Thursday, April 30, 2009

Read the tea leaves of the economy

Milken Institute panel on the current state of the economy and where the market is headed. Highly worth watching. Panelists include Meredith Whitney (one of the best banking analysts), Rebecca Patterson (JP Morgan), David Soloman (Goldman Sachs).

Read the tea leaves...

China's jobless migrant workers reaches 30m

According to BoFIT:

As many as 30 million migrant workers now out of work. At the end of January, the official estimate for the number of unemployed migrant workers was about 23 million. Last week, the deputy head of the Chinese State Council's Development & Research Center said the actual amount is now about 30 % higher. Estimates of the size of the pool of migrant workers also vary. The government recently increased its estimate from 130 million people to about 225 million, of which 13 % are thought to be jobless at the moment. Some 14 million migrant workers who recently lost their jobs have apparently decided to remain in their rural home districts after returning home to cele-brate this year's Chinese New Year holiday rather than struggle to find new work in the cities.

China's official unemployment rate, which does not count unemployed country-dwellers, is still a relatively modest 4.3 %. The official unemployment rate, however, has been rising since the fourth quarter of 2008 with the slowdown in economic growth and factory closings. The government still says it wants to keep the official unem-ployment rate below 4.6 % in 2009 and has targeted the creation of 9 million new jobs by the end of the year. In the first three months of this year, an estimated 2.7 million new jobs have been created, about 12 % less than in the same period in 2008. Even so, the current rate of job crea-tion is more than 50 % higher than the rate of job creation 4Q08. China's official unemployment numbers are gener-ally considered unreliable; some estimates put China's unemployment rate in recent months at around 10 %.
Labour market disputes (e.g. due to unpaid wages) are on the increase. Almost 100,000 civil claims were filed in the first quarter, a nearly 60 % jump from 1Q08.

Poll: Will Ken Lewis be out?

Wednesday, April 29, 2009

A new era of thrift

Call it the new frugality. Americans are spending less and saving more. Is this a temporary move and a generational change? It is believed that the great expansion of consumer credit since early 80s will not come back and personal saving rate will have to go back to the pre-boom level, averaged at 10%. To remind you the personal saving rate was negative a few years ago.

Let's first look at the history of personal saving rate in the US:

Then here is a graph of consumption as percentage of GDP over the years:

Finally, listen to this intelligent discussion on the New Shrift in America from On Points.

Tuesday, April 28, 2009

These Zombie Banks

"They are dead but they just don't know it". In the real situation, it should be: they are dead but they just don't admit it.

Monday, April 27, 2009

Bear Market Rally: then and now

I am not indicating at all we are going to have another Great Depression, mainly because today's policy makers learned the past mistakes, especially Fed's monetary/credit policy is much more expansionary (also innovative) than in Great Depression. Bernanke's famous comments were "we won't do it again". But one and half years into recession, banking sector is still in a huge mess. I am very worried.

The graphs below compare bear market rallies, then (1929-1933) and now (2007- ).

Great Deleveraging:

Great Depression:

(click to enlarge)

Charlie Rose with Joe Stiglitz and Bill Ackman

Stiglitz is 2001 Nobel prize winner of Economics; Ackman is the hedge fund manager who rocked the wall street with his book on shortselling.

GM outlines restructuring plan

Government's bankruptcy threat seems quite effective. GM ditched Pontiac brand, keeping Chevy, Cadillac, Buick and GMC. GM will also close 42% of its dealership stores. The plan also includes a debt-to-equity exchange program and bond holders will not be happy about the huge haircut. GM may eventually go to bankruptcy court.

Sunday, April 26, 2009

Becker questions Fed's ability to remain independent

Gary Becker looks back the history and draws the analogy that today's Fed will face difficulty (political pressure) reversing quickly the recent huge monetary expansion once the economy recovers (highlights are mine).

Central Banks Cannot Easily Maintain their Independence

Most richer nations nowadays, and many developing nations, have "independent" central banks, such as the European Central Bank and the Federal Reserve Bank. "Independence" cannot be precisely defined, but it is supposed to indicate that the central bank of a country has the freedom to make decisions which the government, represented by the Treasury in the United States, does not like. The purpose of independence is to allow monetary policy to be decided independently of fiscal policy, although obviously even independent banks and governments may respond in consistent ways to broad economic events, such as the present recession.

The motivation for having an independent central bank is the many occasions in the past when subservient central banks accommodated the government's desire to spend more without raising additional taxes. Central banks accommodate fiscal authorities essentially by buying government securities that help finance government spending. In return for receiving government debt, a central bank would either directly print additional currency that governments can spend, or it would create reserves in commercial banks that lead to an expansion of bank deposits and monetary aggregates, such as M1. Either way, inflation would result from this monetization of the government debt, often severe inflation and even hyperinflation. Hostility to rapid inflation led to the political support behind giving central banks much greater independence from fiscal authorities.

The history of the Federal Reserve's transition in and out of independence is illuminating (see Allan Meltzer's book, A History of the Federal Reserve, 2003). The Fed fully and enthusiastically compromised its independence from the Treasury during World War II. It bought large quantities of government debt to help the government finance the large wartime deficit. Inflation from the resulting big expansion of the money supply was suppressed through wage and price controls. This inflation became open after removal of these controls at the end of the war.

For a half dozen years after that war was over, President Truman and the Treasury pressured then much more reluctant Fed officials into maintaining the Fed's subservience. Eventually, however, the Fed regained its independence in the famous Accord reached in March 1951. Nevertheless, the Vietnam War, the Great Society Program, and the reinstitution of wage and price controls by Richard Nixon in the early 1970s led to later erosions of the Fed's independence.

Even during normal times, central banks, whatever their nominal independence, are under strong pressure to accommodate expansionist fiscal policy, especially as elections approach. During extraordinary times, whether in peacetime or during wars, this pressure usually becomes too powerful to resist. So the rather complete bending of the Fed to the Treasury's wishes during the present worldwide recession is not surprising. Still, that does not make it right, and I have some doubts about the Federal Reserve's recent behavior.

One concern is the somewhat arbitrary choices the Fed made about which banks to bailout and which ones to close or merge into other banks. This added significantly to the enormous uncertainty already prevalent in financial markets. I am also worried about the Fed's support of the huge federal deficits generated by the sharp expansion in federal spending. I understand such actions are necessary to help governments fight wars, but why help finance so much spending during this recession, particularly spending that has dubious stimulating potential? One example is the almost $800 billion so-called stimulus package that will do little to stimulate the economy, but will greatly raise long term government spending in directions desired by the President and Congress (see the posts on January 11 of this year). Another example of dubious government spending that the Fed seems willing to help finance is the ill thought out Treasury plan for hedge funds and other financial institutions to buy toxic bank assets (see the criticism of this plan in my posts on March 29 and 31).

