Monday, June 30, 2008
Sunday, June 29, 2008
The Economic Costs of the Endless War
Attention turns back to Iraq tomorrow when General Petraeus reports on the endless war in Iraq. In recent months the bad news from there (Basra has been a bloodbath and the government-initiated truce may not hold) has been eclipsed by the bad news on the economy. The two are closely related -- but not in the way some contend.
Let’s be clear. The cost of the War in Iraq – so far estimated to total somewhere between 1 and 3 trillion dollars – is not directly responsible for the economic mess we’re in. Wars can cause inflation when a nation’s resources are already fully committed, as when Lyndon Johnson escalated the war in Vietnam at the same time he was mounting a war on poverty. But when a nation’s resources are underutilized wars have been known to get economies back on track, as we learned when Franklin D. Roosevelt took the nation to war in 1941.
The US economic expansion that began in 2001 was anemic as expansions go, so the American economy has had enough capacity to support a war in Iraq without igniting inflation. Most inflation pressures now are coming from abroad – from higher oil and commodity prices. And while unrest in the Middle East has contributed to that inflation, defenders of the war say oil prices would be even higher, now and in the future, were we not in Iraq. They’re wrong, but this particular debate is a sideshow.
With the US economy falling into recession, we have even more unused capacity. That’s not in itself a reason for continuing to spend billions of dollars for the Iraqi War, of course. The war is a terribly inefficient stimulus to the US economy. A dollar spent on repairing a bridge in Iraq doesn’t have nearly the multiplier effect on our economy as a dollar spent repairing a bridge here in the United States.
More to the point – and here’s what Americans need to understand – a dollar spent in Iraq is a dollar we do not have to spend here, not only repairing our own bridges, roads, and water and sewage systems, but also giving Americans access to health insurance and children access to good schools, fully funding Social Security and Medicare, investing adequately in non-carbon based energy sources and green technologies, and borrowing less from abroad.
In other words, the real economic cost of the Iraqi War doesn’t show up in the business cycle, and it's not responsible for the current recession. The real economic cost will show up years from now in a standard of living that for most Americans will be significantly lower than we might otherwise have enjoyed.
Let’s be clear. The cost of the War in Iraq – so far estimated to total somewhere between 1 and 3 trillion dollars – is not directly responsible for the economic mess we’re in. Wars can cause inflation when a nation’s resources are already fully committed, as when Lyndon Johnson escalated the war in Vietnam at the same time he was mounting a war on poverty. But when a nation’s resources are underutilized wars have been known to get economies back on track, as we learned when Franklin D. Roosevelt took the nation to war in 1941.
The US economic expansion that began in 2001 was anemic as expansions go, so the American economy has had enough capacity to support a war in Iraq without igniting inflation. Most inflation pressures now are coming from abroad – from higher oil and commodity prices. And while unrest in the Middle East has contributed to that inflation, defenders of the war say oil prices would be even higher, now and in the future, were we not in Iraq. They’re wrong, but this particular debate is a sideshow.
With the US economy falling into recession, we have even more unused capacity. That’s not in itself a reason for continuing to spend billions of dollars for the Iraqi War, of course. The war is a terribly inefficient stimulus to the US economy. A dollar spent on repairing a bridge in Iraq doesn’t have nearly the multiplier effect on our economy as a dollar spent repairing a bridge here in the United States.
More to the point – and here’s what Americans need to understand – a dollar spent in Iraq is a dollar we do not have to spend here, not only repairing our own bridges, roads, and water and sewage systems, but also giving Americans access to health insurance and children access to good schools, fully funding Social Security and Medicare, investing adequately in non-carbon based energy sources and green technologies, and borrowing less from abroad.
In other words, the real economic cost of the Iraqi War doesn’t show up in the business cycle, and it's not responsible for the current recession. The real economic cost will show up years from now in a standard of living that for most Americans will be significantly lower than we might otherwise have enjoyed.
Saturday, June 28, 2008
Friday, June 27, 2008
On college endowments
According to a study released yesterday by the National Association of College and University Business Officers (NACUBO), the endowment fund of Harvard University is worth $34.6 billion, a 19.8% percent higher than a year ago. 76 colleges and universities sit on endowments over $1b. Even more impressively, almost every one of the 733 institutions analyzed reports a double-digit increase in the value of its fund. (Look up the endowment of your alma mater here.)
