Gas Tax Pander Bears

Hillary Clinton is following John McCain's lead again, the Times reports:

Senator Hillary Rodham Clinton lined up with Senator John McCain, the presumptive Republican nominee for president, in endorsing a plan to suspend the federal excise tax on gasoline, 18.4 cents a gallon, for the summer travel season. But Senator Barack Obama, Mrs. Clinton’s Democratic rival, spoke out firmly against the proposal, saying it would save consumers little and do nothing to curtail oil consumption and imports.

Politically, it seems like an odd moment for Obama to eschew a cheap pander (somewhere, Paul Tsongas is smiling), but on the substance he is right, as Dean Baker explains:

Actually, almost all economists would agree that the tax cut proposed by Senators Clinton and McCain would save consumers nothing. With the supply of gas largely fixed by the capacity of the oil industry (they claim to be running their refineries at full capacity), the price will not change in response to the elimination of the tax. The only difference will be that money that used to go to the government in tax revenues will instead go to the oil industry as higher profits.

As Baker notes, the public is ill-served by coverage that fails to make clear the impact (or lack thereof) of this proposal.

The Tax Policy Center's Len Burman and Eric Toder are also critical. They write "unless the plan's aim is to boost short-term profits for petroleum refineries, the proposal makes no sense."

Update: More from the Washington Post's Fact Checker, Thomas Friedman, Howard Gleckman and Paul Krugman (who seems to have a hard time saying anything positive about Obama).

Update #2 (5/2): Apparently I'm not the only one having a Paul Tsongas flashback. Meanwhile, Clinton campaign official Howard Wolfson says: “There are times that a president will take a position that a broad support of quote-unquote experts agree with. And there are times they will take a position that quote-unquote experts do not agree with.” Ugh.

Ex-Fiscal Conservatives

In the Times, David Leonhardt profiles McCain economics advisor Douglas Holtz-Eakin. Although the tone is sympathetic, Leonhardt cannot avoid asking the awkward question "are there any fiscal conservatives anymore?"

Holtz-Eakin headed the Congressional Budget Office when it took a stab at "dynamic scoring." Though that sounds like something Billy Dee Williams might do, it actually means trying to incorporate "supply side" effects into estimates ("scoring") of the revenue losses associated with tax cuts. Leonhardt writes:

When Douglas Holtz-Eakin took over in 2003 as the director of the Congressional Budget Office — the nation’s bean counter in chief — he walked right into a firestorm.

For years, Republicans had been pushing the budget office to change the way it estimated the cost of a tax cut. Rather than looking only at the revenue lost, they argued, the office should also consider how tax cuts would change behavior. With lower tax rates, businesses would invest more, workers would work more — and the government would thus get a tax windfall. This, in a nutshell, is supply-side economics.

A bearded academic, Mr. Holtz-Eakin had just finished a stint in the Bush administration and had spoken favorably about dynamic analysis. So his appointment excited Republicans almost as much as it scared Democrats. Senator Kent Conrad went so far as to call it “a mistake.”

But it turns out that both parties underestimated Mr. Holtz-Eakin. He did indeed begin using dynamic analysis, which makes a lot of sense, since tax rates really do alter people’s behavior. Yet he used it as it should be used.

What the budget office found, as study after study has shown, was that any new revenue that tax cuts brought in paled in comparison with their cost....

Now Holtz-Eakin is working for a candidate who opposed the 2001 and 2003 Bush tax cuts, but now wants to extend them, and go further. McCain's vague promises of spending cuts to keep the deficit under control are reminiscent of David Stockman's "magic asterisk." Leonhardt:

To deal with the deficit, Mr. McCain has said that he will get tough on year-to-year spending, both in military programs and domestic ones. Then he will try to remake Medicare and Medicaid so that, as Mr. Holtz-Eakin puts it, they no longer pay doctors “based on what they do to people, instead of what they do to make people well.” It’s a fine idea.

The problem is that the campaign has been far, far more detailed about its tax cuts, which would worsen the deficit, than its spending cuts, which would reduce it. Mr. McCain has proposed the elimination of the alternative minimum tax (at a cost of $60 billion a year), new child tax deductions ($65 billion), a corporate tax cut ($100 billion) and faster write-offs for corporate investments in new equipment ($50 billion to $75 billion).