The huge increase in bank reserves is a major consequence of the Fed's monetization of the government's large spending programs. Reserves went from about $8 billion in early Fall to around $800 billion, or a hundred fold increase in only 6 months. The recession rather than the wage and price controls imposed during prior periods is keeping inflation suppressed at present. Once the economy begins to recover, the inflationary risks will be enormous. In order to soak up these reserves, the Fed would have to sell large quantities of its government securities back to the private sector. These sales would put downward pressure on security prices- that is, upward pressure on interest rates- that will slow the economy's expansion at that time. For this reason, any government in power then, whether Democratic or Republican, will vigorously resist such Fed actions.

Hence it is not obvious that the Fed will be able to conduct these sales sufficiently smoothly to prevent either a recession or a serious bout of inflation. These are not pressing concerns when a serious recession is the immediate problem, but they will become major challenges down the road.

Rosenfeld: Ten years after LTCM

Eric Rosenfeld brings us back to ten years ago what went wrong at LTCM. Refreshing if you link the collapse of LTCM to the current financial crisis.

A few take-away points:

1. The benefits from diversification based on historical correlations is great only if correlations don't change during sudden move;

2. The collapse of LTCM is not a problem of flight-to-quality, rather, it's the problem of everybody trying to get out of the same trades LTCM had.

3. We need to seriously deal with counterparty risk, and work out a solution. Otherwise, the too-big-to-fail problem will haunt us, always.

The power of blogging

The V, the L, the U or the big D?

David Wessel at WSJ ponders on what kind of recession and recovery we will end up with.

There is no doubt where the economy is now. "By any measure, this downturn represents by far the deepest global recession since the Great Depression," the International Monetary Fund declared Wednesday.

But there's more than the usual uncertainty about where it is going. The key is the U.S. Even though its slice of the world economy is smaller than it once was, it's still huge. The U.S. led the world into the abyss, and it will lead the world economy out of it.

But how fast and when?

The alphabet can help to imagine the possibilities and the path of the economy. There's the letter V: the kind of quick rebound that usually follows a deep recession. Or U: a longer recession and slow recovery. There is L: years of painfully slow growth. And W: a temporary upturn as the economy feels the jolt of fiscal stimulus that quickly wears off. Finally, there's the big D, not the shape but another Great Depression.

With history a guide, consider three starkly different scenarios.

The V

The late Victor Zarnowitz, a student of the business cycle, had a rule: "Deep recessions are almost always followed by steep recoveries." The mild recession of the early 1990s and early 2000s were followed by mild recoveries. But the U.S. economy grew faster than a 6% pace in the four quarters after the deep 1973-75 recession and faster than a 7.75% pace after the even deeper 1980-82 downturn.

The IMF says this is the worst recession that the world has seen since the Great Depression. So what will happen next? Economics Editor David Wessel discusses three possible scenarios.

"In deep recessions," says Michael Mussa of the Peterson Institute for International Economics, "there is usually a growing sense of gloom as the recession deepens." Then the forces that triggered recession -- say, plunging home prices -- abate. The adrenaline of tax cuts and government spending kicks in. With inventories so lean, the slightest uptick in demand prompts a sharp increase in production, and the natural dynamism of capitalism reasserts itself.

"Experience suggests all of this should work, and I believe it will," Mr. Mussa predicts. Governments have administered huge doses of fiscal and monetary stimulus. Home-building and car-buying are so low they can't fall much further. Many consumers shy away from buying because they're frightened, not broke, and that state of mind can change quickly and liberate pent-up demand.

But the Federal Reserve caused the deep recessions of the 1970s and 1980s when it put its foot on the brake to stop inflation; it ended them when it let up. This time, Fed has its foot to the floor and the economy is still slowing. And so much stock-market and housing wealth has evaporated that a quick turn in consumer spirits seems unlikely. Plus, the repair of the banks remains far from complete, restraining lending.

The odds of the V: 15%.

The Big D

If one asked a roomful of economists two years ago to put odds on a repeat of the Great Depression, nearly all would have said zero. In early March, The Wall Street Journal posed the question to about 50 forecasters -- defining depression as a decline in output per person of more than 10%, four times worse than the decline the IMF anticipates. On average, they put odds at one in seven; several put them above one in four.

[Deeper Decline]

"This is a Depression-sized event," says economic historian Barry Eichengreen of the University of California at Berkeley, citing the global decline in industrial production and world trade. The big difference: In 1929, governments dithered, or worse. In 2009, they've rushed to the rescue.

To go from today's deep recession to a depression something would have to go wrong. It could be a financial catastrophe on the scale of last fall's bankruptcy by Lehman Brothers or another panic-inducing event. Or a crash in the dollar, one that forces interest rates up at just the wrong moment. Or it could be political gridlock that stops governments in the U.S. or Europe from spending enough to fix the banks before a big one fails, or keeps them for doing more on the fiscal or monetary fronts as the economy deteriorates.

Or it could be virulent deflation that pulls down prices and incomes, making debts, which don't fall when prices do, a heavier burden. The textbook remedy is easy money and big government deficits. But so much of that has been tried it's easy to question its efficacy or to imagine resistance around the world to doing.

The odds of the big D: 20%.

The L

For a decade after its stock market and real-estate bubble burst in 1990, Japan bumped along at an annual growth of just 0.5%. It was dubbed the Lost Decade, and it could happen here. The recession ends but the economy plods along, growing too slowly to bring down unemployment for years.

As the IMF observed this week, recoveries following recession caused by financial crises are "typically slower." Those following recessions that occur simultaneously across the globe "have typically been weak." Back in the 1990s, as U.S. banks struggled, the Fed talked a lot about "financial headwinds." Those were zephyrs compared to the gale-force winds that the economy confronts today.

If financial markets stabilize but don't improve steadily, or if housing prices continue to drift down, or if confidence remains shaky, the U.S. economy could languish for a time. American consumers, once known for spending in the face of prosperity or adversity, could finally decide to prepare for retirement by saving more, having just learned that neither 401(k) retirement accounts nor home values rise inexorably. And the U.S. can't count on increasing exports, the solution when emerging-market economies run into financial trouble and the reason Japan didn't do even worse in the 1990s. The rest of the world is in no shape to buy.

An unfolding depression could scare Congress to act boldly, but the L is less ominous -- and perhaps more likely as a result. There would be months when the economy appeared to be strengthening so the temptation to wait-and-see would be strong.

Put the odds of the L at 55%. That adds to 90%. So put 10% odds on the U, less pleasant than the euphoric V but far less painful than a Lost Decade. That's the rough consensus of economic forecasters; it means U.S. unemployment grows for another year and a half.

Bottom line: The odds favor a long slog.

China's bamboo shoots of recovery

Bamboo shoots, or green shoots, or whatever. The signs of recovery in China seem to be much more robust than in the US. In the US, what we have is a deceleration of decline; but in China, some key economic indicators actually had a big rebound. One of the common misconceptions about Chinese economy is the importance of trade. The argument goes since trade accounts for more than 40% of China's GDP, a global economic slowdown led by the US will undoubtedly drag down China. There are certain truth in the argument and we did see China's GDP growth had a dramatic fall, but the 40% share number is deceiving.