Chart 1 (click to enlarge)
The increase in the value of the endowments has been the result of at least two factors: risk taking and stock market bonanza. First, higher-education institutions invest large portions of their wealth on high-risk, high-return securities. On a dollar-weighted average, in 2007 they held a 47.4% of their funds in equities, an 18.2% in hedge funds, a 5.4% in private equity, and a 3.6% on venture capital investments. Wealthier universities hold riskier portfolios than the average. (See Chart 1.)
Second, average stock prices have increased almost every single year for over 25 years. In spite of the burst of the dot-com bubble in 2000, the inflation-adjusted Dow Jones Industrial Average Index ended 2007 at a level five times higher than in 1982. Even the most passive portfolio manager would have achieved high returns in this stock market.
Chart 2 (click to enlarge)
No surprise then that most universities have performed so well. Over the last ten years, the return on most endowments beats the S&P 500 index, which grew at a healthy 7.1% annual rate itself. (See Chart 2.) In the case of the largest portfolios, universities beat the market by a long shot.
News of these fabulous riches has prompted some sectors to demand that universities share more of their wealth. Lawmakers remind them that, as tax-exempt institutions, “they’re supposed to offer public benefit in return for (that) exemption.” Private foundations, which are also tax-exempt, are required by law to spend 5% each year; the average for colleges is 4.6%, with little variation across levels of wealth (see data). Parents, on the other hand, don’t understand why tuition keeps going up while universities continue to amass wealth. Little do they suspect that the cost of college is stoked by the self-interest of parents and students themselves, not that of universities.
The classic explanation for the rise of tuition is that the college premium —the positive gap between the earnings of college graduates and high school graduates— has increased the demand for college education, thereby raising its equilibrium price.
More interestingly, the stock market has also made tuition rates go up, according to a paper* by my former colleague at the University of Chicago Pablo Peña (pdf). Rises in asset prices increase the amount of resources available to universities. Part of that wealth is spent on inputs that improve the quality of education: more and better qualified professors, and newer and more sophisticated facilities, such as labs, computers and libraries, for instance. Higher quality, in turn, increases the amount of human capital accumulated in college, and ultimately affects life-time earnings, i.e. the returns to education. Prestige considerations may be at work too: celebrity professors and state-of-the-art facilities increase the reputation of the institution, adding to the value of the diploma. Therefore, larger endowments spur the demand for college education, and drive up tuition rates.
Differences in the value of endowments across universities are vast: the combined value of the top ten colleges represents 35% of total endowment assets. In light of Pablo’s theory, the implications of this inequality depend on what universities and colleges spend their money on.
If they continue to use their wealth to improve the quality of the service they provide, demand for college education and tuition levels will continue to rise. Differences in tuition rates and education quality between top-notch and second-tier institutions will continue to widen too, since endowments and asset returns are highly concentrated. Also, because the ablest students —those with highest SAT scores or best records of achievement in high school— benefit the most from the quality of college education, the matching of the best students with the best institutions will intensify. Differences in the quality of students across colleges will increase.
On the other hand, universities could start using their endowments to increase capacity or subsidize the cost of college. In this unlikely scenario, the equilibrium price of higher education will probably decline, the quality of college education will drop, and the college premium —the earnings of college graduates vis-à-vis high-school graduates— will drop.
Selected institutions have recently been announcing that they will increase financial aid. Recent announcements might suggest that this could actually happen among selected institutions. Harvard and Dartmouth have eliminated loans from their aid packages and will be giving grants instead; and Yale has followed in their footsteps. These de facto cuts in average tuition rates are not going to change the system. First, they won’t change the quality of education at top universities, for which the foregone tuition revenue is peanuts. Second, they won’t reduce the cost of attendance of the average college student, because the number of institutions that can afford foregoing tuition revenues is small.
But improved aid packages at top schools will make their programs affordable to the brightest students, regardless of their financial situation. If the newfound altruism of the Harvards and Yales has any effect, that will be an even more pronounced assortative matching of colleges and applicants by quality. The scope of these developments is very limited, but it’s good news —at least for believers, like myself, in a free, merit-based education system.
