenever I read a dissertation prospectus, the key question I ask the student is: "What is the question being asked?", not what is the methodology. (Admittedly, the subdisciplines have different "characters", as alluded to by Paul Krugman; my focus was open economy macroeconomics, rather than macroeconomics/monetary economics.).

How monolithic?

I wonder if indeed the macroeconomic mainstream is as monolithic as conveyed by various observers. For instance, one certainly perceives a certain homogeneity amongst Ph.D.'s trained at certain universities. And there's a certain similarity in the mode of analysis preferred by economists in financial firms. Since the financial press tends to focus on Wall Street economists, one gets a misleading impression regarding the degree of uniformity of views.

To make this more concrete, let's consider whether academic economists differ in their views regarding the economy, as compared to those in the financial sector. I have some indirect evidence, pulled from Dilbert's survey of economists in the American Economics Association (see also [5]). Scott Adams, with the assistance of Joshua Libresco of the OSR Group, was kind enough to have the stats pulled. Last summer, academic economists believed that a President Obama administration would promise more progress on the economy than a McCain administration, by a 2 to 1 margin (n=314); in contrast financial sector economists were equally split. The sample in the latter case is quite small (n=29) (I dropped the undecided/no difference responses). Nonetheless, a difference in means test (recalling the variance of a binomial is (1/4)/n) rejects the null hypothesis of equality at 6%, using a two tailed test.

(As an aside, this finding further suggests that when the WSJ says most economist oppose a second stimulus, that probably characterizes Wall Street economists better than all AEA economists. Even for Wall Street economists, it's interesting to note that a majority of economists feel the stimulus package has already improved economics prospects, and will have a bigger impact in subsequent months. Hence, opposition to a second stimulus among WSJ-surveyed economists is not necessarily rooted in skepticism about the aggregate demand enhancing effect of the ARRA. (One would need a cross-tabulation of responses to verify that assertion.))

Concluding thoughts

If my conjecture is correct, then the supposed failure of macroeconomics is more the failure of macroeconomics as described in the popular press, rather than of the discipline itself (after all, Joseph Stiglitz is as much of the economics discipline, if not more, than Eugene Fama.) My conclusion: Not quite time to jettison the apparatus of modern macroeconomics.

For a less personal perspective, see Brad Delong and Paul Krugman, as well as my April post on "macroeconomic schisms".

Note that forecasted GDP (in the tan shaded area) is above the level implied by e-forecasting. E-forecasting's estimate is that GDP will be down by 9.9% (SAAR) in 2009Q1. If this more dire forecast proves accurate (Deutsche Bank predicts -8.0% SAAR), then -- as Brad Delong likes to say -- we'll need a bigger stimulus package.

See also Calculated Risk's discussion of the employment report: [1], [2], [3].

Side note: for those wanting to hear my take on the G-20 meetings, Minnesota Public Radio had an hour with me on the air yesterday (link here).

This brings me to the results Cheung and I obtained. In "Further Investigation of the Uncertain Unit Root in U.S. GDP" (NBER technical working paper here), we found that using post-War quarterly GDP up to 1994, we couldn't reject the null hypothesis of a unit root, nor the null hypothesis of trend stationarity (using the ADF and KPSS tests, respectively). However, for annual data from 1869 to 1994, we could reject the unit root null and fail to reject the trend stationary null (we were working with per capita numbers, but the difference is unessential).

Here's a plot of (log) GDP.

I thought if I updated the analysis to include data up to 2008, I'd obtain similar results. Imagine my surprise when I found that for data 1967q1-2008q4, the ADF (w/constant, trend) test rejects the unit root null with a p-value of 0.048, and the Elliott-Rothenberg-Stock Dickey-Fuller test at the 0.01 level. At the same, the KPSS (trend stationary null) test fails to reject at conventional levels. (The annual results confirm the results Cheung and I obtained earlier). In other words, over the last forty years, log US GDP looks trend stationary.

What's the relevance of these findings to the current debate? First, let me say I don't think this has any impact on how one thinks about the relative importance of technology versus demand shocks. Second, I don't think univariate analyses are the only way to go (for instance, in ordinary times, one might want to use consumption to infer potential GDP, and hence identify the trend in GDP). But what it does tell me is that the Campbell-Mankiw characterization of real GDP as being best fit by an ARIMA is perhaps no longer most apt. (For more on unit roots and trends from a nontechnical perspective, see this post.)

Two caveats.

• Just because one finds the data rejects a TS null doesn't mean that that is the best way to treat the data in, say, regressions involving other variables. I.e., just because the data is trend stationary doesn't mean that shocks to the series can't be persistent. They might be so persistent that a unit root characterization is not a bad approximation.
• The rejection of the unit root null is sample dependent. Extending the sample back to 1947q1 yields a failure to reject the unit root null (the series still fails to reject the trend stationary null).

A simple regression of log GDP on a time trend and lagged log GDP, over the 1967q1-08q4 period yields the following:

Where Adj-R² = 0.9995, SER = 0.008

The AR1 coefficient of 0.945 (se = 0.03) implies a half life of 12.25 quarters, or slightly over 4 years for a deviation from output. Since AR coefficients are biased downward, this is a downwardly biased estimate of the half life.

Given that output is trending upwards (at about 3% per annum, in log terms) in a deterministic fashion, then the argument that big drops in output are accompanied by faster growth rates makes sense. The CEA post that makes use of the regression from the 2009 Economic Report of the President [large pdf] produced by the Bush White House (reproduced below) is in this world appropriate (in Mankiw's unit root world, it wouldn't be appropriate).

That being said, I think that additional information is always useful. And in this case, I stressed (in my last discussion of this graph) that the overpredicted growth rates were for the recoveries associated with financial system problems, such as a credit crunch. This means (in my opinion) that it is essential to fix the banking system in order for the faster growth to be realized.

Note that I haven't addressed any issues regarding trend breaks as an alternative to unit roots or trends. Interested readers can refer to this paper, in a cross-country context.