Of course, there are some who are in denial about the budgetary consequences of a tax cut, still peddling the claim that somehow revenues will rise - and one of those cranks, Arthur Laffer, is also advising McCain (as is Kevin Hassett, co-author of "Dow 36,000;" see Jeff Frankel's comments). Given the varied quality of his advisors, and his flip-flops on the issues, what McCain really thinks - and really would do in office - is anyone's guess. Washington Post columnist Ruth Marcus believes we're not getting straight talk:

Call it McCainsian Economics. Its seminal treatise: "The General Theory of Getting Elected."

In the space of just a few years, McCain has morphed from someone who worried about the cost of the Bush tax cuts into a rabid tax-cutter. You don't need a fancy equation to explain this turnabout. McCain is running for president at the helm of a party that's deathly allergic to taxes and highly suspicious of him on this score. His campaign-trail buddy is Phil Gramm, the former Texas senator. When it comes to fiscal responsibility versus more tax cuts, Gramm is what your mother would call a bad influence.

McCain 2001 said he could not "in good conscience support a tax cut in which so many of the benefits go to the most fortunate among us, at the expense of middle-class Americans." McCain 2008 pushes a tax policy that makes Bush's plan look like a soak-the-rich scheme....

Although some respectable economists do believe that tax cuts can alter incentives and induce additional labor supply and capital accumulation, the notion that those effects would be large enough to increase revenues is well known to be fantasy. For example, this analysis by Greg Mankiw, a Republican and former Bush advisor, and Matthew Weinzerl used a neoclassical growth model to find that, in the long run, the supply side effects reduce the revenue impact of capital and labor taxes by 50% and 16.7%, respectively (that's after a transition to a new steady state; the effects are much smaller at, say, a 10-year horizon). What their analysis appears to leave out is the impact of deficit spending, which reduces capital accumulation through the "crowding out" effect (i.e. the government borrows some of the saving that otherwise would have financed investment).

This Jeff Madrick column from 2003 has more on the CBO study of the dynamic effects of tax cuts, and is also a nice example of the way in which macroeconomists use a grab-bag of different types of models.

Mark Thoma comments on Leonhardt's story, as does The Economist's Free Exchange.

Update (4/26): Krugman says "it’s really sad to see Holtz-Eakin lending his reputation to this sort of thing."

Brauchli Chopped?

Or so I think Rupert Murdoch's New York Post might have headlined this Times story about change at one of his other properties. The Times' editors were, naturally, more restrained:

Wall St. Journal Editor Expected to Resign

Marcus W. Brauchli will step down as the top-ranking editor of The Wall Street Journal after less than a year in the job, four people briefed on the matter said on Monday, just four months after Rupert Murdoch took control of the paper.

Mr. Brauchli, 46, will announce his resignation soon, according to friends and current and former colleagues, all of whom requested anonymity because they were not authorized to discuss the matter. They differed as to whether he was being forced out as managing editor of The Journal, one of the most coveted posts in journalism, or leaving out of frustration.

Perhaps Murdoch was inspired by this classic song: (sorry, couldn't resist...)

Screech of the Inflation Hawks

A good resource for monetary policy tea leaf reading is the Wall Street Journal's Real Time Economics Blog, which does yeoman work tracking the utterances of Fed officials. RTE reported Thursday that some of the regional Fed Presidents are hinting that they have had enough of the rate cuts:

Federal Reserve Bank of Dallas President Richard Fisher has for several months now been among the central bank’s outspoken critics of the way the Fed conducts monetary policy. He stuck to his guns Thursday, saying he had a “strong reluctance” to cutting rates again. “The answer, to be curt, is not to compound the bad by repeating the oft-prescribed remedy of inflating our way out of our predicament with a wing-and-a-prayer promise that it can always be reined in later,” Fisher said, speaking at an event in Chicago. He reiterated his belief the Fed’s best tools to combat the current threat to the economy rests in its expanded or newly launched initiatives aimed at providing liquidity to financial markets. Fisher is currently a voting member of the interest rate setting Federal Open Market Committee, and he formally opposed the Fed’s last two rate cuts.