According to recent research (see my previous post), China's trade sector, if measured by value added, only accounts for less 10% of GDP. The importance of trade is overly exaggerated. I quote Justin Lin, chief economist of the World Bank: What China is experiencing is a decline of absolute rate of growth (recoupling), but relatively speaking, China is going to grow much faster than all the advanced economies, including the US (decoupling).

According to another research done by Albert Kiedel at Carnegie Endowment, China's GDP growth is almost independent of US GDP fluctuations (see the chart below), at least from 1988 to 2007.

(click to enlarge)

This Economist piece below has a more detailed analysis:

Signs that a giant fiscal stimulus is starting to work

THE Chinese consider eight to be a lucky number because it sounds like the word meaning "prosperity". And luck, combined with a massive fiscal stimulus, may yet help the government to achieve its growth target of 8% in 2009. Earlier this year, most economists thought such growth was impossible at a time of deep global recession, but some are now nudging up their forecasts.

At first sight, the GDP figures published on April 16th were disappointing. China's growth rate fell to 6.1% in the year to the first quarter, less than half its pace in mid-2007. On closer inspection, however, the economy is starting to perk up. Comparing the first quarter with the previous three months, GDP rose at an estimated annualised rate of around 6%, after nearly stalling in the fourth quarter (see chart). By March the economy was gaining more speed, with the year-on-year increase in industrial production rising to 8.3% from an average of 3.8% in the previous two months. Retail sales were 16% higher in real terms than a year ago, and fixed investment has soared by 30%, signalling that the government's infrastructure-led stimulus is starting to work.

Exports, on the other hand, tumbled by 17% in the year to March and global demand is widely expected to remain weak this year. This is the main reason why some economists expect GDP growth of "only" 5% for 2009 as a whole. But the gloomier forecasts tend both to overstate the importance of exports and to understate the size of the government's stimulus.

Contrary to conventional wisdom, China's sharp economic slowdown was not triggered by a collapse in exports to America. Its growth began to slow in 2007, well before exports stumbled, driven by a collapse in the property market and construction. This was the result of tight credit policies aimed at preventing the economy from overheating. The global slump dealt a second blow late last year, but China is less dependent on exports than is commonly believed. Exports account for nearly 40% of GDP but they use a lot of imported components, and only make up about 18% of domestic value-added. Less than 10% of jobs are in the export sector.

If a collapse in domestic demand led China's economy down, it can also help lead it up again. Not only is China's fiscal stimulus one of the biggest in the world this year, but the government's ability to "ask" state-owned firms to spend and state banks to lend means that the government's measures are being implemented more rapidly than elsewhere. To take one example, railway investment has tripled over the past year.

Only about 30% of the government's 4 trillion yuan ($585 billion) infrastructure package is being funded by the government. Most of the rest will be financed by bank lending, which had already soared by 30% in the 12 months to March, twice its pace last summer. JPMorgan thinks that this credit and investment boom could lift GDP growth to an annualised pace of over 10% in each of the next three quarters.

Jonathan Anderson, an economist at UBS, argues that the property market could be as important as the fiscal stimulus in determining China's fate. After falling sharply last year, housing sales rose by 36% in value in the year to March. Housing starts are still down, but if sales continue to strengthen, construction could pick up in the second half of 2009. That would also help to support consumption: about half of China's job losses among migrant workers have been in the building industry.

If construction does recover and infrastructure spending continues to rise, then even if exports remain weak, China could see growth of close to 8% this year—impressive stuff when rich economies are expected to contract by 4-5%. There are growing concerns about the quality of that growth, however. The World Bank estimates that government-influenced spending will account for three-quarters of China's GDP growth this year. The clear risk is that politically directed lending creates more overcapacity, poor rates of return and future bad loans for banks.

These are valid concerns. But Andy Rothman, an economist at CLSA, a brokerage, reckons that state-owned firms mainly plan to increase their spending on upgrading existing production facilities, rather than expanding capacity. Also, about half of the increase in investment is on public infrastructure. This will inevitably include some white elephants but, in a poor country, the return on infrastructure investment is generally high. There is no need to build "bridges to nowhere" when two-fifths of villages lack a paved road to the nearest market town.

What about the risks to banks? The last time they were forced to support the government's stimulus policy, during Asia's financial crisis in 1998, Chinese banks were left with large non-performing loans. Bad loans will rise again this time, but Tao Wang, also at UBS, argues that banks are in a stronger position than in 1998. China is one of the few countries in the world where bank credit has fallen relative to GDP over the past five years. Banks have an average loan-to-deposit ratio of only 67%, low by international standards, and less than 5% of banks' loans are non-performing, down from 40% in 1998.

The biggest task for China is to find a new engine for future growth. It cannot rely on exports, nor can the investment stimulus be sustained for long. Without stronger consumer spending, China's growth will be much slower than in recent years. Reforms to improve health care and the social safety net will take many years to encourage people to save less.

Andy Xie, an independent economist based in Shanghai, suggests that the quickest way to boost consumption would be for the government to distribute the shares that it holds in state-owned enterprises to households, and to force those firms to pay larger dividends. But the authorities in Beijing are unlikely to take his advice. How else could they lean on big firms to support the economy in times like these?

Saturday, April 25, 2009

Rogoff: Stress test not stressful

Interview of Ken Rogoff, former IMF chief economist and professor at Harvard Economics. He predicts unemployment rate will peak at 11%.

Whitney on current state of banking

This is a must-watch.

Note: Meredith Whitney is again dead right on her forecast of credit line cut. Yesterday, I just received a letter from my credit card company and my credit line was cut in half. I have a very high credit line but I almost never borrowed money. Cutting credit line will save banks from putting extra reserves for the potential loss. So in this environment, your FICO score does not matter.

Friday, April 24, 2009

China doubles gold reserve

China is in a Dollar Trap. A sudden dump of US dollar is out of question. It will hurt the US, China and the world economy. But it does not mean China cannot gradually diversify away from the US dollar. The recent data shows China just doubled its gold reserves from 600 tonnes to 1054 tonnes. China now became the 7th largest holder of gold in the world, surpassing Switzerland and Japan.

Data in December 2008:

Data in March 2009:

(source: TMGM)

UK: the sick man once again?

Martin Wolf is worrying about UK's fiscal deterioration (source: FT):

Is the UK once again the economic sick man? Or is it, as Alistair Darling, chancellor of the exchequer, argued in his Budget speech on Wednesday, just one of a number of hard-hit high-income countries? The answers to these questions are: yes and yes. The explanation for this ambiguity is that the fiscal deterioration is extraordinary, but the economic collapse is not.

