Mankiw on 'what Keynes would have done?'

Greg Mankiw explains Keynesian policy prescriptions in current situation --- Government now becomes the last resort to generate aggregate demand, but he is worried about the long-term impact of budget deficits; The Fed should have a bigger role to play and it has some secret weapons.  This is a must-read.

IF you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. His insights go a long way toward explaining the challenges we now confront.

According to Keynes, the root cause of economic downturns is insufficient aggregate demand. When the total demand for goods and services declines, businesses throughout the economy see their sales fall off. Lower sales induce firms to cut back production and to lay off workers. Rising unemployment and declining profits further depress demand, leading to a feedback loop with a very unhappy ending.

The situation reverses, Keynesian theory says, only when some event or policy increases aggregate demand. The problem right now is that it is hard to see where that demand might come from.

The economy's output of goods and services is traditionally divided into four components: consumption, investment, net exports and government purchases. Any expansion in demand has to come from one of these four. But in each case, strong forces are working to keep spending down.

CONSUMPTION The Conference Board reports that consumer confidence is near its record low. It is easy to understand why consumers are so scared. House values have declined, 401(k) balances have shrunk and unemployment is up. For many people, the sense of economic uncertainty is greater than they've ever experienced. When it comes to discretionary purchases, like a new home, a car, or a washing machine, wait-and-see is the most rational course.

A bit more saving is not entirely unwelcome. Many economists have long lamented the United States saving rate, which is low by international and historical standards.

For the overall economy, however, a recession is not the best time for households to start saving. Keynesian theory suggests a "paradox of thrift." If all households try to save more, a short-run result could be lower aggregate demand and thus lower national income. Reduced incomes, in turn, could prevent households from reaching their new saving goals.

INVESTMENT In normal times, a fall in consumption could be met by an increase in investment, which includes spending by businesses on plant and equipment and by households on new homes. But several factors are keeping investment spending at bay.

The most obvious is the state of the housing market. Over the past three years, residential investment has fallen 42 percent. With house prices continuing to decline, increased building of new homes is not likely to be a source of robust demand over the next few years.

Business investment has lately been stronger than residential investment, but it is unlikely to pick up the slack in the near future. With the stock market down, interest rates on corporate bonds up and the banking system teetering on the edge, financing new business projects will not be easy.

NET EXPORTS Not long ago, it looked as if the rest of the world would save the United States economy from a deep downturn. From March 2004 to March 2008, the dollar fell 19 percent against an average of other major currencies. By increasing the price of foreign goods in the United States and reducing the price of American goods abroad, this depreciation discouraged imports and bolstered exports. Over the last three years, real net exports have increased by about $250 billion.

In the coming months, however, the situation may well go into reverse. As the United States financial crisis has spread to the rest of the world, fast-moving international capital has been looking for a safe haven. Ironically, that haven is the United States. Since March, the dollar has appreciated 19 percent, a move that will put a crimp in the export boom.

GOVERNMENT PURCHASES That leaves the government as the demander of last resort. Calls for increased infrastructure spending fit well with Keynesian theory. In principle, every dollar spent by the government could cause national income to increase by more than a dollar if it leads to a more vibrant economy and stimulates spending by consumers and companies. By all reports, that is precisely the plan that the incoming Obama administration has in mind.

The fly in the ointment — or perhaps it is more an elephant — is the long-term fiscal picture. Increased government spending may be a good short-run fix, but it would add to the budget deficit. The baby boomers are now starting to retire and claim Social Security and Medicare benefits. Any increase in the national debt will make fulfilling those unfunded promises harder in coming years.

Keynesian economists often dismiss these long-run concerns when the economy has short-run problems. "In the long run we are all dead," Keynes famously quipped.

The longer-term problem we now face, however, may be more serious than any that Keynes ever envisioned. Passing a larger national debt to the next generation may look attractive to those without children. (Keynes himself was childless.) But the rest of us cannot feel much comfort knowing that, in the long run, when we are dead, our children and grandchildren will be dealing with our fiscal legacy.

So what is to be done? Many economists still hope the Federal Reserve will save the day.

In normal times, the Fed can bolster aggregate demand by reducing interest rates. Lower interest rates encourage households and companies to borrow and spend. They also bolster equity values and, by encouraging international capital to look elsewhere, reduce the value of the dollar in foreign-exchange markets. Spending on consumption, investment and net exports all increase.

But these are not normal times. The Fed has already cut the federal funds rate to 1 percent, close to its lower bound of zero. Some fear that our central bank is almost out of ammunition.

Fortunately, the Fed has a few secret weapons. It can set a target for longer-term interest rates. It can commit itself to keeping interest rates low for a sustained period. Most important, it can try to manage expectations and assure markets that it will do whatever it takes to avoid prolonged deflation. The Fed's decision last week to start buying mortgage debt shows its willingness to act creatively.

It is hard to say how successful monetary and fiscal policy will be in avoiding a deep downturn. But as events unfold, you can be sure that policymakers in the Fed and Treasury will be looking at them through a Keynesian lens.

In 1936, Keynes wrote, "Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slave of some defunct economist." In 2008, no defunct economist is more prominent than Keynes himself.

The return of Larry Summers

Take a deep look at Obama's economic policy from the viewpoints of his chief economic adviser: Larry Summers. (source: NYT)

Summers, Merton and Soros in one Panel

Panel discussion on the market, the current state of the economy, financial engineering and many interesting issues, including Larry Summers, Robert Merton and George Soros. 

Jeremy Grantham Interview

Interview of legendary investor, Jeremy Grantham:

2008: The most volatile market ever

This is from Bespoke:

Over the last 50 trading days, the average absolute daily percentage change of the S&P 500 has been...wait for it...3.82%!  That means the S&P 500 is averaging a daily move of up or down nearly 4%.  This is definitely one of the craziest statistics of the current bear market, and unfortunately, the majority of the daily moves have been down.  In the history of the S&P 500, there has never been a more volatile period.  Back in February of last year, the 50-day average absolute change was just 0.33%.  When we ever do get back to daily moves of less than 1%, traders are going to be falling asleep at their desks after going through this turmoil.

China's Steel Production

The slump in China's steel production, the first since 1995

Read more here (source: WSJ)

Wallet Biopsy

BW has an interesting story on how hospitals may be using your financial records against you.  Sometimes, a good credit score may hurt you.

Why don't 'we' see it coming?

Paul Krugman writes on NY Times:

Lest We Forget

By PAUL KRUGMAN

A few months ago I found myself at a meeting of economists and finance officials, discussing — what else? — the crisis. There was a lot of soul-searching going on. One senior policy maker asked, "Why didn't we see this coming?"

There was, of course, only one thing to say in reply, so I said it: "What do you mean 'we,' white man?"

Seriously, though, the official had a point. Some people say that the current crisis is unprecedented, but the truth is that there were plenty of precedents, some of them of very recent vintage. Yet these precedents were ignored. And the story of how "we" failed to see this coming has a clear policy implication — namely, that financial market reform should be pressed quickly, that it shouldn't wait until the crisis is resolved.

About those precedents: Why did so many observers dismiss the obvious signs of a housing bubble, even though the 1990s dot-com bubble was fresh in our memories?

Why did so many people insist that our financial system was "resilient," as Alan Greenspan put it, when in 1998 the collapse of a single hedge fund, Long-Term Capital Management, temporarily paralyzed credit markets around the world?

Why did almost everyone believe in the omnipotence of the Federal Reserve when its counterpart, the Bank of Japan, spent a decade trying and failing to jump-start a stalled economy?

One answer to these questions is that nobody likes a party pooper. While the housing bubble was still inflating, lenders were making lots of money issuing mortgages to anyone who walked in the door; investment banks were making even more money repackaging those mortgages into shiny new securities; and money managers who booked big paper profits by buying those securities with borrowed funds looked like geniuses, and were paid accordingly. Who wanted to hear from dismal economists warning that the whole thing was, in effect, a giant Ponzi scheme?

There's also another reason the economic policy establishment failed to see the current crisis coming. The crises of the 1990s and the early years of this decade should have been seen as dire omens, as intimations of still worse troubles to come. But everyone was too busy celebrating our success in getting through those crises to notice.