Another official has also suggested he’d be uncomfortable with a move to lower interest rates further. Federal Reserve Bank of Richmond President Jeffery Lacker told reporters at a conference on credit held by his bank in Charlotte, N.C., Thursday that “inflation is a problem now. It’s too high.” The official, who isn’t a voter this year, leaned against the dominant view among policy makers, which is that moderating, if not contracting, economic activity, will lower price pressures. “I’d be uncomfortable just waiting for economic slack to bring [inflation] down.”

On Friday, Philadelphia Fed President Charles Plosser also expressed concern about inflation.

How concerned one is about inflation depends, in part, on the measure chosen (or perhaps the choice of measure depends on one's concern).
The most-watched measure of inflation, the rate of change of the Consumer Price Index (CPI, in green), has risen above 4% - some ammunition for the inflation hawks in the upcoming FOMC meeting. However, the CPI is believed to slightly overstate inflation - an alternative is to use the deflator for personal consumption expenditure (i.e. the deflator for the C part of GDP, in red) - which makes the inflation picture less alarming, but only slightly so. If we take out the prices of food and energy and look at "core" inflation (blue), then the inflation picture doesn't look so bad.

The FOMC's next scheduled meeting is April 29-30. The Cleveland Fed calculates the probabilities of different outcomes of the meeting implied by prices of options traded on the Chicago Board of Trade. The markets are betting that the inflation hawks will not have the upper hand in the committee; they forecast a cut in the target, to 2.0% (or, possibly 1.75%):

Bryanism Comes to the WSJ

By eroding the real value of debts, unanticipated inflation redistributes wealth from creditors to debtors (nominal interest rates incorporate expected inflation). In the late 19th century, the populists, led by William Jennings Bryan, argued for an inflationary policy - adding silver to the monetary base - to benefit indebted farmers. Arguably, the crushing deflation of the time provided a reasonable justification for faster money growth, as farmers faced fixed nominal debt payments while the price of their crops fell year after year.

The populists were opposed by conservative eastern moneyed interests who supported the gold standard behind the banner of "sound money." These days, we trust the Wall Street Journal opinion pages to represent conservative moneyed interests, so it was a bit of a surprise to read this:

The policy alternatives in the post-housing-bubble world are painfully unpleasant. In my view, the least bad option is for the Federal Reserve to print money to help stabilize housing prices and financial markets. Yes, use reflation to soften the pain for Main Street and Wall Street.

The writer is associated with the conservative American Enterprise Institute, no less. Hat tip: Mark Thoma.

Update (4/15): Sound money is restored to its rightful place: on today's WSJ opinion page, Martin Feldstein says "Enough With The Rate Cuts."

Evidence on the Savings Glut Hypothesis

A country's current account is the difference between its saving and investment: a country with a current account surplus is saving more than necessary to finance its domestic investment. The difference goes to purchase foreign assets, a so-called "capital outflow." In recent years, the US has been running large current account deficits ($739bn or 5.3% of GDP in 2007), which means US savings is not sufficient to finance domestic investment and the difference is made up by selling US financial assets to foreigners (i.e. the US has a net capital inflow).

In 2005, Ben Bernanke offered a novel hypothesis that the US current account deficit was driven by a "savings glut" in the rest of the world, especially in emerging market countries. The current account surpluses of the emerging countries were used to purchase US assets, contributing to high US share prices and housing values (due to long-term interest rates kept low by the inflow of foreign saving into the US bond market). This increase in the wealth of US households drove the low savings rate - i.e., US households felt they could consume more because of the increases in home equity and stock prices.

On his blog, Brad Setser provides some evidence in favor of the savings glut hypothesis:

In 2007, the savings rate of the emerging world savings was almost 10% of GDP higher than its 1986-2001 average. Investment was up as well – in 2007, it was about 4% higher than its 1986-2001 average. However the rise in the emerging world’s savings was so large that the emerging world could investment more “at home” and still have plenty left over to lend to the US and Europe. That meets my definition of a “glut.”...