Let us start with the economy. According to the International Monetary Fund's latest World Economic Outlook, the UK economy will contract by 4.1 per cent this year, followed by a further contraction of 0.4 per cent next year. This, it should be stressed, is far worse than the 3.5 per cent contraction in 2009 and 1.25 per cent expansion in 2010 forecast by the Treasury.

The IMF puts forward the following forecasts for other big economies: -3.8 per cent in 2009 and 0.0 in 2010 for all advanced countries; -2.8 per cent and 0.0 for the US; -4.2 per cent and -0.4 per cent for the eurozone; -5.6 per cent and -1.0 per cent for Germany; and -6.2 per cent and 0.5 per cent for Japan. Thus, the UK's forecast performance is close to the mean for all advanced countries and better than for Germany and Japan.

The striking feature, indeed, is that the worst-hit economies are not those of profligate, high-spending countries, such as the UK and US, but of prudent, high-saving countries, such as Germany and Japan. People in the latter tend to see this as unfair, because it is undeserved. Well, life is unfair.

The serious answer is that the economic and financial health of sellers and creditors cannot be divorced from that of buyers and debtors. If customers are bankrupt, suppliers are likely to be in the same predicament. This is why Japan has suffered a collapse in manufacturing output comparable to that of the US during the Great Depression: a fall of 37 per cent since the start of 2008.

Now turn to the fiscal position. The IMF forecasts the UK general government deficit at 9.8 per cent of GDP in 2009 and 10.9 per cent next year. In the UK Budget, the Treasury forecasts the general government deficit at 12 per cent of GDP, or over, in 2009-10 and 2010-11. This suggests that the IMF forecasts are much too optimistic. Whether it is equally over-optimistic about other countries' fiscal positions I do not know.

In any case, the IMF forecast deficit for the UK for next year is the highest in the Group of Seven leading high-income countries. Only Japan, on 9.8 per cent, and the US, on 9.7 per cent come close. Meanwhile, Germany's deficit next year is forecast at "only" 6.1 per cent of GDP. Moreover, the 8.3 percentage point deterioration in the UK deficit between 2007 and 2010 is also the highest in the G7, with only Japan (a 7.3 percentage points deterioration) and the US (a 6.8 percentage points deterioration) coming close.

Not surprisingly, the UK is also forecast to have a relatively large deterioration in its net public debt, with a rise of 29 percentage points between 2007 and 2010 from 38 to 67 per cent of GDP. This time Japan, with a deterioration of 34 percentage points, is ahead, and the US, with 27 percentage points, just behind. But Germany's rise is only 16 percentage points. Moreover, the UK's net debt is forecast to continue to rise thereafter. It could well hit 100 per cent of GDP.

So why has the fiscal deterioration been so severe in the UK, when the economic deterioration has not been?

The obvious answer is that the sectors of the UK economy that have collapsed – housing and finance – are particularly revenue-intensive. As a result the ratio of current receipts to GDP is expected to shrink from 38.6 per cent in 2007-08 to 35.1 per cent in 2009-10 – a fall of 3.5 percentage points.

A deeper answer is that it is the countries where the debt-fuelled spending of the private sector was highest that have seen the largest swings in the balance between private income and spending. The shift in this balance in the UK's private sector between 2007 and 2010 is forecast (implicitly) by the IMF at 9.6 per cent of GDP (from minus 0.2 per cent to plus 9.4 per cent). The swing in Germany, in contrast, is just 0.6 percentage points.

When the private sector shrinks its spending relative to incomes, either the current account or the fiscal balance must shift in equal and opposite directions. The current account deficit always changes relatively slowly. It is hard to change the economy's structure quickly. So it has been the fiscal position that has deteriorated massively.

Thus, in the crisis-hit countries themselves, the consequence of the private sector cutback has been the fiscal deterioration. In the export-oriented countries, the result has been a massive contraction in exports and output. The huge fiscal deteriorations in the UK (and US) and the huge declines in manufactured output and exports in Germany and Japan are two sides of one coin.

So where does this leave us? The answer is that the next leg in the crisis, for both sides, will come when (or if) the huge fiscal deficits themselves become unsustainable. This is the great economic peril that lies ahead – and not just for the UK.

Thursday, April 23, 2009

Will Americans turn into Europeans?

Alberto Alesina and Paola Giuliano at Harvard wonder about the question whether the crisis and the rising populism will turn Americans into Europeans.

Will Americans turn into "inequality intolerant" Europeans? Such a radical shift is unlikely, but this column argues that this crisis may be a turning point towards more government intervention and redistribution in the US. More and more Americans believe that hard work is insufficient to climb the income ladder and are expressing anger against "unfairly" accumulated wealth. Politicians should prefer wise policies but may be tempted by populist outbursts.

The current financial crisis will reduce income and wealth inequality. The rich who heavily invested in financial and stock markets have lost much more than the less wealthy. The relatively poor "young" may face the sale of the century. Go and tell a young (and poor) just-married couple that the collapse of housing prices is a problem; mention to a young worker just beginning to accumulate retirement money that low stock prices are a problem!

Many will consider this reduction in inequality the silver lining of the crisis and a welcome development. This is especially the case because many people are acutely aware of the increase in income inequality that occurred in many (especially English-speaking) countries in the last three decades and perhaps tend to think of it as "unfair". Those who became rich from complicated financial instruments and sophisticated investments in derivatives are now seen as undeserving of their wealth. The extraordinary bonuses of certain incompetent managers, especially those bailed out by the taxpayers, have certainly not helped gain them sympathy. Nevertheless, a frontal attack on the finance world is pure populism; finance serves a very productive purpose. One cannot mix criminals like Bernie Madoff with unlucky or even excessively leveraged, overly risk-taking, sometimes incompetent, and overpaid managers. Politicians should not throw fuel on any anti-finance or anti-Wall Street sentiments. There is enough anger against "unfairly" accumulated wealth; we do not need more.

The increase in income inequality of the last three decades in the US is not extraordinary if viewed from a very long-term perspective. The thirty years after the Second World War were the period of the "Great Compression" – a sharp reduction in income inequality (Piketty and Saez 2003). A few months ago, just before the crisis, we were back to roughly to the level of the 1920s, which was the norm in previous decades, not to mention the level of inequality and of social immobility of pre-capitalist societies. But the perception that this increase in inequality was unfair will greatly weigh on the way it will be handled and the political backlash it will create.

Our research (Alesina and Giuliano 2009) suggests that this is a situation in which voters will demand especially strong action to reduce inequality, even in a country like the US, where inequality is much more tolerated than in Europe. All over the world, the poor favour more redistribution than the rich, which is not surprising. But beyond that basic fact, the attitude towards what is the right amount of redistribution varies greatly and is affected by many more variables than just current income. In particular, when people perceive that the income ladder is the result of differences in hard work, effort, and creativity, even the relatively poor may accept large differences in income. This is partly because their sense of justice tells them that these are fair inequalities and partly because they feel that the income ladder can be climbed if it really depends only on effort and hard work. This is true both when comparing individuals within a country and comparing average attitudes across countries.