Consider, in particular, what happened after the crisis of 1997-98. This crisis showed that the modern financial system, with its deregulated markets, highly leveraged players and global capital flows, was becoming dangerously fragile. But when the crisis abated, the order of the day was triumphalism, not soul-searching.

Time magazine famously named Mr. Greenspan, Robert Rubin and Lawrence Summers "The Committee to Save the World" — the "Three Marketeers" who "prevented a global meltdown." In effect, everyone declared a victory party over our pullback from the brink, while forgetting to ask how we got so close to the brink in the first place.

In fact, both the crisis of 1997-98 and the bursting of the dot-com bubble probably had the perverse effect of making both investors and public officials more, not less, complacent. Because neither crisis quite lived up to our worst fears, because neither brought about another Great Depression, investors came to believe that Mr. Greenspan had the magical power to solve all problems — and so, one suspects, did Mr. Greenspan himself, who opposed all proposals for prudential regulation of the financial system.

Now we're in the midst of another crisis, the worst since the 1930s. For the moment, all eyes are on the immediate response to that crisis. Will the Fed's ever more aggressive efforts to unfreeze the credit markets finally start getting somewhere? Will the Obama administration's fiscal stimulus turn output and employment around? (I'm still not sure, by the way, whether the economic team is thinking big enough.)

And because we're all so worried about the current crisis, it's hard to focus on the longer-term issues — on reining in our out-of-control financial system, so as to prevent or at least limit the next crisis. Yet the experience of the last decade suggests that we should be worrying about financial reform, above all regulating the "shadow banking system" at the heart of the current mess, sooner rather than later.

For once the economy is on the road to recovery, the wheeler-dealers will be making easy money again — and will lobby hard against anyone who tries to limit their bottom lines. Moreover, the success of recovery efforts will come to seem preordained, even though it wasn't, and the urgency of action will be lost.

So here's my plea: even though the incoming administration's agenda is already very full, it should not put off financial reform. The time to start preventing the next crisis is now.

The End of an Era of the Wall Street

The era that defined Wall Street is finally, officially over. Michael Lewis, who chronicled its excess in Liar's Poker, returns to his old haunt to figure out what went wrong.

Tracking government bailout

NY Times details the government bailout plan so far.  I was stunned by the sheer amount the US government has committed.  History is in the making.  It'd better work; otherwise, huge budget deficits coupled with super easy monetary policy, it's not impossible that the dollar will eventually collapse, and the international monetary system will have to be revamped.


link to the graphical analysis

China looks attractive to fund managers

Source: Financial Times

China has become the top investment choice of emerging market funds and Asian investors in spite of the country's deteriorating economic outlook, according to a global survey of fund managers.

(graph courtesy of Bespoke)

A record 67 per cent of investors are overweight in Chinese equities relative to the total assets they have under management, compared with just 19 per cent of asset managers favouring China a year ago, the Merrill Lynch monthly survey showed.

This is an abrupt turnround from the situation three months ago when a majority of fund managers were underweight on China. The 149 fund managers questioned control $536bn of assets.

"China is the preferred market despite the collapse of growth expectations, because investors think the country still has lots of policy tools to support growth, and see it as less hard hit by the credit crunch," said Michael Hartnett, emerging markets equity strategist at Merrill.

On November 10, China unveiled a $586bn fiscal stimulus package aimed at boosting infrastructure growth and consumer spending in rural areas, where per capita income is still low.

However, the growth outlook for China is deteriorating, with a net 86 per cent of respondents expecting the Chinese economy to weaken in the next 12 months.

Mr Hartnett described the magnitude of China's slowdown as a "wild card" and said it was still unclear whether the country would face a hard or soft landing.

China is well placed to cash in on the collapse in commodities prices as it is a net importer of oil and has a strong currency. It has also been more insulated from the credit crunch than other parts of the world. "China is currently seen as the sole Asian beneficiary of policy stimulus and falling oil prices," Mr Hartnett said.

2008 Stock Market Crash

Forward-looking Protectionism?

Ha-Joon Chang defends trade protectionism, and he explains what he means by "forward looking protectionism".  If you ask my opinion: no matter what fancy term you came up, protectionism is still protectionism.  That's something we should best avoid talking about during the time of crisis, unless you want to have another Great Depression.   I haven't read Chang's book.  But simply linking Hamilton's merchanist policy in 19th century to the rise of US economy in modern times seems too suspicious to me.

The case for forward-looking protectionism in the US

By electing Barack Obama, US citizens have spoken – they not only want a more inclusive and less war-like country but one with different economic policies.

Many of Mr Obama's economic policies are unlikely to prove contentious. Few would argue against tighter financial regulation, given today's financial mess. Increased taxes for high-earners would be hard to oppose after the glaring absence of trickle-down from the Bush tax cuts – after all, the majority of the high-earners voted for him.

Mr Obama's trade policy, however, is already causing controversy. He has vowed to protect American jobs and even argued for re-negotiating the NAFTA. There is already some hand wringing among free-trade economists, worrying that his protectionist policies may destroy the world trading system in the same way the infamous Smoot-Hawley Tariffs of 1930 did after the Great Depression. They counsel that the US should maintain its historical commitment to free trade.
However, contrary to what most people think, the US is the true home of protectionism. Between the 1830s and the 1940s, against superior European competition, the US developed its industries behind literally the highest tariff wall in the world, with the average industrial tariff rate ranging between 35% and 55%. Even the Smoot-Hawley Tariffs were not an aberration – the average US industrial tariff in 1931 was, at 48%, well within the historical range.

Moreover, the theory that justified such protectionism, namely, the 'infant industry' argument, had been first developed by none other than the first Treasury Secretary of the US – Alexander Hamilton (that's the guy you see on the $10 bill). Hamilton argued that producers in relatively backward economies needed to be protected and nurtured through tariffs, subsidies, and other government policies before they mature and can compete with producers from more economically developed countries.

Of course, the protectionism that Mr Obama is advocating is protection to ease the adjustment of mature industries, rather than to promote infant industries. The case for such protectionism is not as overwhelming as that of infant industry protection. However, well-designed and time-bound protection of mature industries can facilitate, rather than hindered, trade adjustment and industrial upgrading. Japan and some European countries in the aftermath of the 1970s Oil Shocks come to mind.

Mr Obama should use protectionism in a similarly forward-looking way. Industries that can be revived through re-tooling of its factories and re-training of its workers should be given protection, but only if they fulfill certain conditions regarding investment and training. Industries that have no future should be given strictly temporary protection to ease phasing-out through orderly liquidation and redundancy.

A forward-looking protectionist strategy will also require a substantial strengthening of the welfare state in the US. A well-designed welfare state with good unemployment insurance and re-training programme can facilitate structural changes by reducing the resistance of the workers to more open trade that exposes them to greater risks. With such a welfare state, workers need not hold on to their current jobs, as it will help them maintain their standards of living during unemployment and find decent jobs in the future. Stronger welfare state is why the demand for protectionism is much weaker in the European economies than in the US, despite the greater acceptance of active role of the government in the former.

Keeping its market open is not enough for the US to play a genuinely positive role in the world trading system. The US should also stop pushing for trade liberalization in developing countries and give them the chance to use (intelligently-designed, of course) infant industry protection, which it invented and benefited so much from. Mr Obama should take a lead in creating a world trading system that allows asymmetric protectionism between the rich countries and the poor countries, with the latter protecting their markets more and gradually opening up in line with their economic development.

All these call for a much more activist role for the US government than it has been the norm. Providing protectionism to facilitate structural changes, and not just to protect existing jobs, would require a much closer coordination between trade policy and those policies to upgrade American industries, such as R&D support and worker training. Redesigning the welfare state as a vehicle to promote skills upgrading and labor mobility would push the US government into an uncharted territory.

These are big challenges. However, the US cannot continue its peculiar mixture of free-trade mythology and uncoordinated, 'reactive' protectionism that has served ordinary Americans and the developing nations so poorly.

Mr Obama has turned a new chapter in US history by becoming the country's first Afro-American president. He will turn a new chapter in world history if he can come up with a forward-looking protectionist strategy that that both protects American jobs better in the long run and help developing countries develop faster.

Ha-Joon Chang teaches economics at the University of Cambridge. He is the author of Bad Samaritans (Random House and Bloomsbury Press).