This is "news", insofar as the announcement came in below expectations (-6.2% vs. Bloomberg consensus of -5.4%, and outside the range of forecasts, -3.8 to -6.1). Hence, I think it is of interest to re-consider exactly how "massive" that stimulus bill was in the context of the implied output gap. In this post I argued the stimulus was, in relative terms, anything but massive. Now, I think that argument has even more force (Brad Delong concurs.) Using the CBO estimates, the output gap in 2008Q4 was 4.4 (versus the 3.8% implied by the earlier advance estimate).

It is unusual, in my experience, to be able to easily discern the impact of a revision on the path of GDP in graphs of this type...

My guess is that in a few months as the full import of the recession becomes obvious, a lot fewer people will be characterizing the stimulus as "massive".

Once again, I want to stress the adjectives "massive stimulus" conjoined to the noun "bill" is a matter of context. Dividing by baseline GDP shows that in a proportional (rather than dollar) sense the bill is rather modest. The fiscal impulse to GDP ratio never exceeds 2.5 ppts in any given fiscal year.

Finally, the degree of "modesty" is highlighted by the challenges -- in the form of the massive negative and persistent output gap [0] -- we are facing in the absence of countervailing fiscal policy.

It's not a perfect bill. I would have preferred more public investment spending, more transfers to the states for fiscal stabilization, and less tax cuts. But it's certainly better than nothing -- or all tax cuts (which is what I gather the opposition wanted). Here is a description of the components that have an impact on state finances.[1]

The Real World

I want to stress two facts. First, the CBO and all major macro forecasting firms (to my knowledge) are projecting a change relative to baseline due to the stimulus bill. I think those who are asserting zero effect from the stimulus should provide the empirical estimates that buttress their case (this is different from saying the effects would be small -- that is implicit in the range of CBO estimates, and the range of multipliers cited by CBO [2]).

The Rest of the World

Second, with rest-of-world output declining [3], and fiscal policies moving toward a more expansionary stance, the fear that additional budget deficits in the US will manifest in a higher risk premium associated with Treasury debt is mitigated. In other words portfolio balance effects [4] are of less concern since all other governments are issuing debt. (Of course, I -- unlike some others -- do believe that deficits matter [5]; holding all else constant, deficits should raise interest rates. Of course, with credit demand collapsing around the world, not all else is held constant.)

The Opponents of Stimulus and the Abdication of Responsibility

By the way, I have been amused at how some policymakers have taken to quoting the "temporary, timely and targetted" criteria attributed to NEC Chair Summers, as if the stimulus does not fit these three criteria.[6] As Figures 1 and 2 demonstrate, the bulk of the stimulus takes place during a period when it would be needed -- namely when the baseline output gap is -7.4 and -6.3 ppts of GDP (Table 1 above). And according to the CBO, the stimulus is temporary (i.e., it "tails off" in the out years). This disjuncture between reality and assertion induces me to restate -- saying something repeatedly without supportive data doesn't make it so. I'd also say that the repeated critique without clear alternative merely highlights the lack of an idea of what would be a better policy. Or as one observer put it:

...congressional Republicans were never really willing to concede the principle that stimulus was needed. Their tax plan was just a rehash of old hash that was never plausibly linked to the particular economic problems we have today. I disagree about the payroll tax for various reasons, but at least it would have been focused on the reality of the situation, rather than just being a pointless political exercise. I believe that reinstitution of the Investment Tax Credit would have been the best Republican alternative. I made the argument here, but got no takers.

...

In the end, Republicans preferred to reject the principle of stimulus, thus taking themselves out of the game. I think that was a mistake, both politically and substantively.

Source: Bruce Bartlett at NRO. (h/t Brad Delong)

Technorati Tags: stimulus bill, recession, output gap, tax cuts, infrastructure investment, multipliers.

For the record, I am certainly among those who had been suggesting that America's low saving rate was a significant problem. Let me begin by reviewing why I said that. Recall that we can separate the various components of GDP (Y) in terms of goods and services purchased by consumers (C), government purchases (G), investment spending (I), and net exports (X):

Y = C + I + G + X

Subtracting C and G from both sides of the equation,

Y - C - G = I + X

The two terms on the right-hand side are the critical determinants of what kind of economic future we'll have. Investment in plant and equipment is the single most important variable that will determine our future productivity and standard of living. And negative net exports, such as the U.S. has increasingly opted for over my lifetime, necessarily involves selling off our national assets and going further into debt to foreigners. The size of our current account deficit is large enough relative to GDP that, if this were any country other than the United States, I would worry that a currency crisis (a sudden flight from dollars) is a very real possibility. And even for the United States, it is something I for one do worry about.

U.S. net exports as a percentage of GDP. Data source: BEA Table 1.1.5.

From the equation above, if we want I + X to be bigger, we must want Y - C - G to be bigger as well. We can define private sector saving to be gross domestic income less consumption spending and net taxes paid:

private saving = Y - C - T.

Notice I'm using the same symbol Y for both GDP and GDI, since the two are conceptually the same-- every dollar of production necessarily generates a dollar of income. There is a statistical discrepancy between the actual measures available for GDP and GDI, though these are not relevant for the longer run issues I'm discussing here. We likewise can define "public saving" to be the excess of the government's receipts over its expenditures,

public saving = T - G,

and national saving to be the sum of private and public saving:

national saving = Y - C - T + T - G = Y - C - G.

In other words,

national saving = I + X

This equation is an accounting identity, as well as a condition that has to characterize equilibrium in any coherent macroeconomic model. Hence my longstanding advocacy of measures to raise the private saving rate or lower the federal deficit.

So then, aren't I delighted that consumers are now, finally, saving more?

Personal saving as a percentage of disposable personal income. Data source: BEA Table 2.1.