For instance, according to the World Values Survey, a large majority of Americans (around 60%) used to believe that the income ladder could be climbed and the poor could make it if they tried hard. Only a minority of Europeans (less than 40%) had the same view. That explains a lot of the difference in the generosity of the welfare state in the two places. Americans think that they live in a socially mobile society with less need for active public redistributive policies. Europeans, by and large, have the opposite feeling. Now Americans may feel that the social mobility that they cherished was not so large after all; investing in derivatives hardly has the same "feeling" in the popular sentiments as, say, working a late shift in a shop.

Therefore, this crisis may have changed American attitudes toward inequality a bit. If they perceive inequality as unfair they will demand more redistribution. The traditional aversion to taxation of Americans may give way to a "soak the rich" feeling. Higher taxes will be needed to handle the booming budget deficits. We would predict that the progressivity of the tax system will also increase, as the median voter will demand it. Politicians should resist such populist measures. Increasing the tax base rather than the brackets is the best way to increase taxes on the rich. A simplification of the byzantine tax code, where the wealthy can often hide income, is way overdue.

Will Americans turn into "inequality intolerant" Europeans? Probably not, but this crisis may imply a turning point towards more government intervention and towards redistribution.


Alberto Alesina and Paola Giuliano (2009) Preferences for redistribution, NBER Working Paper 14825.
Piketty, Thomas and Emmanuel Saez. 2003. "Income Inequality in the United States, 1913-1998." Quarterly Journal of Economics, 118(1): 1–39.

Sinking together

The world economy is cliff-diving, together. Emerging markets are doing relatively better.

(source: IMF)

Europe challenges world economic recovery

Report from today's Journal:

Europe's economy faces a deeper recession and a slower recovery than the U.S. or other parts of the world, making it the region that is most hurting prospects for an early end to the global economic slump.

The EU's economy is set to contract 4% this year, even worse than the 2.8% drop projected for the U.S., according to new forecasts published Wednesday by the International Monetary Fund.

(click to enlarge; source: IMF)

Those figures came as the U.K. released a budget that includes its biggest jump in the national debt since World War II. Germany, Europe's biggest economy, shrank by 3.3% in the first quarter -- a steep slide from a 2.1% contraction in the last quarter of 2008. Leading German economics institutes said Wednesday that the country's economy is set to contract 6% this year, which would be its worst recorded performance since 1931.

European banks' losses from the global financial crisis are now projected to overtake U.S. banks' losses, according to IMF figures, which could hurt the banks' ability to lend liberally to help the bloc out of its crisis. More than half of the losses on continental Europe are homemade, the IMF said, reflecting bad loans to European firms and households rather than toxic U.S. securities.

The worsening outlook for the 27-nation EU is a blow for many of the region's governments, who have argued that the U.S. is the center of the global economic storm and that Europe's problems are smaller. Because of that, plus fear of rising inflation and public debt, authorities in much of Europe have been slower than those in the U.S. or leading Asian economies to cut interest rates or adopt ambitious fiscal-stimulus measures.

"At some deep level the European banks and policy makers don't get it: that they helped cause the crisis, that their slow response is part of the reason that the economy is bad, and that more is on the way," says Simon Johnson, a former IMF chief economist.

Europe's poor prospects are likely to rebound on the U.S., Asia and other regions, given that the EU's $18.4 trillion economy makes up 30% of the world economy.

In a sign of such spillover, Peoria, Ill.-based equipment maker Caterpillar Inc. said its first-quarter sales to Europe fell 46% from a year ago, significantly more than its sales declines in the U.S., Asia or Latin America, as it announced a first-quarter loss on Tuesday.

Even European firms' hopes are pinned on other regions where countries are spending more on stimulus plans. At Munich-based engineering firm HAWE Hydraulik SE, owner Karl Haeusgen is hoping that signs of life in the U.S. and China will lead to new export orders. In recent months, his orders have fallen as much as half from a year ago.

HAWE is holding on to its workers at idle German factories only because the government is helping to pay their salaries -- a policy many European countries use to damp unemployment figures. "That we have a downturn is not surprising, but the intensity is unexpected and abnormal," says Mr. Haeusgen.

In France, labor protests became more violent this week as workers stormed and ransacked a government building near Paris, after they failed in court to prevent their tire factory, owned by German auto-parts company Continental AG, from being shut down. German Trade Union Federation head Michael Sommer warned his country's industrialists this week that such social unrest could spread to Germany if mass layoffs multiply.

On Tuesday, credit-rating agency Standard & Poor's predicted that debt defaults among high-risk European companies would overtake defaults among low-rated U.S. companies.

Some business surveys and economic data suggest the pace of Europe's contraction might be easing. But signs of a recovery in coming months appear weaker than in other regions, such as Asia and the U.S., where economists say more aggressive government efforts are starting to show some effect.

Tentative signs of relief in Asia include Chinese factory output and auto sales, which improved in March. Japan is also seeing some glimmers of hope, as exports in March nearly halved from a year earlier but rose from February, the first monthly gain since May last year.

Policy makers are partly to blame for the severity of the euro zone's slowdown, say some analysts. "When you think of the broader monetary and fiscal policy mix, it's clearly been more aggressive in the U.S.," says David Mackie, economist at J.P. Morgan in London.

The European Central Bank cut its key interest rate to 1.25% from 4.25% in October, and is expected to trim the rate to 1% in May. That's still well above comparable rates in the U.S. and U.K.

Governments in Europe also have been slower to use fiscal policy to support demand.

Fiscal stimulus measures over a three-year period of 2008-2010 are equivalent to 4.8% of last year's gross domestic product in the U.S. and 4.4% in China, according to the IMF -- but only 3.4% in Germany, 1.5% in the U.K., and 1.3% in France.

The weakening of Europe's banking sector is potentially more damaging for the wider economy than woes at U.S. banks, because Europe's financial system relies more on bank lending and less on securities markets. Although Europe's banks have bigger balance sheets than U.S. lenders, so that their losses are smaller as a proportion of total assets, they will need more fresh money than the U.S. to repair their capital buffers, the IMF said.

An IMF report published Tuesday said that write-downs at Western European banks outside the U.K. will total $1.109 trillion for 2007-2010, topping the U.S. total of $1.049 trillion. Banks in the euro zone have so far written down only 17% of their losses, compared with roughly 50% at U.S. banks, the IMF said. U.K. banks have written down about a third of their $310 billion in expected losses, the report said.

Restrictive lending by banks trying to repair their capital ratios is holding back European businesses. At French racing-bicycle maker Look Cycle International SA, sales are suffering because the bicycle stores and distributors it deals with in markets including France and Italy can't get enough financing, says Look Chief Executive Thierry Fournier. "Dealers and distributors have problems with their banks, so everybody is more cautious about placing orders or holding stocks," he says.