The big drivers of this trend. “Developing Asia” and the "Middle East." Developing Asia saved 45% of its GDP in 2007 -- up from 33-34% in 2002 and an average of 33% from 1994 to 2001 (and 29% from 86 to 93). Investment is up too. Developing Asia invested 38% of its GDP in 2007, v an average of between 32-33% from 1994 to 2001. Investment just didn't rise as much as savings. The Middle East also saved 45% of its GDP in 2007 – up from 28% of GDP back in 2002 and an average of 25% from 1994 to 2001 and an average of 17-18% from 1986 to 1993. Investment is up just a bit -- at 25% of GDP in 2007 v an average of 22% from 1994 to 2001.

The Middle East oil producers appear to behaving in a manner consistent with the permanent income hypothsesis - if the current high oil prices represent a transitory increase in their income, an increase in saving will allow them to spread the increase in consumption over a longer time period.

The current account surpluses of "Developing Asia" (most prominently, China) are harder to make sense of. If these countries expect higher income in the future, the logic of consumption smoothing implies they should be borrowing today. Moreover, conventional assumptions about production technology imply the returns on capital should be higher where capital is scarce - i.e. capital should flow from the US (with has a large capital stock and therefore should have a low marginal product of capital) to the developing countries, rather than in the other direction (this previous post discussed the perversity of a poor country - China - lending to a rich one - the US).

Carry On Wayward Yen

A recent Econ 317 homework problem (ch. 10, problem #5 from Greg Mankiw's intermediate macro book) illustrated the concept of uncovered interest parity (UIP). One of the major puzzles in open-economy macroeconomics is the fact that this condition fails to hold in the data. On his blog, Mankiw muses on whether there is money to be made in the "carry trade," which relies on the violation of UIP:

It is rare that I leave an economics conference with information that will change my personal financial decisionmaking. But I was close yesterday. A fascinating discussion of a paper on the carry trade made me wonder whether I should put a little money there.

The carry trade refers to the act of borrowing from countries with low interest rates, lending to countries with high interest rates, and profiting from the interest rate differential. It is based on the hope that exchange rates will not move too much against you to wipe out the profit. In other words, it is gambling that a condition known as uncovered interest parity will not hold. In the past, this strategy has been a money-maker. That is, uncovered interest parity is a plausible hypothesis that empirical studies usually reject.

We don't have the UIP violations quite figured out yet, but surely a brilliant economist like Mankiw would not entertain the thought that there any large bills on the sidewalk to be picked up. Besides, he already knows a much less risky way to get rich. (and yes, the title of this post is a Kansas reference)

Congratulations to Steven Pearlstein

I was pleased to see Steven Pearlstein, the Washington Post's excellent business columnist, recognized with a Pulitzer Prize for commentary. His columns can be found in the business section on Wednesdays and Fridays, though hopefully the editors will now see fit to give his work a more prominent placement.

Biofuels: Revenge of the Anchovies?

On the board in intermediate macroeconomics today:

Supply shocks
1973: Oil price shock; Food price shock

The students were already familiar with 1973 OPEC embargo from an earlier discussion of the productivity slowdown, but second shock required some explanation. So I told them the story about the failure of the anchovy harvest (next time I'll get the details right - it was off the coast of Peru due to the 1972 El Nino) which contributed to a worldwide spike in food prices because of the anchovy's role as an ingredient in animal feed and fertilizer. This is an example of "cost push" inflation which would shift the Phillips curve upward.

Former St. Louis Fed president William Poole is not a fan of the anchovy story. In a 2004 speech, he said:

In the four decades since the beginning of the Great Inflation of the 1960s and 70s, economists and central bankers have acquired a much better understanding of the source and consequences of inflation. When the Great Inflation began, it was common to cite one or another idiosyncratic events as the driving force behind the observed change in prices: OPEC, steel prices, anchovies and forth. Anchovies? Few today will understand this reference, so I’ll have to explain that some analysts argued that the disappearance of anchovies from the coast of Peru in 1972 had something to do with rising inflation in 1973. Today, however, economists universally accept the proposition that sustained inflation or deflation is, in the words of Milton Friedman, “everywhere and always a monetary phenomenon.”

Note the word sustained - we generally accept the quantity theory of money as an explanation of movements in the price level over the long run, but things like harvests and oil price shocks may matter in the short run. (To abstract from transitory volatility due to food and energy prices the Fed often focuses on "core" inflation measures; see this earlier post).