Well, no. It is one thing to identify a higher national saving rate as the long-term goal, and quite another thing to try to get there overnight in the form of a sudden drop in consumption spending. Here I am very much taking the side of Brad DeLong ([1],[2]) and Arnold Kling and against Eugene Fama ([1], [2]) and John Cochrane. The relevant question is whether, in response to an abrupt decrease in consumption spending such as we're now experiencing, some of the other variables (most importantly, Y) might adjust in response as well. It is certainly true that in a very simple economic setting-- for example, an economy that consists of a single farm producing only one good-- the decision to save more of your income (leave some of your wheat unconsumed) is necessarily identical to the decision to invest more (save the wheat for later). And one can write down more complicated models in which economic actors and markets adjust in a way to see through the veil of production and exchange and make sure it is I + X that adjusts in response to a higher saving rate, and not Y.

But it's also possible to write down models in which there are significant frictions that cause the adjusting to come in the form of lower Y in response to lower demand. The traditional such friction is the textbook Keynesian notion that wages and prices fail to adjust. In such models, responding to the lower C by increasing G may succeed in mitigating the loss in Y. Though here I must agree with Cochrane that those same models imply that if monetary policy could stimulate aggregate demand, that would achieve the same objective. I am definitely of the view that it is within the current power of the Federal Reserve to stimulate demand, and have urged the Fed to try to aim for a 3% inflation rate over the next several years.

But where I may disagree with some of my colleagues is in their presumption that wage or price rigidities are the core frictions that are responsible for producing the present situation. I have in my research instead stressed technological frictions. For example, when spending on cars abruptly falls, there is a physical, technological challenge with getting the specialized labor and capital formerly employed in manufacturing cars into some alternative activity. In my mind, it is a mistake to pretend that any federal program is capable of immediately re-employing those resources into an alternative, equally productive enterprise. More fundamentally, I have suggested that our present situation is as if someone had quite successfully sabotaged the basic functionality of our financial system. Until we once again have a financial sector that can successfully allocate credit to worthy projects, we're not possibly going to be able to produce as much in the way or real goods and services, no matter what the level of aggregate demand or stimulus package might be. In terms of the textbook Keynesian models that people play with, I'm suggesting that "potential" GDP growth for 2009:Q1-- that growth rate which, if we try to exceed it by stimulating aggregate demand, we primarily just get more inflation-- is in fact a negative number. I do not accept the proposition that there is a level of government spending-- however large a number you choose to suggest-- that will prevent the unemployment rate from rising above 8%. But I do believe that if the government borrows a sufficiently large amount, we will have to worry in a very concrete way about what will sustain the foreign demand for U.S. assets.

What, then, do I propose? The first principle that's quite clear to me is that drops in state and local government spending, or increases in state and local taxes, are a likely response to the current situation and are clearly counterproductive. Hence I've advocated ([1], [2]) additional federal borrowing in order to provide unrestricted block grants to states. That's a simple, effective plan that could and should be immediately implemented, while still preserving complete flexibility in responding to our serious longer run challenges.

I also am very comfortable endorsing additional government investment in infrastructure for which the argument can be made that the facilities could make a significant contribution to future productivity. At the top of my personal list would be investments in the electricity transmission grid, mass transit, and basic scientific research.

And unquestionably the number 1 priority for the federal government should be to restore a functioning financial sector. That in my mind should be done in a way that maximizes the return on any taxpayer funds invested.

But rushing through new government spending plans, just for the sake of spending? Count me off of that bandwagon.

Technorati Tags: macroeconomics, economics, fiscal stimulus, block grants

Greg Mankiw had a great article last weekend in which he challenged the view that macroeconomists have learned enough to prevent a repeat of the Great Depression. Greg notes some disturbing similarities between our current difficulties and the problems of the 1930s:

From 1930 to 1933, more than 9,000 banks were shuttered, imposing losses on depositors and shareholders of about $2.5 billion. As a share of the economy, that would be the equivalent of $340 billion today. The banking panics put downward pressure on economic activity in two ways. First, they put fear into the hearts of depositors. Many people concluded that cash in their mattresses was wiser than accounts at local banks. As they withdrew their funds, the banking system's normal lending and money creation went into reverse. The money supply collapsed, resulting in a 24 percent drop in the consumer price index from 1929 to 1933. This deflation pushed up the real burden of households' debts....

Deflation across the economy is not a problem (yet), but deflation in the housing market is the source of many of our present difficulties. With so many homeowners owing more on their mortgages than their houses are worth, default is an unfortunate but often rational choice. Widespread foreclosures, however, only perpetuate the downward spiral of housing prices, further defaults and additional losses at financial institutions.

Greg is certainly correct that house price declines have a potential to cause similar problems today as we saw in the 1930s. But I believe it is more than an academic distinction whether we are talking about a relative price change (house prices go down but the dollar price of most other items goes up) or a true deflation (the dollar price of almost everything you buy goes down). The reason is that the latter problem is absolutely one that the Federal Reserve could fix, whereas the former problem may not be.

In a general deflation, the purchasing power of a dollar bill goes higher and higher, and as Greg notes, this can produce big economic problems, as it did for the U.S. in the 1930s or Japan in the 1990s. But it is absolutely a problem that the Federal Reserve can fix. If you increase the quantity of dollar bills fast enough, you're sure to create inflation, not deflation. And the Federal Reserve has unlimited power to increase the quantity of dollar bills.

Some of my colleagues still talk of the possibility of a liquidity trap, in which the central bank supposedly has no power even to cause inflation. Their theory is that interest rates fall so low that when the Fed buys more T-bills, it has no effect on interest rates, and the cash the Fed creates with those T-bill purchases just sits idle in banks.

To which I say, pshaw! If the U.S. were ever to arrive at such a situation, here's what I'd recommend. First, have the Federal Reserve buy up the entire outstanding debt of the U.S. Treasury, which it can do easily enough by just creating new dollars to pay for the Treasury securities. No need to worry about those burdens on future taxpayers now! Then buy up all the commercial paper anybody cares to issue. Bye-bye credit crunch! In fact, you might as well buy up all the equities on the Tokyo Stock Exchange. Fix that nasty trade deficit while we're at it! Print an arbitrarily large quantity of money with which you're allowed to buy whatever you like at fixed nominal prices, and the sky's the limit on what you might set out to do.