More data:
Tuition rates: table of nominal rates (html), graph of real rates (pdf, Figure 1)
Technorati tags: economics, education, college, endowments, college tuition
Chart 1 (click to enlarge)
The increase in the value of the endowments has been the result of at least two factors: risk taking and stock market bonanza. First, higher-education institutions invest large portions of their wealth on high-risk, high-return securities. On a dollar-weighted average, in 2007 they held a 47.4% of their funds in equities, an 18.2% in hedge funds, a 5.4% in private equity, and a 3.6% on venture capital investments. Wealthier universities hold riskier portfolios than the average. (See Chart 1.)
Second, average stock prices have increased almost every single year for over 25 years. In spite of the burst of the dot-com bubble in 2000, the inflation-adjusted Dow Jones Industrial Average Index ended 2007 at a level five times higher than in 1982. Even the most passive portfolio manager would have achieved high returns in this stock market.
Chart 2 (click to enlarge)
No surprise then that most universities have performed so well. Over the last ten years, the return on most endowments beats the S&P 500 index, which grew at a healthy 7.1% annual rate itself. (See Chart 2.) In the case of the largest portfolios, universities beat the market by a long shot.
News of these fabulous riches has prompted some sectors to demand that universities share more of their wealth. Lawmakers remind them that, as tax-exempt institutions, “they’re supposed to offer public benefit in return for (that) exemption.” Private foundations, which are also tax-exempt, are required by law to spend 5% each year; the average for colleges is 4.6%, with little variation across levels of wealth (see data). Parents, on the other hand, don’t understand why tuition keeps going up while universities continue to amass wealth. Little do they suspect that the cost of college is stoked by the self-interest of parents and students themselves, not that of universities.
The classic explanation for the rise of tuition is that the college premium —the positive gap between the earnings of college graduates and high school graduates— has increased the demand for college education, thereby raising its equilibrium price.
More interestingly, the stock market has also made tuition rates go up, according to a paper* by my former colleague at the University of Chicago Pablo Peña (pdf). Rises in asset prices increase the amount of resources available to universities. Part of that wealth is spent on inputs that improve the quality of education: more and better qualified professors, and newer and more sophisticated facilities, such as labs, computers and libraries, for instance. Higher quality, in turn, increases the amount of human capital accumulated in college, and ultimately affects life-time earnings, i.e. the returns to education. Prestige considerations may be at work too: celebrity professors and state-of-the-art facilities increase the reputation of the institution, adding to the value of the diploma. Therefore, larger endowments spur the demand for college education, and drive up tuition rates.
Differences in the value of endowments across universities are vast: the combined value of the top ten colleges represents 35% of total endowment assets. In light of Pablo’s theory, the implications of this inequality depend on what universities and colleges spend their money on.
If they continue to use their wealth to improve the quality of the service they provide, demand for college education and tuition levels will continue to rise. Differences in tuition rates and education quality between top-notch and second-tier institutions will continue to widen too, since endowments and asset returns are highly concentrated. Also, because the ablest students —those with highest SAT scores or best records of achievement in high school— benefit the most from the quality of college education, the matching of the best students with the best institutions will intensify. Differences in the quality of students across colleges will increase.
On the other hand, universities could start using their endowments to increase capacity or subsidize the cost of college. In this unlikely scenario, the equilibrium price of higher education will probably decline, the quality of college education will drop, and the college premium —the earnings of college graduates vis-à-vis high-school graduates— will drop.
Selected institutions have recently been announcing that they will increase financial aid. Recent announcements might suggest that this could actually happen among selected institutions. Harvard and Dartmouth have eliminated loans from their aid packages and will be giving grants instead; and Yale has followed in their footsteps. These de facto cuts in average tuition rates are not going to change the system. First, they won’t change the quality of education at top universities, for which the foregone tuition revenue is peanuts. Second, they won’t reduce the cost of attendance of the average college student, because the number of institutions that can afford foregoing tuition revenues is small.
But improved aid packages at top schools will make their programs affordable to the brightest students, regardless of their financial situation. If the newfound altruism of the Harvards and Yales has any effect, that will be an even more pronounced assortative matching of colleges and applicants by quality. The scope of these developments is very limited, but it’s good news —at least for believers, like myself, in a free, merit-based education system.