Bank Lending: Where is the clog?

WSJ questions the 'conventional wisdom' that banks are not lending in current crisis.

All around Washington, policy makers are scrambling to figure out how to get banks lending again. Lawmakers have criticized banks for not using new federal money to make loans and have threatened to place conditions on additional money. Regulators last week sent out a directive, encouraging banks not to hold back on lending.

But there's a flaw in that logic. Banks actually are lending at record levels. Their commercial and industrial loans, at $1.6 trillion in early November, were up 15% from a year earlier and grew at a 25% annual rate during the past three months, according to weekly Federal Reserve data. Home-equity loans, at $578 billion, were up 21% from a year ago and grew at a 48% annual rate in three months.

I pulled the data out from Federal Reserve. Below chart shows you what banks loans (industrial and commercial) look like (the blue line). The y-o-y change is still positive, well above 10%.

The real problem, according to WSJ, is the old loans got backstopped by banks and these revolving credit lines are crowding out new loans. Also in crisis, loans are not getting securitized due to the credit market turmoil (the red line in the chart above):

The point is that banks are being forced to act as backstops to a reeling financial system just as the banks, too, are vulnerable. Simply demanding they lend more misses the broader point of the role they're playing in the crisis, and how to manage it.

"They provide a measure of protection to vulnerable firms, helping them forestall financial distress." But there is a dangerous downside. During the boom, many of these credit lines were extended to firms with shaky prospects, like GM. Now, banks are on the hook to lend to them, often even if they don't want to. This is likely crowding out making new loans to healthier firms.

Crowding out is one problem. Another is the markets. During the boom, many bank loans were packaged into securities. With markets for those securities shut down, banks have lost this important escape valve for making new loans.

They further looked at new bank loans to large corporate borrowers -- the kinds of loans that typically get resold and packaged into securities. While overall banks' loan books are growing, this kind of lending, which used to get distributed among banks and other investors, fell by 46% in the August-to-October period from the same period a year earlier.

Testimony of High-flying Hedge Fund Managers

Links to the testimonies of last week:

George Soros of Soros Fund Management

James Simons of Renaissance Technologies

John Paulson of Paulson & Co.

Ken Griffin of Citadel

The Age of Aging

How does the demographics change the world economy? Is China ready for the aging society?  According to UBS' Magnus, the median age of China will be 47 in year 2040, that's 2 years older than the US. 

China's one-child policy is pushing China onto aging society faster.  China needs to establish its social security system sooner and at one point, the one-child policy also has to be abolished.

Listen to this interesting interview  (source: Bloomberg)

Charlie Rose with Bill Ackman

Charlie Rose's interview with Bill Ackman, hedge fund manager of Pershing Square Capital Management LP.  As usual, some really good stuff.

Cochrane: Time to buy stocks?

John Cochrane says stock is cheap at least as measured by dividend/price ratio, but you need to have the appetite for further downfall in the short term (source: wsj):

Cochrane may well be right, but judging by historical P/E ratio, it may be still too early to call the bottom.

chart via Mike Panzner

Financial Engineering vs. Real Engineering, Again

An update on my previous post on financial engineering vs. real engineering. Here is an interesting chart from MIT's Andrew Lo. We are likely to see a sharp convergence of the two lines (esp. the post grads) in coming years.

Paulson: We stabilized financial system

Henry Paulson interview on CNBC:

"I think the system has been stabilized.  I don't think people are going to bed at night wondering which major financial institution might have a problem."

Krugman says depression economics returns

Krugman writes on NY Times --- His central message: this ain't normal time, so extraordinary measures are needed:

To see what I'm talking about, consider the implications of the latest piece of terrible economic news: Thursday's report on new claims for unemployment insurance, which have now passed the half-million mark. Bad as this report was, viewed in isolation it might not seem catastrophic. After all, it was in the same ballpark as numbers reached during the 2001 recession and the 1990-1991 recession, both of which ended up being relatively mild by historical standards (although in each case it took a long time before the job market recovered).

But on both of these earlier occasions the standard policy response to a weak economy — a cut in the federal funds rate, the interest rate most directly affected by Fed policy — was still available. Today, it isn't: the effective federal funds rate (as opposed to the official target, which for technical reasons has become meaningless) has averaged less than 0.3 percent in recent days. Basically, there's nothing left to cut.

...

What does all this say about economic policy in the near future? The Obama administration will almost certainly take office in the face of an economy looking even worse than it does now. Indeed, Goldman Sachs predicts that the unemployment rate, currently at 6.5 percent, will reach 8.5 percent by the end of next year.

All indications are that the new administration will offer a major stimulus package. My own back-of-the-envelope calculations say that the package should be huge, on the order of $600 billion.

So the question becomes, will the Obama people dare to propose something on that scale?

Let's hope that the answer to that question is yes, that the new administration will indeed be that daring. For we're now in a situation where it would be very dangerous to give in to conventional notions of prudence.

History of Great Depression

PBS video archive has a good historical review of the Great Depression. Learning history is believed to help us avoid repeating the same mistakes...but I wonder how the history would really help if human beings tend to have a 'short memory' and their inherent greed/fear nature can never be rid of.

Becker: No Silver Lining in Depression

Gary Becker argues against the idea that a severe recession or depression may help cleanse the excesses in the economy as the "Austrian" school of economics would claim. He explains why depression should be avoided at all cost.

Some older theories of business cycles-usually associated with the "Austrian" school of economics- claimed that recessions and depressions were useful in helping to remove the poison from an economy that builds up during good times. For example, weaker companies are the first to go when the demand for an industry's product falls during recessions. Employees who are allowed a lot of slack during good times are forced to work harder during recessions in order to keep their jobs.

Positive effects such as these may be somewhat important during very mild downturns, but they are overwhelmed during major recessions and depressions by the negative effects. I define a "major" recession as having an extended period of unemployment rates at 9 percent or more, coupled with declining GDP. It looks like the US and the world economies may be headed for such a recession for the next year or so.

Economists have underplayed the cost to individuals of mild to severe recessions in part because they have neglected the cost of the "fear" generated by bad economic times. In his1932 inaugural address in the midst of the Great Depression Franklin Delano Roosevelt reassured he American public that the "Only Thing We Have to Fear Is Fear Itself". In fact they had a lot more to fear, but Roosevelt recognized the great importance of fear during depressions. In the present crisis too, consumers and workers have multiple fears due to various kinds of uncertainty. Homeowners fear that they may lose their homes after having used most of their savings as down payments on their homes. The employed fear that they will be laid off, while the unemployed fear that its duration will be quite long, and that they eventually will only get jobs that are much inferior to the ones they had. To be sure, some of the unemployed in many countries will receive unemployment compensation, but many unemployed American do not qualify for this benefit. Moreover, unemployed workers in this country usually receive much less than their earnings while employed, and after a while they run out of benefits, although benefits get extended during recessions.

The fear about losing one's job interacts with fears about being unable to make payments on homes, cars, and other consumer durables. Unemployed persons start missing payments on their homes or cars. If this goes on for several months, they may have their cars repossessed, and their homes put into foreclosure, usually at a time when home prices are down a lot, so that can at best regain only a fraction of the equity they put into their homes.

In addition, the burden of a major recession is not shared uniformly. It usually falls disproportionately on unskilled workers, the young, and those in shaky financial positions, which tend to be persons with lower educations and incomes. For example, the unemployment rate of high school dropouts is traditionally several times that of college graduates, so when the average unemployment rate goes from 6 to 9 percent, that of college graduates may rise to about 4 percent, while that of dropouts will increase to over 20 percent. This recession may be a bit different since the financial sector is being hit so hard. Individuals and families already in shaky circumstances get hit especially hard by major recessions.

It is relatively easy to measure what happens to the unemployment rate during recessions and its differential incidence among different groups, or the number of persons who drop out of the labor force because they despair of finding a job. One can also measure relatively accurately the effects on profits, wages, the path of GDP and personal incomes, and other important variables. It is far harder to measure precisely the effects of serious recessions on individual welfare and happiness. Surveys of reported happiness find that workers who become unemployed are less happy than they were, and persons whose incomes have fallen reported a decline in their happiness, at least initially. Divorce rates and even suicide rates also tend to rise during major recessions, as does crime, discrimination against minorities and immigrants, and pressure toward greater protectionism.