Of course, the reason I don't advocate such policies is that they would cause a wee bit of inflation. It's ridiculous to think that people would continue to sell these claims against real assets at a fixed exchange rate against dollar bills when we're flooding the market with a tsunami of newly created dollars. But if inflation is what you want, put me in charge of the Federal Reserve and believe me, I can give you some inflation.

Notwithstanding, I think Greg is raising a very valid point. Allowing the overall deflation in the U.S. in the 1930s and Japan in the 1990s was one quite fixable policy error. But perhaps modern macroeconomists have deluded ourselves into thinking that if this policy error had not been made, the whole episodes could have been avoided. How bad would the Great Depression have been if the price level had not fallen? Not as bad as it was, I'm convinced, but maybe still pretty bad.

I still like Brad DeLong's perspective on all this:

Is 2008 Our 1929? No. It is not. The most important reason it is not is that Bernanke and Paulson are both focused like laser beams on not making the same mistakes as were made in 1929....

They want to make their own, original, mistakes..

Technorati Tags: macroeconomics, economics, Federal Reserve, deflation, Great Depression, liquidity trap

Prior to the establishment of the Federal Reserve in 1913, the United States would periodically experience events that are often referred to as "financial panics." Rick Mishkin noted that these usually occurred after a recession began and a major financial institution had failed, and were characterized by a sharp increase in the spread between the interest rate paid by higher risk versus lower risk borrowers.

The graph below plots the difference between the interest rate on 3-month certificates of deposit and 3-month treasury bills. The alarming behavior of this spread began in August 2007, when it spiked up to 243 basis points, higher than anything seen in the previous 20 years. Aggressive responses from the U.S. Federal Reserve and other central banks last August succeeded in bringing banks' borrowing costs back down, though we saw subsequent comparable spikes in December 2007 and March 2008.

Gap between interest rates on 3-month certificates of deposit and 3-month treasury bills, from Federal Reserve Statistical Release H.15.

But those events would barely be noticed when compared with what happened last week. Following the bankruptcy of Lehman Brothers, the spread reached 527 basis points on Thursday.

Financial intermediaries, who earn their profit by lending at a modest markup over their borrowing cost, simply can not be expected to function in this kind of an environment. Lending institutions that had been solvent before this week would not remain so for long if this situation were to persist. Only the safest customers could be expected to obtain loans, and only after paying very high interest rates.

To respond to this situation, Treasury Secretary Paulson has proposed a plan whose key feature is the authorization to spend $700 billion to purchase troubled assets from financial institutions.

By my count, the Federal Reserve has already extended something on the order of $455 billion in loans collateralized by some of these same troubled assets, namely $125 billion in repos, $150 billion in the term auction facility, $50 billion in "other loans", $30 billion from the Bear Stearns deal, and $100 billion in "other Federal Reserve assets". That $455 billion total does not include this week's $85 billion loan to AIG, nor the $180 billion in reciprocal currency swap lines.

My primary criticism of these previous unconventional actions by the Fed is that they are better characterized as fiscal policy rather than monetary policy. They unquestionably represent an implicit potential commitment of Treasury dollars. If the latest $700 billion Treasury proposal were to take these assets off the books of the Federal Reserve and put them onto the Treasury's balance sheet, and have Paulson rather than Bernanke be the guy who makes these calls of when and where to put the taxpayers at risk, I would be all for it.

But I gather that instead the $700 billion is construed to be in addition to the comparable sum that's already been committed by the Federal Reserve. And it seems to be in addition to the $1.7 trillion in debts from Fannie and Freddie that the U.S. Treasury has now apparently assumed, and is in addition to the guarantees on $3.1 trillion in agency MBS for which the Treasury has again apparently assumed responsibility.

And do you think that this week's $700 billion is going to be the last such request?

Granted, these numbers I've been adding up represent loans or guarantees, which are something very different from outright expenditures. Actual losses should only amount to a small fraction of this sum. But even a small fraction of $6 trillion is still a huge number.

Before we can solve these problems, we need to agree on what caused them. In a narrow mechanical sense, that seems straightforward to answer. Reckless underwriting standards and excessively low interest rates contributed to bidding up house prices to unsustainable levels. Real estate price declines have now engendered current and prospective future default rates that translate into large capital losses for institutions holding assets based on those loans. This erosion of capital makes creditors wary of extending any new funds to these institutions.

But there is also a deeper question here that is harder to answer. How did the financial system come to be susceptible to such a profound degree of miscalculation and inappropriate leveraging of risk in the first place? My answer would be that the core problem was financial arrangements in which the gains went to one group but the downside risk was borne by somebody else. The loan originators offered unsound loans, but still made big profits because they sold those bad loans off to the loan aggregators. Fannie and Freddie earned themselves nice income while the loans were performing, but the taxpayers absorbed the loss when the loans went bad. CEOs and fund managers earned huge bonuses while the boom went on, leaving stockholders and investors holding the bag when things went sour.

And I agree with the Financial Stability Forum that the key changes we need to make to avoid such problems are more transparency in accounting and stronger capital requirements. Transparency is vital so that that creditors, shareholders, fund investors, and regulators can better perceive the risks to which they are exposed. Stronger capital requirements are necessary to ensure that the principal actors are risking their own capital and not just somebody else's.

How you get from our current situation to one where financial institutions are adequately capitalized is of course one of the key challenges of the moment. We can't just impose tougher requirements and expect everybody to extricate themselves from the mess they're in without some federal contributions. But I do not see that a clear vision of exactly what is expected and required, in the way of modified capital standards and risk management procedures, for any institution that receives federal assistance is a key part of any of the proposals. And it should be.

Transparency strikes me as something that ought to be easier to achieve. I would start with a centralized clearing house for reporting all derivative contracts and collateral pledged for them, and requiring financial statements such as annual reports to communicate clearly the specific exposures that those entail. Perhaps there's a fear that if we had a clear communication of exactly who is holding the bag, that could exacerbate the kinds of destabilizing capital flights with which we've been fighting. But I think the uncertainty itself may be even more destabilizing.

Before the taxpayers are asked to commit such sums, we are owed a coherent and compelling explanation of why this kind of problem is never going to occur again.