More data:
Tuition rates: table of nominal rates (html), graph of real rates (pdf, Figure 1)
Technorati tags: economics, education, college, endowments, college tuition
Thursday, June 26, 2008
Economy Slowing Says Calculated Risk
Great Blogger, Calculated Risk "Clearly the economy is slowing sharply"
Wednesday, June 25, 2008
The Senate Housing Bill Won't Do Squat
The housing bill emerging from the Senate is something Herbert Hoover would have been proud of. Like Hank Paulson’s much-touted plan for “overhauling” Wall Street by deregulating it, the Senate housing bill “helps” distressed homeowners by giving them lots of little things that won’t really help them at all. Lesson: The Fed (and, indirectly, taxpayers) can bail out investment banks but there’s no stomach for bailing out regular folk who got caught in the downdraft.
Paulson’s proposal, remember, leaves out the most important overhaul of all – forcing investment banks, hedge funds, and other bank-like financial institutions to maintain capital in proportion to the risks they take on. Now the Senate bill leaves out the most important things distressed homeowners need – changing bankruptcy law so borrowers have enough bargaining power to get refinanced, and letting the Federal Housing Administration guarantee the refinanced loans if lenders reduce the amounts the borrowers owe to reflect the reduced home values.
If the market were working, lenders would automatically refinance most of these loans. After all, it’s better for them to have someone in a house paying a mortgage than being stuck with an empty house and nobody paying anything. But as we now know, the loans were repackaged with other loans into securities which were then resold to other investors. So the original lenders no longer have the authority or the incentive to do the refinancing. Hence, there's no market that will automatically do the refinancing. That’s why we need carrots and sticks: A new bankruptcy law that would give distressed homeowners the power to go into bankruptcy to get refinanced if investors don't respond, plus federal guarantees to back up any investor who buys up the securities at a discount and then works with borrowers to refinance the loans.
But as with Paulson’s proposal, the bankers and lenders who are still in relatively good shape went into action. Their lobbyists, working with and through Republicans, watered the Senate Democrats’ housing bill down to almost nothing. If this recession turns much worse, all of them may rue the day they blocked the housing bill. And Democrats will regret how easily they caved.
Paulson’s proposal, remember, leaves out the most important overhaul of all – forcing investment banks, hedge funds, and other bank-like financial institutions to maintain capital in proportion to the risks they take on. Now the Senate bill leaves out the most important things distressed homeowners need – changing bankruptcy law so borrowers have enough bargaining power to get refinanced, and letting the Federal Housing Administration guarantee the refinanced loans if lenders reduce the amounts the borrowers owe to reflect the reduced home values.
If the market were working, lenders would automatically refinance most of these loans. After all, it’s better for them to have someone in a house paying a mortgage than being stuck with an empty house and nobody paying anything. But as we now know, the loans were repackaged with other loans into securities which were then resold to other investors. So the original lenders no longer have the authority or the incentive to do the refinancing. Hence, there's no market that will automatically do the refinancing. That’s why we need carrots and sticks: A new bankruptcy law that would give distressed homeowners the power to go into bankruptcy to get refinanced if investors don't respond, plus federal guarantees to back up any investor who buys up the securities at a discount and then works with borrowers to refinance the loans.
But as with Paulson’s proposal, the bankers and lenders who are still in relatively good shape went into action. Their lobbyists, working with and through Republicans, watered the Senate Democrats’ housing bill down to almost nothing. If this recession turns much worse, all of them may rue the day they blocked the housing bill. And Democrats will regret how easily they caved.
Tuesday, June 24, 2008
Monday, June 23, 2008
Income mobility and education
As goats on a tree, reaching for the best leaves, we all strive to be the ones at the top. But even in America, the land of opportunity, only good climbers make it. And lately even the fittest seem to be having a hard time.
The table below shows the percentage of people who moved from a given group in the income distribution to any other one, between 1994 and 2004. (The data come from the Panel Study of Income Dynamics, and the income measure is household taxable earnings.) The lowest degree of income mobility occurs among the poorest and the wealthiest: 58% of households in the bottom 20% of the distribution stay there, and 60% of those in the wealthiest quintile don’t move either.
Pooling people from all ages together, however, can be misleading. The typical earnings profile over a lifetime is hump-shaped: earnings start low, rise up until the individual is in her 50s, then begin a slow decline, and fall sharply with retirement. Because of this non-monotonicity, movements up and down the earnings distribution may have little to do with climbing the social ladder.