Relative to these major costs, the alleged benefits of a recession to the United States seem quite small, and some of them could also be costs on balance. For example, how many infrastructure projects can be undertaken when states are already running deficits, and face even larger ones in the coming months? The federal government will have a huge deficit during the next year, perhaps a trillion dollars, because of the $700 billion bailout, the stimulus package, and the expected sharp declines in tax revenues.

A serious recession will certainly lead to increased regulation of business and labor markets. Some greater regulation of financial markets would certainly be desirable, as I have argued in prior posts, but some of the likely new regulations will be harmful, such as greater protectionism, wage-type controls over income of top executives, higher taxes on capital gains, and others.

The decline in oil prices by over 50 percent to $60 or less a barrel will certainly help American consumers and companies since the US imports about 2/3 of the oil it uses. It is also helpful to American interests to have less revenue flowing to Venezuela, Russia, and some of the Middle Eastern countries. On the other hand, the US is a major exporter of grains and beef, and the decline in their prices will cause considerable problems for farmers. On balance, I believe the decline in commodity prices is a plus for the US, but not a huge one, especially if oil prices begin to rise sharply after the world recession is over.

A serious recession will further erode the pay and bonuses of top executives at financial and other companies, which many will be happy to see. Managers of mutual and hedge funds and investment banks may have been making much more money than is justified by their productivity, but surely the misery inflicted on the lesser skilled workers, low income families, poor homeowners, and other economically weaker groups is not worth any benefits from a sharp fall in the incomes of those at the top.

So my bottom line in discussing the question whether depressions have a silver lining is that any such lining is very thin and small compared to the major costs to households, workers, and small businessmen.

Moral hazard is everywhere

The recent plan to modify mortgage terms for people who can't pay may trigger bigger default as everybody wants to get a cut from the bailout (source: wsj)

Another day, another bailout: This time homeowners get to benefit from mortgage-modification programs, designed to stem the tide of foreclosures by making it easier for borrowers to stay current on their loans.

But the latest plans from Fannie Mae and Freddie Mac, joining banks such as J.P. Morgan Chase and Citigroup, hold plenty of risks.

Take investors in mortgage-backed securities. Modifications to mortgage holders' interest rates could leave some MBS holders with reduced interest payments. Forgiveness of principal, meanwhile, could lead to capital losses.

A bigger worry could be that these modification programs are too effective. In that case, "many current borrowers will wave the white flag of surrender and also try to get a modification," Rod Dubitsky, a senior strategist for asset-backed securities at Credit Suisse, wrote in a recent report.

The danger is that loan holders who otherwise could meet their payments would decide to fall behind to get their cut of the bailout. That could unleash a chain reaction that drives default rates even higher.

That means another dose of moral hazard. Federal officials stopped worrying months ago about that for companies, as they piled up bailout upon bailout to keep the financial system from collapsing. Now officials risk injecting warped incentives into the behavior of individuals.

If the programs take pressure off house prices, MBS holders and borrowers could both make out better than if there weren't any modifications.

But the financial crisis has shown time and again that it is tough to anticipate the unintended consequences resulting from attempts to quell the turmoil.

Watch this CNBC video to get more out of the modification plan.

Markowitz on thinking about portfolio theory in crisis

From Wall Street Journal. The highlights are mine.

The Father of Portfolio Theory on the Crisis

In the early 1950s, when young Harry Markowitz was looking for an area of economics to pursue, a chance encounter with a stockbroker in Chicago led him to apply a new logic about risk to what had been an investment industry based on touting individual stocks. He revolutionized the investing world by showing how to create diversified portfolios that reduce risk and maximize return.

Our current credit crisis arose from an imbalance of risk and return in portfolios of mortgage-backed and other debt securities, so it seems timely to ask the father of modern finance what went wrong and what to do about it.

Now 81 and still teaching and advising funds, Mr. Markowitz has good news and bad news. The bad news is that bailouts to restore liquidity aren't addressing the real problem. The good news is that once we have the information to measure the losses of bad risk-taking, markets will recover.

Mr. Markowitz doesn't excuse the financial engineers who bundled complex mortgage-based and other securities. They violated the first principle of his portfolio theory. "Diversifying sufficiently among uncorrelated risks can reduce portfolio risk toward zero," he says in an interview. "But financial engineers should know that's not true of a portfolio of correlated risks."

In traditional Markowitz-inspired investing, such as mutual funds and index funds, there is a discipline around variables such as asset classes and models of covariance. In contrast, collateralized mortgage obligations and related securities had no such discipline. These risks sank together. "Selling people what sellers and buyers don't understand," he says with understatement, "is not a good thing."

In a now-famous paper on portfolio selection in the Journal of Finance in 1952, Mr. Markowitz wrote that risks that are not correlated with one another work best, while investments that move together -- owning both Ford and GM -- are riskier. This idea, which seems obvious now, was so novel then that when Milton Friedman reviewed Mr. Markowitz's University of Chicago Ph.D. dissertation, he half-joked it couldn't lead to a degree in economics because the topic was not economics. Mr. Markowitz got the degree and in 1990 shared the Nobel Prize in economics for portfolio theory.

As with all new information tools at our disposal, applying portfolio theory to investing entails its share of trial and error. Mr. Markowitz admits some people might object to asking him how to repair the credit crisis. "You, Harry Markowitz, brought math into the investment process," he imagines some people thinking. "It is fancy math that brought on this crisis. What makes you think now that you can solve it?"

He draws a line between his portfolio theory and its later misapplication. "Not all financial engineering is always bad," he says, "but the layers of financially engineered products of recent years, combined with high levels of leverage, have proved to be too much of a good thing." In contrast, classic investment portfolios such as mutual funds and index funds continue to reduce risk.

In an essay recently posted on the Web site of Index Funds Advisors titled "What to Do About the Financial Transparency Crisis," Mr. Markowitz calls for urgency in addressing the underlying problem of mismatched securities. So long as there is continued "obscurity of billions of dollars of financial instruments," we run the risk of Japan-style stagnation. Banks there, with the support of the Ministry of Finance, refused to mark bad debts to market for a decade.

"Just as with all securities, the fundamental exercise of the analysis and understanding of the trade-off between risk and return has no shortcuts," Mr. Markowitz says. "Arbitrarily assigning expected returns absent an understanding of the risks of the securities is precisely how the economy arrived at this point."

Mr. Markowitz reckons it could take a year before we have the transparency we need. Assessing the value of mortgage-backed securities requires scrutinizing mortgages down to the level of individual ZIP Codes. "The valuation process will take as long as it takes, but it is the primary step toward effectively utilizing the very controversial bailout and avoiding the structural problem of a stagnant economy."

How to avoid more such crises? Politicians need to learn a lesson. "If the choice is requiring mortgages for people who don't qualify or keeping the banking system sound, we should learn to opt for sound banking every time," he says. Also, since "financial engineers seem to get their necks chopped off periodically," they shouldn't get bailed out when it happens.

The father of modern finance knows how badly correlated portfolios create risk instead of controlling risk. Mr. Markowitz deserves a hearing from policy makers for his insistence that they focus on restoring information and transparency to the credit markets, making losses clear and resetting prices accordingly. To put the issue in probability terms, the odds are between very remote and nonexistent that the economy can recover until these basic steps are taken.

Morgan Stanley says Euro breakup is not impossible but unlikely

Morgan Stanley entertains the possibility of a breakup of Euro.  Some good analysis.

Krugman defends FDR

Paul Krugman defends FDR and advises Obama to be bolder:

New Deal economics

Everybody's talking new New Deal these days — and, predictably, the FDR-haters are out in force, with all the usual claims about FDR having actually made the Great Depression worse. (To the right, way back when, FDR was "That Man." Now Obama is "that one." Interesting.)

Eric Rauchway is all over this. Basically, the anti-FDR argument on the data is based on (a) considering people employed by the WPA "unemployed" (even though they were getting paid, and building public works that are in use to this day) plus (b) always focusing on 1938 — the year in which the economy suffered a serious setback from the progress of the previous four years.

Let me offer two pictures, beyond what Eric provides, to clarify things.

