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.

A Plan for the Mortgage Mess

In the Times, Alan Blinder looks at the Frank-Dodd plan for dealing with the mortgage mess. He identifies some issues that still need to be resolved, but, overall:

[T]he Frank-Dodd proposal, which, while not a panacea, offers a smart approach to a knotty set of problems — an approach that should breathe some life into the housing market, the mortgage market and the related securities markets. Their design is not flawless. But do you know of any perfect solutions? It deserves our support.

See also the economic example worked out by Brad deLong.

Obama-nomics

Barack Obama spoke on the economy in New York on Thursday. He placed the call for increased supervision of the financial sector in historical context:

[T]he American experiment has worked in large part because we guided the market's invisible hand with a higher principle. A free market was never meant to be a free license to take whatever you can get, however you can get it. That's why we've put in place rules of the road: to make competition fair and open, and honest. We've done this not to stifle but rather to advance prosperity and liberty. As I said at Nasdaq last September, the core of our economic success is the fundamental truth that each American does better when all Americans do better; that the well-being of American business, its capital markets and its American people are aligned. I think that all of us here today would acknowledge that we've lost some of that sense of shared prosperity. Now, this loss has not happened by accident. It's because of decisions made in board rooms, on trading floors and in Washington. Under Republican and Democratic administrations, we've failed to guard against practices that all too often rewarded financial manipulation instead of productivity and sound business practice. We let the special interests put their thumbs on the economic scales. The result has been a distorted market that creates bubbles instead of steady, sustainable growth; a market that favors Wall Street over Main Street, but ends up hurting both. Nor is this trend new. The concentrations of economic power and the failures of our political system to protect the American economy and American consumers from its worst excesses have been a staple of our past: most famously in the 1920s, when such excesses ultimately plunged the country into the Great Depression. That is when government stepped in to create a series of regulatory structures, from FDIC to the Glass-Steagall Act, to serve as a corrective, to protect the American people and American business.

Ironically, it was in reaction to the high taxes and some of the outmoded structures of the New Deal that both individuals and institutions in the '80s and '90s began pushing for changes to this regulatory structure. But instead of sensible reform that rewarded success and freed the creative forces of the market, too often we've excused and even embraced an ethic of greed, corner cutting, insider dealing, things that have always threatened the long-term stability of our economic system. Too often we've lost that common stake in each other's prosperity. Now, let me be clear. The American economy does not stand still and neither should the rules that govern it. The evolution of industries often warrants regulatory reform to foster competition, lower prices or replace outdated oversight structures. Old institutions cannot adequately oversee new practices. Old rules may not fit the roads where our economy is leading. So there were good arguments for changing the rules of the road in the 1990s. Our economy was undergoing a fundamental shift, carried along by the swift currents of technological change and globalization. For the sake of our common prosperity, we needed to adapt to keep markets competitive and fair. Unfortunately, instead of establishing a 21st century regulatory framework, we simply dismantled the old one, aided by a legal but corrupt bargain in which campaign money all too often shaped policy and watered down oversight. In doing so we encouraged a winner take all, anything goes environment that helped foster devastating dislocations in our economy.

Of course, some of that "legal but corrupt bargain" was struck while a certain Clinton was in office...

Robert Kuttner and Jared Bernstein were both enthusiastic about the speech, and vexed that Paul Krugman was not (consistent with his general attitude towards Obama).

On housing, Obama (and Clinton) have been supportive of the proposals by Rep. Barney Frank and Sen. Chris Dodd. They would allow people with "under water" mortgages (i.e. who owe more than their houses are worth) to re-finance into mortgages guaranteed by the Federal Housing Administration. The value of the new loans would be limited to 85% of the previous loans, so the current lenders would take a hit, but they would escape the risk of taking a much larger loss from a foreclosure. The Bush administration seems to be moving in the same direction. But McCain is not; he says “it is not the duty of government to bail out and reward those who act irresponsibly, whether they are big banks or small borrowers.”

Laissez-Faire is Dead, Again

The Fed's recent aid to the financial sector - expanding "discount window" lending to investment banks and arranging (and providing a dowry for) the marriage of Bear Stearns and JP Morgan - has led to growing recognition of the limits of "free market" dogma and the need for regulation of the financial sector. Financial Times columnist Martin Wolf says:

Remember Friday March 14 2008: it was the day the dream of global free- market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve, the institution responsible for monetary policy in the US, chief protagonist of free-market capitalism, declared this era over. It showed in deeds its agreement with the remark by Josef Ackermann, chief executive of Deutsche Bank, that “I no longer believe in the market’s self-healing power”. Deregulation has reached its limits.