As an example: suppose the economy is populated by two individuals, one of whom is 35 and earns $45,000, and the other one is 55 and makes $75,000. So the older person is at the top of the distribution. Ten years later, the young individual has accumulated experience and earns $65,000, whereas the older person, now 65, has retired and doesn’t earn any labor income. The younger individual is at the top of the earnings distribution now. If we were oblivious to the age of these individuals, this two-person society would look remarkably mobile: the poorer person moved to the top and vice versa. In reality, the observed mobility is the product of the normal course of earnings over peoples’ lives.
The fortunes of a person are more likely to change early in life. Twentysomethings are less likely to be attached to a house, a family, or a job. They job-hop, experiment, go back to school. Over time, some people land a dream job —or a “comfort job”— and stay there. And some others simply grow roots: they have mortgages to pay, and spouses and kids to drag along. We also become more risk averse with age.
The data bear these intuitions: 67% of households whose head was between 22 and 29 in 1994 had switched quintiles ten years later; 54% of those between 30 and 39 did so, about the same as among the 40-49 age group.
Things get much more interesting when I look at mobility within education groups. Schooling is probably the single most important factor determining a person’s chance to “make it.” People with less education are less employable. They also experience smaller changes in productivity, so their earnings curve is less steep. And they have fewer opportunities to fill high-powered positions —the sort that provide a pay boost if one is successful. In this, however, the evidence doesn't support my expectations.
Between 1975 and 1985, and within the group of college graduates, 61% of households moved to a different economic class, whereas 59% of high school graduates were mobile -barely a difference. And twenty years later, 54% of college grads and 60% of people with a high school degree were mobile. (See chart.)
Click to enlarge
What made the economic ladder more slippery for college grads? Following the reasoning above, maybe people have less appetite for risk, and are taking jobs that are safer but also offer fewer opportunities to leap-frog over income classes. Starting up a business, for instance, is one of the riskiest endeavors one could pursue. But statistics show that animal spirits have not subdued —the fraction of entrepreneurs and self-employed has risen over the last 30 years.
A second explanation is that unobserved ability, not education, is behind opportunity. A couple of decades ago earning a college degree was a major feat. Only the well-off, highly-motivated and bright ever put their feet in a University. Nowadays going to college is almost a given. As a result a college degree has become a weaker signal of one’s competence. Highly capable individuals still get ahead, but the vast majority of college graduates do not belong to that breed.
Finally, but not less importantly, it might be a problem of too many grads chasing too few jobs with incentive-based pay. In spite of all the talk about stock options, the number of positions with (significant) variable compensation has grown more slowly than the body of individuals with a University diploma. More well-educated people land jobs without the power or the incentives to rise fast on the pay scale.
This calcification of the white-collar society is worrying. More and more individuals go to graduate school in order to earn that M.B.A., M.A., or even Ph.D., that will give them an edge over their peers. That behavior is perfectly rational, and yet self-defeating. The latest batches of college grads remind me of hamsters on a wheel rather than goats.
Technorati tags: economics, income mobility, inequality, income inequality, upward mobility
Sunday, June 22, 2008
Risk Factors For A 2008 Recession
Here are the top risk factors for 2008 US Recession:
- Continuing Housing Bust
- High Oil Prices
- Security Issues
- Credit Crunch
- High Consumer Debt
- Large Trade Deficit
- Consumer Spending is slowing (it makes up 70% of the US GDP)
- Commercial Construction decline
Saturday, June 21, 2008
Hank Paulson's Punt
It’s being called the broadest overhaul of Wall Street regulation since the Great Depression. But look closely at the proposal announced this morning by Treasury chief Hank Paulson, and you’ll find a thin veneer of regulatory filagree -- designed to appease a public outraged by the mismanagement of its savings and the taxpayer-financed bailout of Wall Street’s well-padded executives, but also, sadly, designed to accomplish just about nothing.
Paulson rearranges and consolidates lots of regulations and seems to beef up the oversight responsibilities of the Federal Reserve. But the Fed would not routinely examine the books of investment banks and hedge funds the way bank examiners now scrutinize regular banks, and agencies like the SEC would actually lose some of their current authority.
Most significantly, the proposal doesn’t call for investment banks, hedge funds, and other currently unregulated financial institutions to hold capital assets proportional to the risks they’re taking on. That’s the case even though the Fed has now subjected taxpayers to the risk of bailing out any large financial institution that gets into trouble because it doesn’t have enough capital to back up its risky bets. Even though two-thirds of subprime mortgages issued in the last five years originated with non-banks that have little or no capital requirements. Even though 80 percent of all lending today is from unregulated banks that hold almost no capital assets.