There's lots of other good analysis out there in the 'sphere. Brad DeLong has a nice exposition of the conditions in which a government intervention could be successful and desirable, and when it could fail. Calculated Risk offers details of how he would run the bailout. Yves Smith and Paul Krugman [1], [2] express their reservations about the Paulson plan. Representative Barney Frank (D-MA) wants to see a cap on executive compensation be part of any bailout. For some comic relief (and heaven knows we could use some at the moment), see the Washington Post (hat tip: Greg Mankiw).

And your thoughts, dear readers?

Technorati Tags: macroeconomics, economics, Federal Reserve, interest rates, credit crunch, Bernanke, financial crisis

First, what is the source of the crisis? Is it as is asserted here in this statement from John McCain today?

....

There are certainly plenty of places to point fingers, and it may be hard to pinpoint the original event that set it all in motion. But let me give you an educated guess. The financial crisis we're living through today started with the corruption and manipulation of our home mortgage system. At the center of the problem were the lobbyists, politicians, and bureaucrats who succeeded in persuading Congress and the administration to ignore the festering problems at Fannie Mae and Freddie Mac.

These quasi-public corporations lead our housing system down a path where quick profit was placed before sound finance. They institutionalized a system that rewarded forcing mortgages on people who couldn't afford them, while turning around and selling those bad mortgages to the banks that are now going bankrupt. Using money and influence, they prevented reforms that would have curbed their power and limited their ability to damage our economy. And now, as ever, the American taxpayers are left to pay the price for Washington's failure.

...

I certainly concur with the first sentence. But I do wonder about the assertion that the problem started with and is fundamentally driven by Fannie Mae and Freddie Mac. After all, neither of these two institutions were at the heart of the massive surge in subprime mortgages that are the most toxic component of these asset backed securities. Smarter people than me (Justin Fox, Tanta at CR h/t Mark Thoma) have been similarly dubious.

Moreover, the originating entities for these subprime mortgages were not Fannie Mae and Freddie Mac, by large, but rather the banks that the Federal government refused to let state agencies regulate. Or the ones the Treasury's OTS itself failed to regulate. To refresh memories, consider this article from December 18, 2007 NYT:

WASHINGTON-- Until the boom in subprime mortgages turned into a national nightmare this summer, the few people who tried to warn federal banking officials might as well have been talking to themselves.

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.

But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of "best practices" and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.

And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.

John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.

"He never gave us a good reason, but he didn't want to do it," Mr. Gnaizda said last week. "He just wasn't interested."

Today, as the mortgage crisis of 2007 worsens and threatens to tip the economy into a recession, many are asking: where was Washington?

An examination of regulatory decisions shows that the Federal Reserve and other agencies waited until it was too late before trying to tame the industry's excesses. Both the Fed and the Bush administration placed a higher priority on promoting "financial innovation" and what President Bush has called the "ownership society."

...

On Tuesday, under a new chairman, the Federal Reserve will try to make up for lost ground by proposing new restrictions on subprime mortgages, invoking its authority under the 13-year-old Home Ownership Equity and Protection Act. Fed officials are expected to demand that lenders document a person’s income and ability to repay the loan, and they may well restrict practices that make it hard for borrowers to see hidden fees or refinance with cheaper mortgages.

It is an action that people like Mr. Gramlich and Ms. Bair advocated for years with little success. But it will have little impact on many existing subprime lenders, because most have either gone out of business or stopped making subprime loans months ago.

...

The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

Virtually every federal bank regulator was loathe to impose speed limits on a booming industry. But the regulators were also fragmented among an alphabet soup of agencies with splintered and confusing jurisdictions. Perhaps the biggest complication was that many mortgage lenders did not fall under any agency's authority at all.

...

And for some more concrete examples of how deregulatory zeal had an effect, consider this account from the WSJ (March 22, 2007):

Regulators appointed by President Bush often have been more sympathetic to industry concerns about red tape than their Clinton administration predecessors. When James Gilleran, a former California banker and bank supervisor, took over the OTS in December 2001, he became known for his deregulatory zeal. At one press event in 2003, several bank regulators held gardening shears to represent their commitment to cut red tape for the industry. Mr. Gilleran brought a chain saw.

He also early on announced plans to slash expenses to resolve the agency's deficit; 20% of its work force eventually left. When he left in 2005, Mr. Gilleran declared that the OTS had "exercised increased diligence in its review of abusive consumer practices" while reducing thrifts' regulatory burden. But his successor, Mr. Reich, a former community banker, has reversed many of Mr. Gilleran's cuts. Citing "understaffing," he hired 80 examiners last year and plans to add 40 more this year. A spokeswoman for Mr. Gilleran, now chief executive of the Federal Home Loan Bank of Seattle, said he wasn't available to comment.

So, from my perspective, locating the source of the current crisis in corruption/influence peddling surrounding Fannie and Freddie exhibits a misreading of recent history. (More important might have been lax monetary policy and the saving glut, and exemptions from capital requirements for certain investment banks... [see Ritholtz])

Second, how hard will the rescue be given the reckless decisions of the past? It seems that whatever entity is established to purchase these bad assets will require some fiscal outlay. Estimates are all over the place, given that there is so much uncertainty over how much the assets will be bought for and eventually sold; here is one account:

U.S. Debt May Grow $1 Trillion on Rescue, Barclays' Pond Says

By Sandra Hernandez

Sept. 19 (Bloomberg) -- The U.S. may have to borrow an extra $700 billion to $1 trillion to fund the biggest rescue of the financial system since the Great Depression, according to Barclays Capital Inc.'s Michael Pond.

Federal takeovers of Fannie Mae, Freddie Mac, and American International Group Inc.; the central bank's expansion of lending to financial firms; and a slowing economy will add $455 billion to the Treasury's borrowing needs, the New York-based interest-rate strategist estimated. Pond said Treasury Secretary Henry Paulson's plan to rid banks of "hundreds of billions" of troubled assets would bring the amount to $700 billion assuming the plan costs $200 billion.