The Wall Street Journal's David Wessel writes:

[S]omething big just happened. It happened without an explicit vote by Congress. And, though the Treasury hasn't cut any checks for housing or Wall Street rescues, billions of dollars of taxpayer money were put at risk. A Republican administration, not eager to be viewed as the second coming of the Hoover administration, showed it no longer believes the market can sort out the mess.

Although the acceptance that unregulated markets and laissez-faire do not automatically lead to the best of all possible worlds may represent a swing of the ideological pendulum, this isn't exactly new. In recent years some have tended to forget, or ignore, what has been long understood: financial markets are characterized by market failures (e.g., asymmetric information) and prone to crises. Therefore, some government intervention is merited.

What we are seeing today is a re-cognition, indeed. Brad deLong explains using the example of British Prime Minister Robert Peel, who understood this in the first half of the 19th century. For a more philosophical view, Mark Thoma usefully points us to "The End of Laissez-Faire," a 1926 essay by John Maynard Keynes tracing the history of laissez-faire dogma, and the role of economists in perpetuating it. Keynes explains that laissez-faire is often misperceived as an implication of economics: "the guarded and undogmatic attitude of the best economists has not prevailed against the general opinion that an individualistic laissez-faire is both what they ought to teach and what in fact they do teach."

Looking for a Job?

The current economic environment may be discouraging to college seniors (and others) looking for a job, but here is some good news: the Federal Deposit Insurance Corporation is hiring. They expect to be busy with more bank failures.

A Run on the Shadow Banking System

Paul Krugman sees parallels between the current problems in the financial sector and banking crises of the depression. In his latest column, he writes:

But sometimes — often based on nothing more than a rumor — banks face runs, in which many people try to withdraw their money at the same time. And a bank that faces a run by depositors, lacking the cash to meet their demands, may go bust even if the rumor was false.

Worse yet, bank runs can be contagious. If depositors at one bank lose their money, depositors at other banks are likely to get nervous, too, setting off a chain reaction. And there can be wider economic effects: as the surviving banks try to raise cash by calling in loans, there can be a vicious circle in which bank runs cause a credit crunch, which leads to more business failures, which leads to more financial troubles at banks, and so on.

That, in brief, is what happened in 1930-1931, making the Great Depression the disaster it was. So Congress tried to make sure it would never happen again by creating a system of regulations and guarantees that provided a safety net for the financial system.

In recent years, the financial sector has increasingly found ways to evade those safeguards (generally with Washington's acquiescence) and a large portion of activity occurs outside of the commercial banking sector:

Wall Street chafed at regulations that limited risk, but also limited potential profits. And little by little it wriggled free — partly by persuading politicians to relax the rules, but mainly by creating a “shadow banking system” that relied on complex financial arrangements to bypass regulations designed to ensure that banking was safe.

For example, in the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages — with nary a regulator in sight.

As the years went by, the shadow banking system took over more and more of the banking business, because the unregulated players in this system seemed to offer better deals than conventional banks. Meanwhile, those who worried about the fact that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned.

In fact, however, we were partying like it was 1929 — and now it’s 1930.

The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren’t pulling cash out of banks to put it in their mattresses — but they’re doing the modern equivalent, pulling their money out of the shadow banking system and putting it into Treasury bills. And the result, now as then, is a vicious circle of financial contraction.

The Fed has responded by broadening its lender of last resort function to allow investment banks as well as commercial banks to borrow and to accept a wider range of securities (including mortgage backed securities) as collateral. The investment banks ("primary dealers") will be able to borrow from the new Primary Dealer Credit Facility (PDCF) - in essence, the Fed is opening the discount window to them. This comes in addition to the loans made available through the Term Securities Lending Facility (TSLF), announced the week before.

Although there are parallels with the banking crises of the 1930's, in the Times, Charles Duhigg explains that a repeat of the depression is unlikely. Partly this is because the structure of the economy has changed - in particular, government plays a much larger role in the economy now, acting as an "automatic stabilizer." Furthermore, economists (and policymakers) have learned some lessons, as evidenced the Fed's quick response (in his professor days, Ben Bernanke was a prominent scholar of the depression). [A minor factual error in the story: the highest unemployment rate of the postwar period was 10.8%, at the end of 1982].

Meanwhile, Congress is looking at updating regulation of the financial sector.