First, here's real GDP (in logs) from 1929 to 1941, plus the trend. (That's to bypass the employment nonsense). You can see that the economy made up a lot of the output gap before the 1938 setback, but by no means all.

Now, you might say that the incomplete recovery shows that "pump-priming", Keynesian fiscal policy doesn't work. Except that the New Deal didn't pursue Keynesian policies. Properly measured, that is, by using the cyclically adjusted deficit, fiscal policy was only modestly expansionary, at least compared with the depth of the slump. Here's the Cary Brown estimates, from Brad DeLong:

Net stimulus of around 3 percent of GDP — not much, when you've got a 42 percent output gap. FDR might have been more of a Keynesian if Keynesian economics had existed — The General Theory wasn't published until 1936. Note in particular that in 1937-38 FDR was persuaded to do the "responsible" thing and cut back — and that's what led to the bad year in 1938, which to the WSJ crowd defines the New Deal.

Implications for Obama: be inspired by FDR, but don't imitate him slavishly. In particular, your economic policy should be bolder, not more cautious.

Setser: How Severe a slump in China?

Brad Setser wonders about the question that is on many China watcher's mind recently. This is an informative piece with a lot of useful links in the debate and a good read especially on the same day when China just announced its huge stimulus plan.

How severe a slump in China?

The US, UK, Eurozone and Japan all look to be in recessions. The US and Europe had been the main drivers of global demand growth – at least for finished goods. That is going to change.

Emerging economies that relied on a commodity windfall to support higher domestic spending and investment may also need to cut back. The windfall isn't what it once was. That also will cut into demand.

Emerging economies that relied on borrowing from the rest of the world to support high levels of domestic spending and investment also will be cutting back. They have been hit by the credit crunch.

China benefits from lower commodity prices. It has no need to borrow from the rest of the world to support high levels of domestic investment.

The world economy could really use a Chinese locomotive. But it increasingly doesn't look like it will get one. A recent Credit Suisse report noted that the latest purchasing managers survey suggests that China is about to enter a manufacturing recession. Export orders fell sharply – as one would expect. But import orders fell more. If that proves an accurate guide to China's demand for the world's goods and services, China won't be doing much to support global growth.

There has long been a rather sterile – at least in my view - debate over how much exports contributed to China's recent growth. It has long been clear that:

a) Most of China's growth didn't come from exports. It couldn't. Net exports almost never generate 10% growth on their own.

b) The absolute size of the contribution of net exports to China's growth was large. In 2005, 2006 and 2007 net exports added between 2 and 3 percentage points to China's growth. 

Net exports contributed positive to China's growth in the first half of the year. The World Bank expects that net exports will contribute around one and a half (1.5) percentage points to China's growth. Real export growth topped real import growth – though both slowed. 1.5% percentage points from net exports isn't bad. It is more than the US had gotten on average over the last seven quarters. Indeed, it is not all that different from the average contribution net exports have made to US growth in 2008.

The Chinese exporters who were doing well just weren't as vocal as the textile and toy producers who weren't. They also tend to be more capital-intensive and thus employ fewer people.  And despite all the (true) talk about the difficulties some Chinese exporters now face, net exports almost certainly contributed positive to China's growth in the third quarter. Real export growth in the third quarter (on a y/y basis) still exceeded real import growth. That is why China's nominal trade surplus was basically flat during the first three quarters of 2008 even though China was paying way more for its commodity imports.

The sharp contraction in US consumption, the rise in the yuan v the euro, Europe's own slowdown and the latest data from China suggests that real Chinese exports could soon fall. If net exports are contributing to growth, it will be from a fall in imports, not a rise in exports. That is sure to slow China's growth.

Absent the close to 3% contribution from net exports in the boom years, China's growth would have been a (respectable) 9% rather than above 11%. With a negative 3% contribution to growth during the boom (as is often the case), growth would have been close to 6%. And if net exports turn negative now China's growth clearly would slow sharply.

But the real key to forecasting China's future growth consequently is determining whether domestic consumption and above all investment will continue to grow strongly in the absence of strong export demand. Remember, over the past few years both domestic investment and exports increased rapidly. If they fall together as well, Chinese growth will slow quite significantly. And unfortunately the latest indicators seem to suggest that they are correlated; consequently domestic demand may fall along with exports.

That isn't good for anyone.

The (likely) fall in construction is particularly worrisome. China's new capital intensive export sectors haven't been huge job generators. Building buildings by contrast employs lots of people – including a lot of migrants from rural areas.

Chinese policy makers recognize that China's economy is slowing. They are trying to stimulate the economy in a host of ways. Loan limits have been lifted (and amusingly, their presence was only formally acknowledged when they were lifted). New infrastructure projects have been announced. Useful (though tardy) steps are being taken to improve China's social safety net. It just isn't clear if they will be powerful enough to offset a smaller contribution from net exports and a (likely) slowdown in investment.

I should note that China is also taking steps to promote exports, notably by increasing its export rebates. That is far less helpful to the global economy.

If the signs from China continue to point to a sharp slowdown, all the large parts of the global economy may enter into a slump at the same time. That isn't good.

A final point: it is often argued that China needs rapid growth in order to generate jobs, and consequently 6-8% growth doesn't cut it. That is only partially true. A lot depends on the composition of growth. Recent Chinese growth has been capital not job intensive, so very rapid growth hasn't translated into rapid job growth. If China shifted the basis of its growth, it might be able to generate more jobs even if the overall pace of growth changes. The risk though is that China won't change the basis of its growth – so slower growth will mean fewer jobs. But we shouldn't lose sight of the fact that it is unusual for a country growing at 5-6% not to be able to generate strong job growth.

The Economist has long argued that a) the RMB wasn't undervalued and b) net exports were not driving China's growth. It certainly has been true that domestic demand mechanically accounted for more of China's growth than net exports. But it also has been the case that the acceleration of China's growth over the last five years has been driven by an increase in the contribution of domestic investment and net exports to China's growth. China's current account surplus rose from around 3% of China's GDP to around 11% of China's GDP in 2007.

As Nouriel Roubini notes, exports are now about 40% of China's GDP. As importantly, the Chinese value-added in Chinese exports has increased; I have estimated that the value added in China's export sector is now close to 20% of China's GDP. Gross US exports are less than 15% of US GDP — and since some US exports (think Boeing planes) have substantial imported content, US value-added would certainly be less than that. As a result, China is quite exposed — for a large and diverse economy — to swings in the global economic cycle.

Moreover, China's own property cycle seems to be swing from boom to bust at the wrong time. So it is possible that China's real exports, investment in the export sector and investment in urban property (construction is a big source of jobs) could all slow in a synchronized way. That is what worries most China watchers right now — the possibility that exports and the main driver of China's domestic demand growth will fall together, leading to a much larger and sharper swing in China's growth than most anticipated a few months ago.

China to stimulate economy with $586 billion

Facing global economic slowdown, China outlined a bold stimulus plan on Sunday (source: WSJ):

China's government announced a two-year stimulus exceeding a half-trillion dollars to offset the impact of slowing global growth and unlock the spending power of its vast population.

Premier Wen Jiabao's cabinet set plans for 4 trillion yuan, or $586 billion, in spending and stimulus measures through the end of 2010 aimed specifically to target people's livelihood, the official Xinhua News Agency said Sunday night.

It was unclear how much the plan, which will target 10 areas from rural infrastructure to low-cost housing, represents new spending and how quickly it can stimulate domestic demand.

The government also will adopt an "active" fiscal policy -- meaning it will spend money and cut taxes -- while the central bank will set a "moderately easy" tone that appears to signal further interest rate cuts and efforts to make banks boost lending, Xinhua said.

China's economy grew at the slowest rate in five years in the third quarter, slipping to 9% from the year before.

China has joined international calls to address faltering global business and consumer confidence, announcing plans that President Hu Jintao will visit Washington this week to meet other world leaders, including U.S. President-elect Barack Obama.

Economists say that while China remains a hopeful source of global growth, its momentum is pulling back more quickly than anticipated. Property prices are under downward pressure, factories are closing as export orders dry up and foreign direct investment is being called into doubt.