Fixing the banking system is particularly tricky in the EU, where 16 of the 27 countries share the euro currency and a central bank, but where banking regulation mostly remains the preserve of the national governments.

"In Continental Europe, there is basically no prospect of any coordinated policy action to identify the weaknesses in the banking system," says Nicolas Veron, a research fellow at Brussels think tank Bruegel.

Europe's economy also faces a greater risk of further deterioration than other regions because of the deep economic and financial crisis in the formerly communist East. Austria-based banks, for example, have some $278 billion in exposure to those countries, equivalent to over 70% of Austria's gross domestic product.

The IMF expects Continental European banks' losses on emerging-market assets to reach $172 billion by 2010, more than four times the emerging-market losses it expects for U.K., U.S. or Asian banks.

Wednesday, April 22, 2009

McCulley: bottoming vs. recovery

Interview of PIMCO's Paul McCulley: housing price is bottoming out but huge inventory will take time to clear. He also commented on PPIP and Janet Yellen's recent speech on Minsky Meltdown.

China's Electric Car Market: The battle is on

China has the strongest incentives to develop the cutting-edge electric cars. Why? Because China has the world's largest population and the fastest growing economy; the rising middle class love the freedom of owning and driving a car; meanwhile, China is one of the most polluted countries in the world and the pressure to improve its environment is the greatest. How to find a middle ground that satisfies consumer demand while relieving the pollution pressure? The answer is electric cars.

China's recent decision to adopt and subsidize electric cars will fundamentally change the auto industry in the world.

The investment of Chinese government in electric cars (the battery technology for example) will spur global competition in energy-saving technology. At the same time, the size of China's domestic auto market also helps automakers to lower the cost of new technology really fast. One of the obstacles to develop electric cars in the US is automakers worry about the market for electric cars will be too small to make a profit. In other words, there is a lack of economy of scale. But with China in the game, automakers shall have no more worries. The US automakers have the option to sell the most-advanced electric cars to China. This in turn will force the US to rethink about its strategic position in global automobile industry. More policy changes in Washington will come naturally out of pressure from the other side of the Pacific.

Why can't US government provide such incentives to automakers first? Because the oil-addicted Big-3 have their strong lobbying power in Washington. Thomas Friedman, the famed New York Times columnist, out of desperation, had once suggested the US had one day of dictatorship so government can force everybody to switch to cleaner technology. Well now, there is no need for that. China's authoritarian government just did a favor to the US and to the world.

Competition is good: it works in economics and business; it also works in politics.

Read more about the coming battle of electric car market in China (source: WSJ):

China Puts Its Electric Vehicles on Center Stage

SHANGHAI -- Chinese auto makers are unveiling a slew of battery-powered cars and other energy-efficient vehicles at this week's auto show here that could make them more globally competitive and eventually help address the air pollution that chokes many Chinese cities.

Alternative-fuel cars were some of the hottest items on display at the Shanghai auto show from homegrown companies like Geely Automobile Holdings Ltd., Brilliance Jinbei Automobile Co. and Chery Automobile Co.

Some of the new and updated models, such as a battery-powered version of Geely's Panda hatchback, may hit the market as early as October, and in some cases they might carry price tags low enough for farmers and other rural residents with limited financial means.

[China BYD Electric Car photo]

The aggressive plans illustrate China's growing commitment to electrified vehicles and its strategy to support auto makers developing various types of electric cars and components with research subsidies. The government sees environmental upsides and a chance for its car makers to gain ground on foreign rivals, since electric vehicles are simpler to engineer than gasoline-engine ones.

Electric vehicles are "definitely affordable and environmentally friendly technology, and we think there's a huge potential market in China for them," Li Shufu, Geely's chairman, said in an interview Monday.

Making electric vehicles affordable will be critical for them to have an impact on the environment, as vehicle ownership continues to rise quickly. The hundreds of thousands of new cars being added every year to roads in China could further damage already shaky air quality if they are oil-based vehicles.

The battery-powered cars that Chinese companies are showing are intended to be much less expensive than those planned by big foreign companies. Great Wall Motor Co., based in northern China's Hebei province, on Monday unveiled its planned GWKulla all-electric car, which will likely be one of China's cheapest battery-powered cars when it hits showrooms as early as next year. Its expected price tag is between 60,000 yuan and 70,000 yuan, or about $8,780 to $10,250. The GWKulla, a short, curvy compact, runs on lithium-ion batteries and can go 160 kilometers (99 miles) when fully charged, the company says.

Chery showed a tiny battery car, the Riichi M1, that boasts similar technology and performance, and is likely to be priced under 100,000 yuan. Geely's Panda, which Geely executive Frank Zhao said the company plans to launch in China as early as October, will be similarly priced.

Those prices are much lower than that of General Motors Corp.'s Chevrolet Volt plug-in hybrid, which is expected to sell for $40,000 when it goes on sales in the U.S. in late 2010. GM plans to launch the Volt in China in 2011.

Chinese auto makers also showed other types of "new energy" vehicles, including regular gasoline-electric hybrids to compete with Toyota Motor Corp.'s Prius hybrid. Among the most notable: a gas-electric hybrid Shanghai Automotive Industry Corp. plans to launch by the end of next year.

China's technologies for electric vehicles, especially batteries, are still lagging behind in some important ways. And while many of the cars being shown this week in Shanghai are touted as "cutting edge" by their producers, it remains unclear how well they will perform -- and how Chinese consumers will react to such "new energy" cars.

In early testing, reviewers said a plug-in electric hybrid sedan from China's BYD Co. launched late last year had some kinks. The car, called the F3DM, was launched at least a year ahead of a similar car planned by Toyota. But the gasoline engine in the BYD rattled and could be noisy when it kicked in, the reviewers said. The steering wheel also tends to get stiff when making turns because of the car's increased weight from the batteries. BYD has said it is aware of these issues and is working resolve them.

"From what we have seen so far, [Chinese electric vehicle] technology is not that advanced" in terms of things like battery life, driving range and recharging, said Nick Reilly, head of GM Asia-Pacific operations, on Monday. "However, they have pretty good cost, and we know the Chinese government and these Chinese companies are investing a lot of money in battery technology, so I think it would be foolish of us to ignore them and believe that we are that far ahead."

Some regulatory and market characteristics make China one of the most promising markets to experiment with electric cars. The government's regulations and policies for things like building electric-car charging stations can be changed more easily here than in places like the U.S. Most Chinese buyers also are purchasing cars for the first time and have not developed particular preferences.

GreatWallMotor's all-electricGWKullaat

Still, "the challenge here is consumers are extremely value-oriented," said Raymond Bierzynski, head of GM Asia-Pacific engineering operations. "They're very much interested in the payback, so we have to be [make sure] value is there." One key move GM is counting on to make the Volt more affordable in China is government incentives, whether they are cash incentives for customers or subsidies for fleet purchases by government agencies.