"We could easily add up to an additional trillion to the outstanding Treasury debt just from the initiatives announced over the past couple of weeks," said Pond, ranked the best Treasury Inflation-Protected Securities analyst in 2008 by Institutional Investor magazine.

The government's liabilities swelled in past weeks as policy makers sought to arrest a growing financial crisis by taking over financial institutions threatened by a shortage of capital.

The Treasury on Sept. 7 took over mortgage-finance companies Fannie Mae and Freddie Mac and said it would buy mortgage-backed debt in the open market. The Fed this week boosted its Treasury auctions to bond dealers by $25 billion, loaned $85 billion to the insurer AIG, and quadrupled the amount of dollars foreign central banks can auction to $247 billion. Paulson today said the government will buy illiquid assets from banks' balance sheets and insure money-market mutual fund holdings.

Deficit Widens

"The odds of the deficit becoming enormous are certainly there," said Nils Overdahl, a bond fund manager in Bethesda, Maryland, at New Century Advisors, which oversees $500 million. "I suspect you will see issuance at a variety of maturities."

The deficit will likely widen to $650 billion in fiscal 2009 because of the U.S. rescue of Fannie and Freddie, analysts at JPMorgan Chase & Co. wrote in a Sept. 12 report.

Over the next decade, the gap between spending and receipts will swell to $5.3 trillion, Goldman Sachs Group Inc. analysts wrote Sept. 10, revising a previous forecast of $3.6 trillion. The non-partisan Congressional Budget Office forecast a record $438 billion deficit for 2009 on Sept. 9.

"The deficit will soar to enormous proportions,'' said Lou Crandall, the chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. ``Even before this week's events, estimates based on visible factors were pointing to a deficit above $500 billion next year, with the prospect of billions of mortgage- backed securities on top of that."

See also this Bloomberg article.

Here, I want to return the issue I've brought up countless times before. We cut taxes, and we embarked upon a war of choice, and in addition to the opportunity and fiscal costs, this constrained our range of actions for the future. Even if you thought the Bush tax cuts of 2001 and 2003 "benefitted" the US economy on net, we know that the war in Iraq has cost on the order of $653 billion nominal dollars from FY03-FY0-09 [2] -- in current dollars that's even more given inflation. Those dollars could have been spent fixing the financial system. Now, we'll have to either borrow or tax to to finance the operation.

So, if you wanted the McCain extension of the Bush tax cuts, and the additional $1.3 trillion tax cuts, then you might wonder about the impact on US borrowing rates. If you were hoping for more domestic initiatives, perhaps to give tax relief to the lower and middle income households, or to invest in infrastructure, the borrowing constraints will be more binding than they otherwise would have been.

Perhaps that's obvious, but sometimes in the midst of crisis, the obvious bears repeating. Here's a picture to illustrate the budget balance outlook pre-intervention....

The purple square is just for illustrative purposes. If you think the Treasury will only have to borrow $350 billion in FY2009, then the orange square is relevant. Further, if we're lucky (and Brad Delong is right), in future years we will recoup all and more of these outlays, so the deficit will be smaller than otherwise. But, in the short run, we'll have to take a hit (of unknown magnitude) now and hope for the best.

Technorati Tags: , subprime, Fannie Mae, Freddie+Mac, and deregulation, Office of Thrift Supervision, and tax cuts.

First, what is the source of the crisis? Is it as is asserted here in this statement from John McCain today?

....

There are certainly plenty of places to point fingers, and it may be hard to pinpoint the original event that set it all in motion. But let me give you an educated guess. The financial crisis we're living through today started with the corruption and manipulation of our home mortgage system. At the center of the problem were the lobbyists, politicians, and bureaucrats who succeeded in persuading Congress and the administration to ignore the festering problems at Fannie Mae and Freddie Mac.

These quasi-public corporations lead our housing system down a path where quick profit was placed before sound finance. They institutionalized a system that rewarded forcing mortgages on people who couldn't afford them, while turning around and selling those bad mortgages to the banks that are now going bankrupt. Using money and influence, they prevented reforms that would have curbed their power and limited their ability to damage our economy. And now, as ever, the American taxpayers are left to pay the price for Washington's failure.

...

I certainly concur with the first sentence. But I do wonder about the assertion that the problem started with and is fundamentally driven by Fannie Mae and Freddie Mac. After all, neither of these two institutions were at the heart of the massive surge in subprime mortgages that are the most toxic component of these asset backed securities. Smarter people than me (Justin Fox, Tanta at CR h/t Mark Thoma) have been similarly dubious.

Moreover, the originating entities for these subprime mortgages were not Fannie Mae and Freddie Mac, by large, but rather the banks that the Federal government refused to let state agencies regulate. Or the ones the Treasury's OTS itself failed to regulate. To refresh memories, consider this article from December 18, 2007 NYT:

WASHINGTON-- Until the boom in subprime mortgages turned into a national nightmare this summer, the few people who tried to warn federal banking officials might as well have been talking to themselves.

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.

But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of "best practices" and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.

And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.

John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.

"He never gave us a good reason, but he didn't want to do it," Mr. Gnaizda said last week. "He just wasn't interested."

Today, as the mortgage crisis of 2007 worsens and threatens to tip the economy into a recession, many are asking: where was Washington?

An examination of regulatory decisions shows that the Federal Reserve and other agencies waited until it was too late before trying to tame the industry's excesses. Both the Fed and the Bush administration placed a higher priority on promoting "financial innovation" and what President Bush has called the "ownership society."

...

On Tuesday, under a new chairman, the Federal Reserve will try to make up for lost ground by proposing new restrictions on subprime mortgages, invoking its authority under the 13-year-old Home Ownership Equity and Protection Act. Fed officials are expected to demand that lenders document a person’s income and ability to repay the loan, and they may well restrict practices that make it hard for borrowers to see hidden fees or refinance with cheaper mortgages.

It is an action that people like Mr. Gramlich and Ms. Bair advocated for years with little success. But it will have little impact on many existing subprime lenders, because most have either gone out of business or stopped making subprime loans months ago.

...