As demand in its major export markets falls, many agree on the need to stimulate spending by China's consumers, unlocking their $4 trillion in savings. A particular concern are the hundreds of millions of people in China's countryside, where the government appears particularly determined to boost spending power and has, for instance, already lifted grain purchase prices.

In Sunday's statement, the government said that among its earmarks will be money for transportation networks, ecology, technical innovation and post-disaster reconstruction. Few specific details on the spending plans were immediately announced.

Other measures include a restructuring of value-added taxes that Xinhua said will reduce business taxes by 120 billion yuan annually. The government will also look for banks to boost lending, removing a government-set lending ceiling and encouraging them to offer credit to smaller businesses, rural borrowers, technical innovators and buyout-oriented firms.

Bold action from Beijing isn't unexpected. The government has in recent months reversed course by slashing interest rates, pouring money into ailing stocks, giving developers leeway to build.

What had been missing in Beijing's aggressive policy mix so far, according to a report last week by JP Morgan, was a "big announcement."

Many economists have been looking for Beijing to unveil a big stimulus package similar to the one it relied on during the Asian Financial Crisis more than a decade ago. Then, Beijing issued massive amounts of domestic bonds to pay to extend highways, repair airports and build ports, a program that was deemed a strong success.

Just a year ago, China had adopted an unprecedented "tight" monetary policy, a step up in its three-year effort to keep the fast-growing economy from barreling out of control because it was expanding too quickly.

Five Myths about Great Depression

Five misconceptions on the Great Depression (source: WSJ):

Five Myths About the Great Depression

The current financial crisis has revived powerful misconceptions about the Great Depression. Those who misinterpret the past are all too likely to repeat the exact same mistakes that made the Great Depression so deep and devastating.

Here are five interrelated and durable myths about the 1929-39 Depression:

- Herbert Hoover, elected president in 1928, was a doctrinaire, laissez-faire, look-the-other way Republican who clung to the idea that markets were basically self-correcting. The truth is more illuminating. Far from a free-market idealist, Hoover was an ardent believer in government intervention to support incomes and employment. This is critical to understanding the origins of the Great Depression. Franklin Roosevelt didn't reverse course upon moving into the White House in 1933; he went further down the path that Hoover had blazed over the previous four years. That was the path to disaster.

Hoover, a one-time business whiz and a would-be all-purpose social problem-solver in the Lee Iacocca mold, was a bowling ball looking for pins to scatter. He was a government activist fixated on the idea of running the country as an energetic CEO might run a giant corporation. It was Hoover, not Roosevelt, who initiated the practice of piling up big deficits to support huge public-works projects. After declining or holding steady through most of the 1920s, federal spending soared between 1929 and 1932 -- increasing by more than 50%, the biggest increase in federal spending ever recorded during peacetime.

Public projects undertaken by Hoover included the San Francisco Bay Bridge, the Los Angeles Aqueduct, and Hoover Dam. The Republican president won plaudits from the American Federation of Labor for his industrial policy, which included jawboning business leaders to refrain from cutting wages as the economy fell. Referring to counteracting the business cycle and propping up wages, Hoover said: "No president before has ever believed that there was a government responsibility in such cases . . . we had to pioneer a new field." Though he did not coin the phrase, Hoover championed many of the basic ideas -- such as central planning and control of the economy -- that came to be known as the New Deal.

- The stock market crash in October 1929 precipitated the Great Depression. What the crash mainly precipitated was a raft of wrongheaded policies that did major damage to the economy -- beginning with the disastrous retreat into protectionism marked by the passage of the Smoot-Hawley tariff, which passed the House in May 1929 and the Senate in March 1930, and was signed into law by Hoover in June 1930. As prices fell, Smoot-Hawley doubled the effective tariff duties on a wide range of manufactures and agricultural products. It triggered the beggar-thy-neighbor policies of countervailing tariffs that caused the international economy to collapse. Some have argued that the increasing likelihood that the Smoot-Hawley tariff would pass was a major contributing factor to the stock-market collapse in the fall of 1929.

- Where the market had failed, the government stepped in to protect ordinary people. Hoover's disastrous agricultural policies involved the know-it-all Hoover acting as his own agriculture secretary and in fact writing the original Agricultural Marketing Act that evolved into Smoot-Hawley. While exports accounted for 7% of U.S. GDP in 1929, trade accounted for about one-third of U.S. farm income. The loss of export markets caused by Smoot-Hawley devastated the agricultural sector. Following in Hoover's footsteps, FDR concentrated on trying to raise farm income by such tactics as setting quotas on production and paying farmers to remove acreage from production -- even though this meant higher prices for hard-pressed consumers and had the effect of both lowering productivity and driving farmers off their land.

- Greed caused the stock market to overshoot and then crash. The real culprit here -- as in the housing bubble in our own time -- is the one identified by the economic historian Charles Kindleberger in the classic book "Manias, Panics, and Crashes": a speculative fever induced by excessively easy credit and broken by the inevitable return to more realistic valuations.

In the late 1920s, cheap and easy money fueled a tremendous increase in margin trading and a proliferation of "investment trusts" that offered little in the way of dividends or demonstrable earnings per share, but still promised phenomenal capital gains. "Speculation," as Kindleberger neatly defined it, "involves buying for resale rather than use in the case of commodities, and for resale rather than income in the case of financial assets."

The last thing Hoover wanted to do upon coming to office was to rein in the stock market boom by allowing interest rates to rise to a more normal level. The key to prosperity, in his view, lay not in sound money and rising productivity, but in letting the good times roll -- through government action aimed at maintaining high wages and high stock market valuations.

- Enlightened government pulled the nation out of the worst downturn in its history and came to the rescue of capitalism through rigorous regulation and government oversight. To the contrary, the Hoover and Roosevelt administrations -- in disregarding market signals at every turn -- were jointly responsible for turning a panic into the worst depression of modern times. As late as 1938, after almost a decade of governmental "pump priming," almost one out of five workers remained unemployed. What the government gave with one hand, through increased spending, it took away with the other, through increased taxation. But that was not an even trade-off. As the root cause of a great deal of mismanagement and inefficiency, government was responsible for a lost decade of economic growth.

Hoover was destined to fill the role of the left's designated scapegoat. Despite that, the one place where he and FDR truly "triumphed" was in enlisting the support of leading writers and intellectuals for government planning and intervention. This had a lasting effect on the way that generations of people think about the Great Depression. The antienterprise spirit among thought leaders of this time (and later) extended to top business publications. "Do you still believe in Lazy-Fairies?" Business Week asked derisively in 1931. "To plan or not to plan is no longer the question. The real question is who is to do it?"

In his economic policies and his incessant governmental activism, Hoover differed far more sharply with his Republican predecessor than he did with his Democratic successor. Calvin Coolidge, president from 1923 to 1929, made no secret of his disdain for Hoover, who served as his secretary of commerce and won praise from such highly regarded liberals as John Maynard Keynes and Jean Monnet. "That man has offered me unsolicited advice for six years, all of it bad," Coolidge said. He mockingly referred to Hoover as "Wonder Boy."

With the vitality of U.S. and world economies at stake, it is essential that the decisions of the coming months are shaped by the right lessons -- not the myths -- of the Great Depression.

Mr. Wilson, a former Business Week bureau chief, is a writer based in St. Louis.

 

Shiller: Worst time yet to come

Bob Shiller gives us a grim yet realistic picture of what lies ahead of us:


(click to play the video)

Black Swan Author put his words into actions

Taleb set up a fund based on the ideas outlined in his popular book "Black Swan". So far he fetched huge investment return in October.

 

For most of October, it seemed nearly everything that could go wrong with the markets did. But the rout turned into a jackpot for author and investor Nassim Nicholas Taleb.

Mr. Taleb last year published "The Black Swan," a best-selling book about the impact of extreme events on the world and the financial markets. He also helped start a hedge fund, Universa Investments L.P., which bases many of its strategies on themes in the book, including how to reap big rewards in a sharp market downturn. Like October's.

Nassim Nicholas Taleb

 

Separate funds in Universa's so-called Black Swan Protection Protocol were up by a range of 65% to 115% in October, according to a person close to the fund. "We're discovering the fragility of the financial system," said Mr. Taleb, who says he expects market volatility to continue as more hedge funds run into trouble.