The anchovy story seemed particularly relevant today, after reading Paul Krugman's latest column, "Grains Gone Wild":

These days you hear a lot about the world financial crisis. But there’s another world crisis under way — and it’s hurting a lot more people. I’m talking about the food crisis. Over the past few years the prices of wheat, corn, rice and other basic foodstuffs have doubled or tripled, with much of the increase taking place just in the last few months. High food prices dismay even relatively well-off Americans — but they’re truly devastating in poor countries, where food often accounts for more than half a family’s spending.

There have already been food riots around the world. Food-supplying countries, from Ukraine to Argentina, have been limiting exports in an attempt to protect domestic consumers, leading to angry protests from farmers — and making things even worse in countries that need to import food.

The increase in food prices is attributable, in part, to the (misguided) fashion for biofuels, Krugman explains:

Where the effects of bad policy are clearest, however, is in the rise of demon ethanol and other biofuels.

The subsidized conversion of crops into fuel was supposed to promote energy independence and help limit global warming. But this promise was, as Time magazine bluntly put it, a “scam.”

This is especially true of corn ethanol: even on optimistic estimates, producing a gallon of ethanol from corn uses most of the energy the gallon contains. But it turns out that even seemingly “good” biofuel policies, like Brazil’s use of ethanol from sugar cane, accelerate the pace of climate change by promoting deforestation.

And meanwhile, land used to grow biofuel feedstock is land not available to grow food, so subsidies to biofuels are a major factor in the food crisis. You might put it this way: people are starving in Africa so that American politicians can court votes in farm states.

So, 2008: Oil price shock; Food price shock? Are biofuels the new anchovy story?

In 1973, sharp rises in the energy (green) and food (orange) components of the consumer price index contributed to the rise in the overall index (blue):

More recently, energy prices are clearly rising, but the food component is tracking the overall index relatively closely:

It might be that the retail price of "food" may not really have much food in it. That is, the prices we pay at the grocery store reflect some amalgamation of the costs of distribution, advertising, chemicals and packaging, in addition to the food itself, with the latter being a relatively minor part. Indeed, the retail price of "food" (red) seems to bear little relationship to the prices obtained by producers of "crude foodstuffs and feedstuffs" (blue):

So, while there may be other reasons to worry, there is little sign of food-price driven inflation.

For developing countries, it may be a more serious matter. However, food price increases cut both ways: while, as Krugman noted, the real incomes of consumers falls, the agricultural sector, which is large in many low income countries, benefits. As Dani Rodrik discusses here, it is precisely the point of many arguments for lowering rich-world agricultural subsidies to raise agricultural prices for the benefit of developing world producers.

Meanwhile, China is struggling with its own food price shocks - but Michael Pettis makes a case that China's inflation is a ultimately monetary phenomenon.

What Bear Necessitated

Congressional hearings this week brought out some interesting details on the takeover of Bear Stearns by JP Morgan Chase that was arranged by the Fed and Treasury a couple of weeks ago. The Times reports:

The testimony also disclosed that regulators were unaware of Bear’s precarious health and did not know until the afternoon of Thursday, March 13, that the firm was planning to file for bankruptcy protection the next morning.

Pummeled by market rumors of insolvency, the investment house lost more than $10 billion —or more than 80 percent — of its available cash in a single day...

The deal was worked out in haste, sealed at 5 am, and maybe not everyone was thinking clearly:

The firm’s chief executive, Alan D. Schwartz, said that he thought on the morning of Friday, March 14, that he had engineered a loan, backed by the Federal Reserve Bank of New York, that bought him 28 days to find a solution.

But he said he realized that he had misunderstood the terms of the loan when the Fed decided later that day that the loan would last only through the weekend and that he had only until Sunday afternoon to find a buyer for the 85-year-old firm.

As Homer Simpson would say, D'oh!

Mr. Schwartz said his misunderstanding of the agreement was “an honest disagreement as to the words” of the loan.

“Everything happened on a very, very short time frame,” he said.

Asked about the adequacy of the price paid to Bear Stearns, Mr. Schwartz said he had no alternative.

“All the leverage went out the window when we were told we had to have a deal done by the end of the weekend,” he said.

James Dimon, the chairman and chief executive of JPMorgan Chase, offered a slightly different view on the question.