Another notable battery car, though its producer decided to skip the Shanghai show, is a super-low-cost, two-seat mini electric car that Chinese parts producer Wonder Auto Technology Inc. and Korean golf cart maker CT&T Co. are expected to begin producing jointly this summer. Though equipped with decidedly low-tech lead-acid batteries and having a top speed of only 60-to-65 kilometers an hour, the car can go 100 kilometers when fully charged, according to the two companies.

The car's biggest appeal is its rock-bottom price of less than 40,000 yuan. Wonder Auto's chairman and CEO, Qingjie Zhao, believes the Chinese-Korean joint venture in Jinzhou (Liaoning province) could boost sales of the car to 50,000 vehicles a year within three years.

"A plug-in hybrid selling for 150,000 yuan is a pipe dream for farmers. It would take five to 10 years before they become truly affordable for everyday folk," Mr. Zhao said. "But low-cost commuter EVs like ours is already a reality, within the reach of thrifty farmers."

Tuesday, April 21, 2009

O'Neill calls China "red hot"

Interview of Goldman Sachs chief economist Jim O'Neill on global economic outlook. He expects positive GDP growth in the US in 3Q, and he says many economists will have to revise their forecast on China's growth, to a much higher level.

Copper as leading economic indicator, Part 2

Weekly chart of Copper May 2009 future price:

(click to enlarge; source: WSJ Online)

To follow up my previous post on Copper as leading economic indicator, here I show you some recent data (courtesy of BCA research) that seem to confirm the story.

The first graph looks at the correlation between copper price and global industrial production (IP). Several interesting observations out of the graph: 1) Copper price is more volatile than IP in recent years (since 2000) as well as late 80s. 2) The predicative power of copper started to show up in early 90s; before that, copper was more like a coincident indicator and sometimes even lagging indicator. This, I suspect, may have something to do with China's integration into the world economy since 90s. 3) Recently, the copper price started to turn the corner. Does this mean the world economy may soon turn the corner, too? Read on...

A counter argument could be: China has been strategically buying copper at very low price (see graph below), but the buying itself does not mean China is having an economic recovery. To link copper price to economic rebound, we need to see the real "green shoots" in the Chinese economy.

So where are the green shoots? Chinese government has been increasing money supply and loan growth sharply (see graph below) to counter the deflationary pressure and stimulate the economy. And the effect was quite effective. At least, China does not have the problem of banking not lending.

In export sector, there are also signs that Chinese economy have turned the corner (see the graph below).

Personally, to make the copper story more convincing, I'd like to see the data of copper inventory flow --- then we can decipher how much copper purchase was pure strategic buying from China and how much was due to actual recovery.

To summarize, I am cautiously optimistic about China's outlook.

China's coming aging problem

Due to its unique population policies, China will face the aging problem quicker than most other developing countries. China's National Bureau of Statistics (NBS) in 2004 shows that the proportion of the population aged 65 years and older was 8.58 percent (now is around 12%), passing the UN's definition of 'aging society', where persons 65 years and over account for over 7 percent of the total population.

China's fertility rate declined from 6 in 1957 to 2.3 in 1980 and then 1.7 since the 1990s. When China's baby-boomer generation (born in 60-70s) retires, around 2030, China will face a severe problem of working labor shortage to support the elders. The current estimate is there may be only two working-age people for every senior citizen, compared with 13 to one now.

The graphs below show what the age structure of China looks like in 2005 and will be in 2050:

In 2005:

In 2050:

(click to enlarge; source: United Nations)

China needs to consider changing its one-child policy sooner rather than later. Other policies should also be implemented in parallel with the loosening of the current draconian one-child policy: build a sound social security and pension system so young workers won't be burdened with supporting the whole family; gradually moving China from a labor-intensive economy to an innovation-led economy (i.e., more output per worker, but this will be much harder to achieve).

Read more about China's aging problem on Bloomberg.

Monday, April 20, 2009

Stress Test: What game will government play?

Government is going to release the results of bank stress test on May 4th. What kind of test results can government afford to release? Government can't fail any bank in the report; otherwise, it will cause bank-run or sink the stock of the failed bank.

What government will do is to make the report look as ambiguous as possible: let everybody pass but identify who is A student and who is D student.

Watch this discussion from Yahoo Techticker:

Mishkin warns Japan-like stagnation

Fred. Mishkin, former member Fed Board of Governors, warns if banks were let stay unfixed as they are today, the US will run serious risk of being hit by another shock and falling into Japan-like long-term stagnation.

Frontline: Inside the meltdown

Frontline of PBS runs a 1-hour program on what's inside the meltdown. A nice review of what has happened since summer 2007, call it the Crash of 2008.

Sunday, April 19, 2009

"Party again" or "Worst yet to come"?

This bear market rally has long legs. Since March 9, the rally has been going on for six weeks now. So what's next? WSJ nicely summarizes the opposing views on each side (bear vs. bull):

With the Dow Jones Industrial Average up 24% from its March low, both bulls and bears are feeling they will soon be vindicated.

The bulls are finding more evidence that this rally is the start of something lasting. The bears warn that the higher the market goes, the more pain will be suffered on the other side.

Strangely, both are pointing to the same part of the economy to make their opposing cases: the lending system.

[Is this rally for real?]

"The epicenter of the fear is the idea that banks are full of toxic assets," says James Paulsen, chief investment strategist at Wells Capital Management, which oversees about $375 billion as Wells Fargo's money-management arm. He thinks the mortgage-backed securities held by banks are worth much more than people think, and that "we could have a V-shaped recovery" in the economy, and the stock market, as confidence in the lending system returns.

George Feiger thinks that idea is crazy.

"The core of the problem is the credit system and the credit system is severely damaged," says Mr. Feiger, who oversees $1.3 billion as chief executive of Contango Capital Advisors, a subsidiary of Zions Bancorp. "Unwinding the credit bubble is going to take years, not quarters. We see this stock rally as an opportunity to sell."

How can smart, experienced investors disagree so strongly, when looking at similar data? Let's hear from the optimists first.

Mr. Paulsen of Wells Capital expects consumers to begin borrowing more heavily against their homes, and sees economic growth recovering amid a pickup in consumer spending and exports. Even if growth doesn't return to where it was, he says, the improvement should be enough to pull stocks up from their heavily depressed levels.

He and others point out that even during the troubled 1930s and 1970s, stocks enjoyed strong, albeit temporary, bull markets. The Dow almost doubled from July 9, 1932, through Sept. 7, 1932, and then did it again in the first half of 1933, even as the banking system continued to crumble. Stocks fell again later, but not back to 1932 levels. Historically, the Dow often has rebounded sharply after being down around 50%, as it was this time.

In the optimists' view, the credit system, juiced by well over $1 trillion in government aid, is slowly repairing itself.

Demand for mortgage refinancing has blossomed as mortgage rates have fallen. Investors are snapping up risky credit instruments such as junk bonds. Last week saw the busiest day for junk-bond sales in more than six months as hospital operator HCA and phone-tower operator Crown Castle International sold debt.