A professor of mathematical finance at New York University, Mr. Taleb believes investors often ignore the risk of extreme moves in the market, especially when times are good and volatility is low, as it was for several years leading up to the current turmoil. "Black swan" alludes to the belief, once widespread, that all swans are white -- a notion that was proven false when European explorers discovered black swans in Australia. A black-swan event is something that is highly unexpected.

Assets under management at Universa have neared $2 billion since the fund launched early last year with $300 million under management. While Mr. Taleb frequently consults with Universa's traders, the Santa Monica, Calif., fund is owned and managed by Mark Spitznagel, who worked for several years in the 1990s as a pit trader on the Chicago Board of Trade.

To execute its strategy, Universa buys far-out-of-the-money "put" options on stocks and stock indexes. These are bets that the market will see a sharp, sudden downturn. They become extremely valuable in a market decline of 20% or more in a one-month period.

When times are good, such options are cheap and Universa gobbles them up, taking small losses along the way. When the market makes a quick, steep turn south, as it has recently, Universa's positions gain value as investors scramble to protect themselves in the downturn by buying puts. The strategy, which keeps more than 90% of assets in cash or cash equivalents such as Treasury bonds, either breaks even or loses small amounts in most months while waiting for periodic, infrequent spikes in volatility.

Here's an example of a trade the fund made recently. In late September, when the Standard & Poor's 500-stock index was trading around 1200, Universa purchased put options that would pay off if the index fell to 850 by late October. Since such a plunge was considered highly unlikely, such options cost only 90 cents. On Oct. 10, those options cost $60 as the S&P 500 tumbled sharply. Universa sold most of its position in the high-$50 range.

Universa also purchased a number of puts on financial stocks, such as Goldman Sachs Group Inc. In late July, it paid $1.29 apiece for options on American International Group Inc., the insurance giant that by September was on the brink of bankruptcy. The puts were priced to pay off if AIG dipped below $25 a share by September. Universa eventually sold them for about $21 apiece.

The fund has "done what it was supposed to do for us," says John Salib, a partner at Landmark Advisors, a New York fund that invests in other hedge funds and that invested in Universa in July. "We wanted to protect our portfolio against this kind of environment."

Mr. Taleb made his first killing on Black Monday, the crash of Oct. 19, 1987, as a trader with the investment bank First Boston (now a part of Credit Suisse), with a large position in out-of-the-money Eurodollar contracts. Investors fled into the highly liquid contracts as the market crashed, causing their value to surge.

While the black-swan strategy has paid off handsomely this year, it hasn't always. Mr. Taleb's previous fund, Empirica Capital, which used similar tactics, shut down in 2004 after several years of lackluster returns amid a period of low volatility. The strategy may face another test after the current bout of market turmoil.

The task for the fund's managers is to persuade clients to stick around after their big gains. Historically, such dramatic downturns have been rare events, occurring only once or twice a decade.

Mr. Spitznagel cautions against optimism. "You could say that so much value has been destroyed that there just isn't much left," he said. That is "a dangerous assumption, since things can always get worse."

Asian Monetary Fund?

Is IMF still relevant, even in the time of crisis, to Asian economies? The Journal ponders the possibility of AMF.

Asia's finance ministers are getting a little cozier.

After nearly a decade of scant progress on regional support systems, governments are making plans to shore up defenses against a fast-worsening global economic crisis.

Already planned is an $80 billion pool of reserves against which central banks can borrow. China, South Korea, and Japan would contribute 80% of that, with the rest coming from the 10 members of the Association of Southeast Asian Nations.

Bilateral deals are in the works as well. South Korea's central bank is working to expand a currency swap deal with China which, according to Korean press reports, could equal one in place with the U.S. Federal Reserve.

The talks showcase Asia's collective financial strength, a gargantuan $4.4 trillion worth of foreign exchange reserves, and have some wondering if the natural extension of this cooperation isn't the creation of a regional alternative to the International Monetary Fund.

Skepticism about what's dubbed the Asian Monetary Fund is warranted. This is an old idea, floated ten years ago by the likes of Eisuke Sakakibara, then Japan's vice finance minister for international affairs. Mr. Sakakibara renewed that call this week.

But there are a few reasons this idea could get more traction than it has in the past, not the least of which is the credit crunch.

The IMF may find itself unable to swat down the idea as it did when the economic crisis was of Asia's own making. The body is adamant that its $200 billion war chest is ample, but Ukraine, Hungary and Iceland are already asking for its help and a wave of problems in the Baltic states could stretch its resources further.

Asian leaders still cringe at the thought of the IMF's one-size-fits-all austerity programs of a decade ago. Pakistan, for one, approached China before starting serious talks on aid with the IMF.

China would certainly play a key role in any pan-Asian initiative in ways it doesn't at the IMF. There, Belgium and the Netherlands together have more votes than China does.

China and Taiwan allow direct shipping links

The Journal reports:

China and Taiwan signed a pact to sharply expand flights between them and allow direct shipping links for the first time, largely erasing some of the biggest remaining obstacles to full business ties between the longtime rivals.

The agreement highlights the determination of leaders in both Taiwan and China to improve relations since Taiwanese President Ma Ying-jeou took office in May after running on a platform of normalizing economic relations with China. Mr. Ma has come under heavy criticism from some in Taiwan for that policy, as the island's economy has weakened despite the moves to open to China's large economy.

Negotiators from Taiwan and China on Tuesday agreed to allow a total of 108 round-trip passenger flights between their cities each week, up from 18 round-trip flights currently. And they will allow 60 cargo flights a month, the first time that goods will be able to travel nonstop between Taiwan and China, despite bilateral trade that has grown rapidly in recent years.

Bob Shiller on why it's so difficult to challenge the crowd

Bob Shiller tells his personal story of why many people knew the bubble coming but still yielded to the 'consensus' view.  A delightful reading from NYT.

Challenging the Crowd in Whispers, Not Shouts

ALAN GREENSPAN, the former Federal Reserve chairman, acknowledged in a Congressional hearing last month that he had made an "error" in assuming that the markets would properly regulate themselves, and added that he had no idea a financial disaster was in the making. What's more, he said the Fed's own computer models and economic experts simply "did not forecast" the current financial crisis.

Mr. Greenspan's comments may have left the impression that no one in the world could have predicted the crisis. Yet it is clear that well before home prices started falling in 2006, lots of people were worried about the housing boom and its potential for creating economic disaster. It's just that the Fed did not take them very seriously.

For example, I clearly remember a taxi driver in Miami explaining to me years ago that the housing bubble there was getting crazy. With all the construction under way, which he pointed out as we drove along, he said that there would surely be a glut in the market and, eventually, a disaster.

But why weren't the experts at the Fed saying such things? And why didn't a consensus of economists at universities and other institutions warn that a crisis was on the way?

The field of social psychology provides a possible answer. In his classic 1972 book, "Groupthink," Irving L. Janis, the Yale psychologist, explained how panels of experts could make colossal mistakes. People on these panels, he said, are forever worrying about their personal relevance and effectiveness, and feel that if they deviate too far from the consensus, they will not be given a serious role. They self-censor personal doubts about the emerging group consensus if they cannot express these doubts in a formal way that conforms with apparent assumptions held by the group.

Members of the Fed staff were issuing some warnings. But Mr. Greenspan was right: the warnings were not predictions. They tended to be technical in nature, did not offer a scenario of crashing home prices and economic confidence, and tended to come late in the housing boom.

A search of the Federal Reserve Board's working paper series reveals a few papers that touch on the bubble. For example, a 2004 paper by Joshua Gallin, a Fed economist, concluded: "Indeed, one might be tempted to cite the currently low level of the rent-price ratio as a sign that we are in a house-price 'bubble.'" But the paper did not endorse this view, saying that "several important caveats argue against such a strong conclusion and in favor of further research."

One of Mr. Greenspan's fellow board members, Edward M. Gramlich, urgently warned about the inadequate regulation of subprime mortgages. But judging at least from his 2007 book, "Subprime Mortgages," he did not warn about a housing bubble, let alone that its bursting would have any systemic consequences.

From my own experience on expert panels, I know firsthand the pressures that people — might I say mavericks? — may feel when questioning the group consensus.