The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

Virtually every federal bank regulator was loathe to impose speed limits on a booming industry. But the regulators were also fragmented among an alphabet soup of agencies with splintered and confusing jurisdictions. Perhaps the biggest complication was that many mortgage lenders did not fall under any agency's authority at all.

...

And for some more concrete examples of how deregulatory zeal had an effect, consider this account from the WSJ (March 22, 2007):

Regulators appointed by President Bush often have been more sympathetic to industry concerns about red tape than their Clinton administration predecessors. When James Gilleran, a former California banker and bank supervisor, took over the OTS in December 2001, he became known for his deregulatory zeal. At one press event in 2003, several bank regulators held gardening shears to represent their commitment to cut red tape for the industry. Mr. Gilleran brought a chain saw.

He also early on announced plans to slash expenses to resolve the agency's deficit; 20% of its work force eventually left. When he left in 2005, Mr. Gilleran declared that the OTS had "exercised increased diligence in its review of abusive consumer practices" while reducing thrifts' regulatory burden. But his successor, Mr. Reich, a former community banker, has reversed many of Mr. Gilleran's cuts. Citing "understaffing," he hired 80 examiners last year and plans to add 40 more this year. A spokeswoman for Mr. Gilleran, now chief executive of the Federal Home Loan Bank of Seattle, said he wasn't available to comment.

So, from my perspective, locating the source of the current crisis in corruption/influence peddling surrounding Fannie and Freddie exhibits a misreading of recent history. (More important might have been lax monetary policy and the saving glut, and exemptions from capital requirements for certain investment banks... [see Ritholtz])

Second, how hard will the rescue be given the reckless decisions of the past? It seems that whatever entity is established to purchase these bad assets will require some fiscal outlay. Estimates are all over the place, given that there is so much uncertainty over how much the assets will be bought for and eventually sold; here is one account:

U.S. Debt May Grow $1 Trillion on Rescue, Barclays' Pond Says

By Sandra Hernandez

Sept. 19 (Bloomberg) -- The U.S. may have to borrow an extra $700 billion to $1 trillion to fund the biggest rescue of the financial system since the Great Depression, according to Barclays Capital Inc.'s Michael Pond.

Federal takeovers of Fannie Mae, Freddie Mac, and American International Group Inc.; the central bank's expansion of lending to financial firms; and a slowing economy will add $455 billion to the Treasury's borrowing needs, the New York-based interest-rate strategist estimated. Pond said Treasury Secretary Henry Paulson's plan to rid banks of "hundreds of billions" of troubled assets would bring the amount to $700 billion assuming the plan costs $200 billion.

"We could easily add up to an additional trillion to the outstanding Treasury debt just from the initiatives announced over the past couple of weeks," said Pond, ranked the best Treasury Inflation-Protected Securities analyst in 2008 by Institutional Investor magazine.

The government's liabilities swelled in past weeks as policy makers sought to arrest a growing financial crisis by taking over financial institutions threatened by a shortage of capital.

The Treasury on Sept. 7 took over mortgage-finance companies Fannie Mae and Freddie Mac and said it would buy mortgage-backed debt in the open market. The Fed this week boosted its Treasury auctions to bond dealers by $25 billion, loaned $85 billion to the insurer AIG, and quadrupled the amount of dollars foreign central banks can auction to $247 billion. Paulson today said the government will buy illiquid assets from banks' balance sheets and insure money-market mutual fund holdings.

Deficit Widens

"The odds of the deficit becoming enormous are certainly there," said Nils Overdahl, a bond fund manager in Bethesda, Maryland, at New Century Advisors, which oversees $500 million. "I suspect you will see issuance at a variety of maturities."

The deficit will likely widen to $650 billion in fiscal 2009 because of the U.S. rescue of Fannie and Freddie, analysts at JPMorgan Chase & Co. wrote in a Sept. 12 report.

Over the next decade, the gap between spending and receipts will swell to $5.3 trillion, Goldman Sachs Group Inc. analysts wrote Sept. 10, revising a previous forecast of $3.6 trillion. The non-partisan Congressional Budget Office forecast a record $438 billion deficit for 2009 on Sept. 9.

"The deficit will soar to enormous proportions,'' said Lou Crandall, the chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. ``Even before this week's events, estimates based on visible factors were pointing to a deficit above $500 billion next year, with the prospect of billions of mortgage- backed securities on top of that."

See also this Bloomberg article.

Here, I want to return the issue I've brought up countless times before. We cut taxes, and we embarked upon a war of choice, and in addition to the opportunity and fiscal costs, this constrained our range of actions for the future. Even if you thought the Bush tax cuts of 2001 and 2003 "benefitted" the US economy on net, we know that the war in Iraq has cost on the order of $653 billion nominal dollars from FY03-FY0-09 [2] -- in current dollars that's even more given inflation. Those dollars could have been spent fixing the financial system. Now, we'll have to either borrow or tax to to finance the operation.

So, if you wanted the McCain extension of the Bush tax cuts, and the additional $1.3 trillion tax cuts, then you might wonder about the impact on US borrowing rates. If you were hoping for more domestic initiatives, perhaps to give tax relief to the lower and middle income households, or to invest in infrastructure, the borrowing constraints will be more binding than they otherwise would have been.

Perhaps that's obvious, but sometimes in the midst of crisis, the obvious bears repeating. Here's a picture to illustrate the budget balance outlook pre-intervention....

The purple square is just for illustrative purposes. If you think the Treasury will only have to borrow $350 billion in FY2009, then the orange square is relevant. Further, if we're lucky (and Brad Delong is right), in future years we will recoup all and more of these outlays, so the deficit will be smaller than otherwise. But, in the short run, we'll have to take a hit (of unknown magnitude) now and hope for the best.

Technorati Tags: , subprime, Fannie Mae, Freddie+Mac, and deregulation, Office of Thrift Supervision, and tax cuts.

Consider first the series that prompted the investigation. In Figure 1, I show (in logs) industrial production and manufacturing production; the former is the one considered by the NBER BCDC.