“Buying a house,” he said, “is not the same as buying a house on fire.”

Or, to the regulators, not really on fire, but suffering from the erroneous perception of fire (people will sometimes jump to conclusions when they see a little smoke...). An unimpressed Floyd Norris explains:

Bear’s principal regulator was the Securities and Exchange Commission, which says it was watching closely. “At all times,” wrote Christopher Cox, the S.E.C. chairman, in the aftermath of the collapse, “the firm had a capital cushion well above what is required to meet supervisory standards.”

Even when the Federal Reserve concluded it had to subsidize a takeover of Bear by JPMorgan Chase to preserve the financial system, Mr. Cox wrote, Bear qualified under the Fed’s rules as “well capitalized.”

Could that indicate there is something wrong with the Fed’s rules? Does it sound a little like a doctor emerging from a funeral to proclaim that he did an excellent job of treating the late patient?

The S.E.C. does not see it that way. It its view, this was a case of an old-fashioned bank run, and no capital standards can stop such a run when confidence is lost.

The Treasury was concerned - rightly - about moral hazard (according to the Times story):

Robert Steel, a Treasury under secretary, said that his boss, Mr. Paulson, had said during the negotiations that the price should be low because the deal was being supported by a $30 billion taxpayer loan.

He said a lower price was desirable to make the broader point to the markets that by rescuing the bank, the government did not want to encourage risky behavior by other large institutions, a concept known as “moral hazard.”

But, as Dean Baker notes, the low price reduces the moral hazard for shareholders, but not for creditors:

The Fed assured all of Bear Stearns' creditors that it would insure Bear's obligations, even though Bear lacked the capital to meet its commitments. It also explicitly made the same guarantee to the customers of the other major investment banks.

This commitment creates an enormous moral hazard problem. Ordinarily, creditors would be very cautious dealing with investment banks of questionable solvency. However, if the loans come backed up by a Fed guarantee, then there is no reason to be concerned about the solvency of the bank.

In such circumstances, investment banks have an incentive to take large risks. Effectively, the Fed has created a "heads I win, tails you lose" situation for the banks and their customers. If they take a big risk and win, they gain make large gains. If they lose, then the Fed covers the losses for the customers, although not for the bank. Nonetheless the opportunity for the creditors to make large one-sided bets is very valuable, so creditors will be willing to share part of this windfall with the banks in the form of large fees.

The Washington Post's Dana Milbank had this take on the hearings:

Meet Alan Schwartz, welfare recipient.

As the chief executive of Bear Stearns, he's getting rather more public assistance than your typical welfare mom -- specifically, $30 billion in federal loan guarantees to help J.P. Morgan Chase take over his firm. But then, Schwartz has had rather more than his share of suffering of late.

As his firm collapsed, he was forced to forgo his entire 2007 bonus, leaving his compensation for the past five years at a paltry $141 million, according to Business Week....

Fortunately for Schwartz, he had a sympathetic audience in the banking committee, whose members have received more than $20 million in campaign contributions from the securities and investment industry, according to the Center for Responsive Politics. "I want the witnesses to know, and others, that as a bottom-line consideration, I happen to believe that this was the right decision," Chairman Chris Dodd (D-$5,796,000) said before hearing a single word of testimony.

"You made the right decision," Sen. Evan Bayh (D-$1,582,000) told the regulators who worked out the loan guarantee.

"The actions had to be done," agreed Sen. Chuck Schumer (D-$6,162,000).

March Unemployment Report

The Bureau of Labor Statistics released the latest unemployment numbers this morning. In March, the unemployment rate increased from 4.8% to 5.1%. According to the household survey, the number of persons employed fell by 24,000, but the number of unemployed rose increased by 434,000. That is because there was an increase in the labor force; this is the opposite of what happened last month, when the unemployment rate actually fell because people were leaving the labor force (to be counted in the labor force you must either be working or looking for work). So, if you like to believe the glass is half-full, you can take some comfort in the increase in the labor force participation rate, from 65.88% to 66.00%. The half-empty view would note that - while the NBER will take its time in declaring a business cycle turning point - the rise in unemployment over the past several months looks similar to the pattern at the beginning of previous recessions (shaded):The NY Times led with the decline of 80,000 in nonfarm payroll employment from the establishment (business) survey (the BLS surveys both businesses and households; the household survey data is used to calculate the unemployment rate).