Paulson says he doesn’t blame the current regulatory structure for current market turmoil. Well, Hank, if it’s not the current Wild-West take-any-risk with other people’s money non-regulatory structure we have now, how do you explain the housing bubble and the credit meltdown and the taxpayer bailout of Wall Street? How exactly are your proposed fixes going to prevent another crisis?
Hank Paulson’s discussion paper – it’s not even meant to be enacted under the Bush Administration – is not broad, it’s not an overhaul, and heaven forbid, if we’re facing another Great Depression, it will do absolutely zilch to head it off.
Paulson rearranges and consolidates lots of regulations and seems to beef up the oversight responsibilities of the Federal Reserve. But the Fed would not routinely examine the books of investment banks and hedge funds the way bank examiners now scrutinize regular banks, and agencies like the SEC would actually lose some of their current authority.
Most significantly, the proposal doesn’t call for investment banks, hedge funds, and other currently unregulated financial institutions to hold capital assets proportional to the risks they’re taking on. That’s the case even though the Fed has now subjected taxpayers to the risk of bailing out any large financial institution that gets into trouble because it doesn’t have enough capital to back up its risky bets. Even though two-thirds of subprime mortgages issued in the last five years originated with non-banks that have little or no capital requirements. Even though 80 percent of all lending today is from unregulated banks that hold almost no capital assets.
Paulson says he doesn’t blame the current regulatory structure for current market turmoil. Well, Hank, if it’s not the current Wild-West take-any-risk with other people’s money non-regulatory structure we have now, how do you explain the housing bubble and the credit meltdown and the taxpayer bailout of Wall Street? How exactly are your proposed fixes going to prevent another crisis?
Hank Paulson’s discussion paper – it’s not even meant to be enacted under the Bush Administration – is not broad, it’s not an overhaul, and heaven forbid, if we’re facing another Great Depression, it will do absolutely zilch to head it off.
Friday, June 20, 2008
Thursday, June 19, 2008
Personal bankruptcy and consumption smoothing
The welfare effects of bankruptcy legislation are not correctly understood. Policymakers and the general public think, for the most part, that laws that protect borrowers in the event of default are beneficial to consumers. In practice, however, those laws have negative effects on the households that need credit most — and, ironically, those whom the legislation was intended to protect.
Traditionally, Chapter 7 has been the most popular type of bankruptcy filing. Under that section of the Bankruptcy Code, a filer relinquishes her assets, minus a certain exempted amount, and in return is discharged from her unsecured debt (credit card debt, personal loans, student loans, etc.).
State law sets those exempted amounts. In Illinois, for instance, exemptions are: $7,500 for home equity, $1,200 for motor vehicles, $750 for tools of the trade, and $2,000 for any other generic property. So suppose that you file for bankruptcy in the “Land of Lincoln,” and that you have $20,000 worth of home equity, and a car with a market value of $600. Then you can sell the house and keep $7,500 of the proceeds, and sell your car and keep the $600 (since that’s below the $1,200 limit).
Since 1978, with the passage of the Bankruptcy Reform Act (BRA), there’s also a federal exemption. Some states allow filers to choose between the state and the federal amounts. Obviously, if given the opportunity, filers use whichever is highest.
There is an enormous disparity of bankruptcy exemptions across states, even after accounting for the existence of the federal limits. For example, in 2006 the states of Texas, Florida, Oklahoma, Iowa, Kansas, South Dakota, and the District of Columbia, all allowed for an unlimited homestead exemption. In the states of Ohio and Virginia, at the other extreme, the limit is set at $5,000 (and those states don’t allow for the application of the federal exemption). The map below shows the maximum exemption that a married homeowner could claim in 2003, after combining homestead and non-homestead amounts, and taking the highest of the state and federal limit (where the federal limit is available). The limits also vary over time, although high-exemption states tend to remain the same over the years.
The amount of the exemption provides insurance for the debtor’s consumption. Suppose that a debtor suffers a setback, such as illness or unemployment, and that she is forced to default on her credit card debt and student loans. In the absence of any exemption, creditors would take a blanket security interest in all of the debtor’s possessions. The existence of an exemption means that she is left with at least a small amount of assets after filing for bankruptcy. Legislators see it as a way to provide a “fresh start.” An alternative view is that a certain amount of assets, and hence consumption, are insured against negative events.