I was connected with the Federal Reserve System as a member the economic advisory panel of the Federal Reserve Bank of New York from 1990 until 2004, when the New York bank's new president, Timothy F. Geithner, arrived. That panel advises the president of the New York bank, who, in turn, is vice chairman of the Federal Open Market Committee, which sets interest rates. In my position on the panel, I felt the need to use restraint. While I warned about the bubbles I believed were developing in the stock and housing markets, I did so very gently, and felt vulnerable expressing such quirky views. Deviating too far from consensus leaves one feeling potentially ostracized from the group, with the risk that one may be terminated.

Reading some of Mr. Geithner's speeches from around that time shows that he was concerned about systemic risks but concluded that the financial system was getting "stronger" and more "resilient." He was worried about the unsustainability of a low savings rate, government deficit and current account deficit, none of which caused our current crisis.

In 2005, in the second edition of my book "Irrational Exuberance," I stated clearly that a catastrophic collapse of the housing and stock markets could be on its way. I wrote that "significant further rises in these markets could lead, eventually, to even more significant declines," and that this might "result in a substantial increase in the rate of personal bankruptcies, which could lead to a secondary string of bankruptcies of financial institutions as well," and said that this could result in "another, possibly worldwide, recession."

I distinctly remember that, while writing this, I feared criticism for gratuitous alarmism. And indeed, such criticism came.

I gave talks in 2005 at both the Office of the Comptroller of the Currency and at the Federal Deposit Insurance Corporation, in which I argued that we were in the middle of a dangerous housing bubble. I urged these mortgage regulators to impose suitability requirements on mortgage lenders, to assure that the loans were appropriate for the people taking them.

The reaction to this suggestion was roughly this: yes, some staff members had expressed such concerns, and yes, officials knew about the possibility that there was a bubble, but they weren't taking any of us seriously.

I BASED my predictions largely on the recently developed field of behavioral economics, which posits that psychology matters for economic events. Behavioral economists are still regarded as a fringe group by many mainstream economists. Support from fellow behavioral economists was important in my daring to talk about speculative bubbles.

Speculative bubbles are caused by contagious excitement about investment prospects. I find that in casual conversation, many of my mainstream economist friends tell me that they are aware of such excitement, too. But very few will talk about it professionally.

Why do professional economists always seem to find that concerns with bubbles are overblown or unsubstantiated? I have wondered about this for years, and still do not quite have an answer. It must have something to do with the tool kit given to economists (as opposed to psychologists) and perhaps even with the self-selection of those attracted to the technical, mathematical field of economics. Economists aren't generally trained in psychology, and so want to divert the subject of discussion to things they understand well. They pride themselves on being rational. The notion that people are making huge errors in judgment is not appealing.

In addition, it seems that concerns about professional stature may blind us to the possibility that we are witnessing a market bubble. We all want to associate ourselves with dignified people and dignified ideas. Speculative bubbles, and those who study them, have been deemed undignified.

In short, Mr. Janis's insights seem right on the mark. People compete for stature, and the ideas often just tag along. Presidential campaigns are no different. Candidates cannot try interesting and controversial new ideas during a campaign whose main purpose is to establish that the candidate has the stature to be president. Unless Mr. Greenspan was exceptionally insightful about social psychology, he may not have perceived that experts around him could have been subject to the same traps.

Robert J. Shiller is professor of economics and finance at Yale and co-founder and chief economist of MacroMarkets LLC.

Wage increase and China's surplus labor

This article from Economist magazine offers some good counter-arguments to the misguided view that China is running out of it's surplus labor (or cheap labor in mass media) as reports spread that factories in coastal China were finding it difficult to find workers even with wage increase (this was before the current global economic slowdown):

Reserve army of underemployed


Is China's pool of surplus labour drying up?

WHAT is the single most important price in the world? Popular answers are the price of oil, American interest rates or the dollar. Yet Chinese wages are, arguably, more important. China has by far the world's biggest labour force, of around 800m—almost twice that of America, the European Union and Japan combined. Thus recent claims that it is running short of cheap labour would, if true, have huge consequences not just for China, but also for the rest of the world.

A seemingly unlimited supply of cheap workers has been one of the main forces behind China's rapid economic growth. But over the past couple of years, factory owners have complained of labour shortages and wages have risen more rapidly, leading some to conclude that China's "surplus" labour has been used up. The country's one-child policy, introduced in 1979, has caused the growth in its labour supply to slow sharply (see chart). After rising by 1.3% a year during the decade to 2005, the population of working age is expected to increase at an annual rate of 0.7% until 2015, and then shrink by 0.1% a year until 2025. At the same time, the shift of workers from agriculture to industry, which has been an important source of productivity gains, will also slow. Jonathan Anderson, an economist at UBS, reckons that these two trends will reduce China's sustainable growth rate from 9-9.5% today to 7-7.5% by 2025.

But as well as boosting growth, the flow of workers from farms to factories has held down manufacturing wages—not only in China, but also throughout the world. The theory behind this was first expounded by Sir Arthur Lewis, an economist from St Lucia, who won the Nobel prize for economics in 1979. He argued that a developing country with "surplus" (ie, underemployed) rural labour could expand industrial employment for many years without causing wage inflation, because employers enjoy such a large supply of labour. During the first 50 years of Britain's industrial revolution, real wages remained more or less flat while profits soared. Likewise in China, as millions of migrants have quit the countryside for urban factories and construction sites, the real wages of low-skilled workers barely rose during the 1980s and 1990s, despite big productivity gains; only recently have they increased rapidly.

This acceleration of wages has prompted some to conclude that China's surplus labour in the countryside has been used up. Last year Cai Fang, the director of the Institute of Population and Labour Economics at the Chinese Academy of Social Sciences, argued that China has reached the "Lewis turning point". By 2009, he predicted, there would be a widespread shortage of workers, pushing up industrial wages. Does this mean the death of China's growth model?

As so often in China, this debate is clouded by the poor data. Until recently, most estimates of surplus labour varied between 150m and 200m people. But the true figure is probably much smaller, because government figures for the rural labour force include millions of migrants who have already moved to cities and others who work in rural industry, not farming.

In addition the population is ageing: the number of workers aged between 20 and 29 fell from 233m in 1990 to 165m in 2005. Many textile and electronics firms hire only young women in their 20s, as they are thought to be less troublesome and more willing to work long hours. Construction firms favour young single men. Older people are not only less employable, but they are also typically less willing to migrate if they have children. After taking account of this, Mr Cai estimates that China's surplus labour has been virtually exhausted.

But Stephen Green, an economist at Standard Chartered, thinks that talk of China's vanishing labour surplus is premature. In a report this year he argued that the surplus would not run out for another decade. Although the number aged between 20 and 29 fell over the past decade, their ranks are now rising again. Using the 2005 census, Mr Green estimates that the 20-something group will increase by a third in the ten years to 2015, as baby-boomers' children join the workforce (see right-hand chart); only then will it start shrinking sharply.

What is more, the recent spurt in urban wages is not necessarily proof that the surplus has gone. Mr Green argues that to attract migrant workers, urban employers have to pay more than rural income, which has increased in recent years, thanks to government policies and higher food prices. The temporary increase in the age group between 20 and 29 over the next few years will also ease the upward pressure on urban pay.

Go East, young women

The World Bank agrees that China's labour surplus has not yet run out. Even when the number of young people drops, the labour supply is determined by more than demographics. Migrant workers are usually excluded from urban social-security schemes and have to pay more for education and health care. The bank suggests that phasing out the household-registration system would encourage more people to move to the city. Vocational training for rural residents aged over 30 would equip them better for jobs in industry. And financial incentives to encourage workers to retire later could also boost the labour supply: only 60% of men and 30% of women aged over 50 have jobs.

Moreover, Mr Cai's estimate of China's labour surplus assumes that 180m workers, or 24% of total employment, are needed for farming. But that is based on today's agriculture. Mechanisation and the consolidation of land plots will boost productivity, meaning that fewer farmers will be needed. That will in turn release more workers for industry. In developed countries only 3% of workers till the land.

China's surplus labour will eventually dry up, but it still seems some years away. In any case, that moment should be cause for cheer not fear in China and elsewhere, because it will lead to bigger gains in income and consumption. That, after all, is the whole point of development.