Late last year, yields on corporate bonds were pushed skyward, adding to the difficulty of issuing new bonds. Since late November, however, even junk-bond yields have been falling, a good sign for corporate borrowers. The difference, or spread, between junk-bond yields and Treasury-bond yields has tumbled, according to Merrill Lynch indexes, although it still is almost twice what it was just a year ago.

The optimists point out that banks including J.P. Morgan Chase, Goldman Sachs Group and Citigroup reported better-than-expected first-quarter profits. Banks are able to issue bonds cheaply with government backing, helping increase their lending margins.

It is signs like these that analysts like Michael Darda have been waiting for. Mr. Darda, chief economist at Greenwich, Conn., brokerage firm MKM Partners, was skeptical of the stock outlook as recently as late last year, but not any longer.

"We continue to believe the expansion will build steam into 2010 as an easy Fed policy collides with the spend-out from the fiscal stimulus," Mr. Darda said in a report. He expects this trend to continue, with the recession ending between June and October. He notes that it is normal for the stock market to recover just ahead of the economy, which makes him bullish now.

The pessimists are turning to similar data to make the opposite case. Bears note that bank profits are due in part to government support, which has reduced the need for write-offs. Some of the new bank lending lately, they add, is because stressed borrowers are being forced to tap their credit lines. And big banks like Citigroup and Bank of America are still relying on government guarantees to sell bonds, a sign that credit markets remain fractured.

"Some people say the economic conditions are starting to bottom here. I would be really surprised if that happens," says Steve Lehman, who helps oversee a $1.8 billion mutual fund at Federated Investors in Pittsburgh. "The banks are technically insolvent. They have become basically Enron-like hedge funds."

He worries that the proliferation of home foreclosures, debt write-downs, severely underfunded pension plans and credit-card losses is far from over, which could hobble economic growth and stock recovery.

At some point, Mr. Lehman says, stocks are likely to fall enough that the ratio of stock prices to corporate earnings for broad stock indexes will drop into single digits, from about 13 now, and stay there a while. That happened during major bear markets in the past but hasn't yet happened this time.

Such a decline could push the Standard & Poor's 500-stock index below 600 before the selling ends, he says, although stocks could go through plenty of ups and downs before that happens. The S&P 500 finished Friday at 869.60. Its lowest close for the current bear market was its 12-year low on March 9 of 676.53.

"Many of the people I deal with every day want to go back to the good old days," adds Mr. Feiger of Contango. "I feel I am surrounded by people who are desperate for the party to start again. I don't see that happening." He, too, believes the damage is deeper than the optimists realize.

He is particularly concerned about what economists call the "shadow banking system." That is the system under which banks sold off loans to investors, including other banks. Those sales permitted a vast expansion of credit, but they also tempted banks to be less careful in their lending. And because they then bought back many such loans in the form of asset-backed securities, the banks ironically were among those left holding the bag.

Now investors won't buy such securities and the shadow banking system has been left for dead. Mr. Feiger estimates that, before the bust, 60% of all loans were held outside the normal banking system. Who, he asks, is going to step up and extend that kind of credit in the future?

Optimistic money managers point out that even if the overall stock pullback isn't over, the Dow industrials enjoyed five surges of 20% or more from September 1929 until they finally hit bottom in July 1932. The bulls want to get in on such rebounds, and add that it won't take 2½ years this time for the market finally to hit bottom.

The bears counter that it is still too risky to try to time the market's violent ups and downs. They feel safer keeping exceptionally large amounts of cash in money-market funds and Treasury bonds.

Whether they wind up changing their minds, and shifting some of that hoard to stocks, could determine how much longer the recent rally continues.

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Saturday, April 18, 2009

Mankiw: Let's have negative interest rate

Greg Mankiw writes on NYT that the Fed should consider ways to make interest rate negative so that cash hoarding becomes less attractive.  He proposes two ways to achieve the goal, both seemingly absurd:

1. The Fed announces that certain series (about 10% of circuting) of notes will become worthless;
2. Increase inflation to make real return of holding money negative.

I am fine with the first lottery approach.  The idea is very innovative, but I am worried about how foreigners holding US $ will react --will they dump the dollar?  The second approach of money printing is what central bankers in the US and UK have already been stealthly doing (they just don't want to say it loud). The question again rests on what should be the appropriate inflation equilibrium.  If the new normal is 4%-6%, not 2%, how should central bankers convince investors into believing they won't inflate even further?  Will the hard-won credit of central bankers by Paul Volcker be totally reversed?   This is a dangerous experiment and I am not sure how it will play out.  But one thing I am sure is that the Great Moderation is totally over, and we will see more volativitily in output and inflation in coming years.

WITH unemployment rising and the financial system in shambles, it's hard not to feel negative about the economy right now. The answer to our problems, however, could well be more negativity. But I'm not talking about attitude. I'm talking about numbers.

Let's start with the basics: What is the best way for an economy to escape a recession?

Until recently, most economists relied on monetary policy. Recessions result from an insufficient demand for goods and services — and so, the thinking goes, our central bank can remedy this deficiency by cutting interest rates. Lower interest rates encourage households and businesses to borrow and spend. More spending means more demand for goods and services, which leads to greater employment for workers to meet that demand.

The problem today, it seems, is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero, so it has turned to other tools, such as buying longer-term debt securities, to get the economy going again. But the efficacy of those tools is uncertain, and there are risks associated with them.

In many ways today, the Fed is in uncharted waters.

So why shouldn't the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3 percent?

At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.

The problem with negative interest rates, however, is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less.

Unless, that is, we figure out a way to make holding money less attractive.

At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. (I will let the student remain anonymous. In case he ever wants to pursue a career as a central banker, having his name associated with this idea probably won't help.)

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn't a flaw — it's a benefit.

The idea of making money earn a negative return is not entirely new. In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it. John Maynard Keynes approvingly cited the idea of a carrying tax on money. With banks now holding substantial excess reserves, Gesell's concern about cash hoarding suddenly seems very modern.

If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.

Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt bequeathed to future generations.

Ben S. Bernanke, the Fed chairman, is the perfect person to make this commitment to higher inflation. Mr. Bernanke has long been an advocate of inflation targeting. In the past, advocates of inflation targeting have stressed the need to keep inflation from getting out of hand. But in the current environment, the goal could be to produce enough inflation to ensure that the real interest rate is sufficiently negative.

The idea of negative interest rates may strike some people as absurd, the concoction of some impractical theorist. Perhaps it is. But remember this: Early mathematicians thought that the idea of negative numbers was absurd. Today, these numbers are commonplace. Even children can be taught that some problems (such as 2x + 6 = 0) have no solution unless you are ready to invoke negative numbers.

Maybe some economic problems require the same trick.

N. Gregory Mankiw is a professor of economics at Harvard. He was an adviser to President George W. Bush.