On the other side of the coin, lenders are hurt by this form of consumer protection. Higher exemptions reduce the payments received by the lender in the event of default, and increase the probability of bankruptcy, since the borrower’s punishment for doing so becomes smaller. Creditors rationally respond to higher exemptions by raising interest rates and rationing credit. This rationing may take the form of fewer households with access to debt, smaller loans, or both. Fewer and smaller loans reduce the amount of consumption that households can finance with debt in times of low income.
In theory, then, bankruptcy exemptions have an ambiguous effect on consumption smoothing. Higher exemptions allow bankrupt households to keep more assets; but those same higher exemptions reduce the supply of credit. It is, therefore, an empirical matter whether higher limits enhance or detract from the role of debt as a consumption insurance mechanism.
To answer that question, I put together data on consumption and lay-offs of American households (from the Panel Study of Income Dynamics), as well as bankruptcy exemptions, for as many years as I could get consistent data for. (In practice, that is 1976 through 2003, with the exception of 1994-1997.) The idea is to estimate by how much a family’s consumption is reduced when its main income earner gets laid off, and see how much the hit to consumption changes with the bankruptcy exemption.
As a warm-up and point of reference, I estimate that, without taking into account the exemptions, a household whose breadwinner gets laid off reduces its consumption by five to six percent. Once I include bankruptcy laws in the econometric analysis, I find that households that live in states with unlimited exemptions reduce their consumption by 16 to 18 percent. Households in the top third of the distribution of (limited) exemptions reduce their consumption by nine to ten percent. For households with lower exemptions the effect of unemployment on consumption is low and statistically insignificant. (See chart.)
Click to enlarge
My interpretation of the results is that consumer debt is an important mechanism of consumption insurance. People use loans and credit card debt not only to finance big-ticket items, but also to make ends meet when disaster strikes. Legislation that makes it harder to obtain debt, such as bankruptcy exemptions or interest rate caps, ends up punishing the weakest: people with low wealth, who could make the most use of credit as an insurance device.
Don’t get me wrong: this is not a call to eliminate bankruptcy exemptions. There is a place for them as a means to provide safety to people who have been struck by unexpected events. A zero-exemption policy would probably expand credit supply — at the cost of leaving thousands of families destitute and without a chance to recover. But exorbitant homestead exemptions go way beyond providing a chance for a “fresh start.” Likewise, there’s no reason why people should be allowed to keep $60,000 worth of personal property, as they can do in Texas.
Surely, medical expenses can easily run into the hundreds of thousands of dollars. But that’s a reason to reform health insurance. Limiting the enforceability of credit contracts is a bad way to lay out safety nets.
This post was based on my own research. The write-up of the paper is still in the making. It will be available on my website by January 28. In the meantime, you can have a look at the slides I prepared for a presentation this Friday.
Technorati tags: economics, personal bankruptcy, consumption, bankruptcy exemption, consumption smoothing
Traditionally, Chapter 7 has been the most popular type of bankruptcy filing. Under that section of the Bankruptcy Code, a filer relinquishes her assets, minus a certain exempted amount, and in return is discharged from her unsecured debt (credit card debt, personal loans, student loans, etc.).
State law sets those exempted amounts. In Illinois, for instance, exemptions are: $7,500 for home equity, $1,200 for motor vehicles, $750 for tools of the trade, and $2,000 for any other generic property. So suppose that you file for bankruptcy in the “Land of Lincoln,” and that you have $20,000 worth of home equity, and a car with a market value of $600. Then you can sell the house and keep $7,500 of the proceeds, and sell your car and keep the $600 (since that’s below the $1,200 limit).
Since 1978, with the passage of the Bankruptcy Reform Act (BRA), there’s also a federal exemption. Some states allow filers to choose between the state and the federal amounts. Obviously, if given the opportunity, filers use whichever is highest.