Bernanke Put?

The Times' Floyd Norris notes that Federal Reserve actions appear to be following the stock market:

Say this for the Fed. It pays attention to what Wall Street wants.

When Wall Street wanted the Fed to ignore all the wild gambling in the derivatives markets, the Fed did so. Alan Greenspan fought to keep regulation away from that market, and argued that it was assuring the safety of financial institutions by allowing risk to be transferred to others. It turns out the exact opposite was true.

Now that the crisis is upon us, and Wall Street is in trouble, the Fed seems to announce new actions whenever investors get worried enough.

I count six separate days in the first quarter, which ended today, when the Fed announced actions. They are:

Jan. 22, when it cut the discount rate.
Jan. 30, when it cut the discount and Fed funds rates.
March 7, when it announced plans to inject money into financial markets
March 11, when the Fed and other central banks announced plans to inject more credit into markets.
March 16, when it financed the rescue of Bear Stearns and cut the discount rate
March 18, when it cut the Fed funds and discount rates.

On a net basis, all the damage for the quarter was done in the days leading up to each Fed action. In the three trading days before each Fed move — a total of 15 days since there was some overlapping — the S.&P. 500 fell almost 145 points and the Dow Jones industrial average lost 1,003 points.

On the other 46 trading days during the quarter, a net nothing happened. The S&P was up about two points, and the Dow was down less than one point.

What we have here is a picture of a Fed that follows the market, and of a market that repeatedly rallies on the news of a Fed move, only to fall again as more bad news comes out.

This is reminiscent of the notion that the Fed, under Bernanke's predecessor, was effectively setting a floor under the stockmarket, sometimes called the "Greenspan put." To explain: a put option grants the holder the right to sell a stock at a certain price; the option is basically an insurance policy establishing a minimum value for the holder (for example, if I buy a share worth $45 and a put option with a "strike price" of $40, if the share falls to $20, I can exercise the option and sell the share to the writer of the option for $40, limiting my loss to $5 plus the price of the option). Reflecting on the 20th anniversary of the October 1987 "Black Monday" stock market crash, The Economist's "Buttonwood" column put it thus:

The third lesson [of the 1987 crash] is that central banks will quickly intervene if they fear the markets are in crisis. They did so again in 1998 [following the LTCM collapse] and in August and September this year.

Twenty years ago, the Fed feared a repeat of 1929: after that year's crash came the Depression. In fact, the economy shrugged off the meltdown with the help of a loosening of monetary policy and recession was postponed until the early 1990s. Indeed, Black Monday now looks like a blip on the long-term stockmarket graph.

Many investors came to believe that central banks would underwrite the markets (the so-called Greenspan, now Bernanke, put). Although central banks did not prevent the equity bear market of 2000-02, the current strength of the stockmarket suggests investors' faith in this put has not been eliminated.

But this could be the most dangerous lesson of all. In Japan in the 1990s, neither near-zero interest rates nor fiscal stimulus saved the market. One day, investors will realise central bankers are not magicians. That might be another Black Monday.

The risk of the "put" (like any insurance, whether actual or perceived) is essentially one of "moral hazard" - that protection from negative consequences leads to riskier behavior. The belief in the "Greenspan put" may have contributed to a stock market bubble (or at least some "frothiness") as people were more eager to buy stock when they felt that they would be protected from declines, and the share prices were therefore bid up excessively (In 2005, Brad deLong argued that the Greenspan put is a myth).

Of course, correlation does not imply causality. Norris' evidence establishes that stock market declines have preceded Fed moves (what an econometrician might call "Granger causality"), but it does not rule out some other event causing both. Over the past several months, it may be that bad news about the functioning of credit markets and the condition of financial institutions has led to both the market declines and the Fed actions. The Fed actions themselves, in turn, provide information to the stock markets about how the Fed will respond to credit market problems. The market movements mean that the Fed actions have not been fully anticipated: so far, the rallies indicate that they have been pleasantly surprised by the Fed's moves, but some ugliness may come when the markets start to expect the Fed to act in certain ways, and the Fed chooses to disappoint them.