The peak was in January 2008 for industrial production. Interestingly, the peak for manufacturing was earlier, in September 2007. I found this remarkable given the stress that has been made about strong export growth supporting US aggregate demand. I would have thought there would be a much less marked decline in manufacturing output. But apparently this is not the case.

Next consider nonfarm payroll employment. I've discussed the various aspects of the August employment situation release already [1], but it's useful to recap what the peak in this series was: December 2007.

Now consider real personal income less transfers and real manufacturing and trade sales, the last two key series focused on by the NBER BCDC.

Both of the series peaked in October 2007, although it is conceivalble that manufacturing and trade sales have reversed course (the last observation is for June).

Now, not all the news is bad for the times-are-fine thesis. The month-old GDP index compiled by Macroeconomic Advisers indicates that June 2008 GDP was substantially up.

Of course, June is in 2008Q2, and we're now puzzling over 2008Q3. We'll just have to wait for Macroeconomic Advisers' newest estimate (which should come out any day now). e-forecasting's estimate for July and August month-on-month annualized growth averages out to 1.65%. The one point that I would observe is that just as official GDP is revised as the source data is revised, so too is the Macroeconomic Advisers series (and presumably the e-forecasting one as well). From the February Macroeconomic Advisers' report on the monthly GDP series:

...As currently estimated, Monthly GDP in December 2007 was at an all-time high, suggesting that it's unlikely that the economy slipped into recession at the end of last year. However, revisions to the underlying source data could overturn this observation.

That's a cautionary note, given what previous revisions have done to the official GDP series: [2], [3].

I'll let the reader decide what to make of these trends. For me, they merely confirm what Jim wrote a week and a half ago.

And if you remain skeptical that we are in, or about to enter, a recession, then three things to consider:

• The current financial crisis is in some sense the reflection of the failure of certain institutions to deleverage, or recapitalize, fast enough. This process is going to further reduce the availability of credit, thereby slowing down the economic activity further -- a process laid out in this post.
• The decrease in the equity markets today, if persistent, will further constrain consumption, to the extent that wealth is a argument in the aggregate consumption function (4 cents on the dollar is the conventional wisdom regarding the MPC out of financial wealth).
• The losses to equity markets -- and jamming up of credit markets -- appears to be a trans-Atlantic phenomenon. Hence, the likelihood that rest-of-world economic activity can continue to sustain US aggregate demand seems ever smaller.

See also Brad Delong.

Technorati Tags: recession, industrial production, manufuacturing production, nonfarm payroll employment, and personal income, sales, and GDP.

Civilian unemployment rate, from FRED, with NBER recessions as shaded regions.

Sure looks like a recession when you inspect a graph the unemployment rate, doesn't it? And it also looks like a recession from the perspective of a model of unemployment dynamics that I published in 2005. If you use that model to analyze the latest unemployment numbers, you'd calculate the current probability of being in a recession at 95%.

Probability that the economy is in either a mild or severe recession at indicated date, as inferred on the basis of the full sample of revised data on the unemployment rate available as of September 2008 calculated using the model in Hamilton (2005).

As I noted when I discussed that model last month, one reason that the above graph seems to be able to identify recessions so clearly is that it uses the full sample of data available today to infer what was the situation at each historical date. If instead you try to base a call only on the data available at the time, the inference is much choppier. Even so, a 95% probability is not likely to be a miss.

Probability that the economy is in either a mild or severe recession at indicated date, as inferred on the basis of data (as currently revised) on the unemployment rate through the indicated date calculated using the model in Hamilton (2005).

That model distinguishes between a mild recession and a severe recession, with the graphs above combining the two. In fact, the August unemployment report leads to a 14% probability that we just entered the "severe contraction" phase. The last time we had a one-month filter probability of that regime higher than that was October of 1982.

Probability that the economy is in a severe recession at indicated date, as inferred on the basis of data (as currently revised) on the unemployment rate through the indicated date calculated using the model in Hamilton (2005).

Last month I also discussed some thresholds for recognizing a recession recently proposed by UCLA Professor Ed Leamer. Leamer says it usually means recession if the unemployment rate has jumped up by 0.8% within the last six months. When Leamer proposed that criterion two months ago, the 6-month increase of 0.5% seemed to leave us well short of the threshold. Today's numbers imply a 6-month increase of 1.3%, shooting past it pretty definitively.

The 6-month change in civilian unemployment rate, from FRED, with NBER recessions as shaded regions and dashed line at +0.8 threshold.

Leamer also said it would be a recession if the 6-month change in the measure of civilian employment based on the BLS household survey fell by more than 0.4%. Today's number of -0.354% would technically fall short of that, if you're determined to split hairs more finely than the allowable pixels in the graph below.

100 times the 6-month change in natural log of civilian employment, from FRED, with NBER recessions as shaded regions and dashed line at -0.4 threshold.

Finally, Leamer said he'd call it a recession if the 6-month change in nonfarm payrolls fell by over 0.5%. Today's NFP report, while disappointing, still leaves us at only -0.3%. Whew! That was a close call, no?

100 times the 6-month change in natural log of seasonally adjusted nonfarm payroll employment, from FRED, with NBER recessions as shaded regions and dashed line at -0.5% threshold.

No. I think we're better off looking at the 12-month rather than 6-month change in nonfarm payrolls. And the 12-month change, now at -0.2%, is clearly a recession-type number:

100 times the 12-month change in natural log of seasonally adjusted nonfarm payroll employment, from FRED, with NBER recessions as shaded regions and dashed line at 0.0 threshold.

And, by the way, calling it a recession when the 12-month change in nonfarm payrolls becomes negative appears to be pretty robust even given the revisions we know are likely to come in these data later.

100 times the 12-month change in natural log of seasonally adjusted nonfarm payroll employment as it would actually have been reported at any given date, from ALFRED, with NBER recessions as shaded regions and dashed line at 0.0 threshold.

So I don't see any way to slice today's report other than to say, at least as far as the employment numbers are concerned, the U.S. is now definitely in a recession.

And if you won't take my word for it, you can hear pretty much the same thing from Brad DeLong, Justin Fox, William Polley, Paul Krugman, and the various economists quoted by WSJ Real Time.

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