There is an enormous disparity of bankruptcy exemptions across states, even after accounting for the existence of the federal limits. For example, in 2006 the states of Texas, Florida, Oklahoma, Iowa, Kansas, South Dakota, and the District of Columbia, all allowed for an unlimited homestead exemption. In the states of Ohio and Virginia, at the other extreme, the limit is set at $5,000 (and those states don’t allow for the application of the federal exemption). The map below shows the maximum exemption that a married homeowner could claim in 2003, after combining homestead and non-homestead amounts, and taking the highest of the state and federal limit (where the federal limit is available). The limits also vary over time, although high-exemption states tend to remain the same over the years.
Bankruptcy exemptions under Chapter 7 of the Bankruptcy Code
(in 2003, for a home owner)
Click to enlarge
(in 2003, for a home owner)
Click to enlarge
The amount of the exemption provides insurance for the debtor’s consumption. Suppose that a debtor suffers a setback, such as illness or unemployment, and that she is forced to default on her credit card debt and student loans. In the absence of any exemption, creditors would take a blanket security interest in all of the debtor’s possessions. The existence of an exemption means that she is left with at least a small amount of assets after filing for bankruptcy. Legislators see it as a way to provide a “fresh start.” An alternative view is that a certain amount of assets, and hence consumption, are insured against negative events.
On the other side of the coin, lenders are hurt by this form of consumer protection. Higher exemptions reduce the payments received by the lender in the event of default, and increase the probability of bankruptcy, since the borrower’s punishment for doing so becomes smaller. Creditors rationally respond to higher exemptions by raising interest rates and rationing credit. This rationing may take the form of fewer households with access to debt, smaller loans, or both. Fewer and smaller loans reduce the amount of consumption that households can finance with debt in times of low income.
In theory, then, bankruptcy exemptions have an ambiguous effect on consumption smoothing. Higher exemptions allow bankrupt households to keep more assets; but those same higher exemptions reduce the supply of credit. It is, therefore, an empirical matter whether higher limits enhance or detract from the role of debt as a consumption insurance mechanism.
To answer that question, I put together data on consumption and lay-offs of American households (from the Panel Study of Income Dynamics), as well as bankruptcy exemptions, for as many years as I could get consistent data for. (In practice, that is 1976 through 2003, with the exception of 1994-1997.) The idea is to estimate by how much a family’s consumption is reduced when its main income earner gets laid off, and see how much the hit to consumption changes with the bankruptcy exemption.
As a warm-up and point of reference, I estimate that, without taking into account the exemptions, a household whose breadwinner gets laid off reduces its consumption by five to six percent. Once I include bankruptcy laws in the econometric analysis, I find that households that live in states with unlimited exemptions reduce their consumption by 16 to 18 percent. Households in the top third of the distribution of (limited) exemptions reduce their consumption by nine to ten percent. For households with lower exemptions the effect of unemployment on consumption is low and statistically insignificant. (See chart.)
Click to enlarge
My interpretation of the results is that consumer debt is an important mechanism of consumption insurance. People use loans and credit card debt not only to finance big-ticket items, but also to make ends meet when disaster strikes. Legislation that makes it harder to obtain debt, such as bankruptcy exemptions or interest rate caps, ends up punishing the weakest: people with low wealth, who could make the most use of credit as an insurance device.
Don’t get me wrong: this is not a call to eliminate bankruptcy exemptions. There is a place for them as a means to provide safety to people who have been struck by unexpected events. A zero-exemption policy would probably expand credit supply — at the cost of leaving thousands of families destitute and without a chance to recover. But exorbitant homestead exemptions go way beyond providing a chance for a “fresh start.” Likewise, there’s no reason why people should be allowed to keep $60,000 worth of personal property, as they can do in Texas.
Surely, medical expenses can easily run into the hundreds of thousands of dollars. But that’s a reason to reform health insurance. Limiting the enforceability of credit contracts is a bad way to lay out safety nets.
This post was based on my own research. The write-up of the paper is still in the making. It will be available on my website by January 28. In the meantime, you can have a look at the slides I prepared for a presentation this Friday.
Technorati tags: economics, personal bankruptcy, consumption, bankruptcy exemption, consumption smoothing
Wednesday, June 18, 2008
Recession Fears Grow
Reuters reports that "Unsold goods are piling up in warehouses as the housing meltdown and soaring oil prices strain consumers, raising fears that already glum fourth-quarter growth prospects may tip toward recession."
"The sluggishness is apparent in the retail sector, where 70 percent of chain stores posted weaker-than-expected October sales results, according to research firm Retail Metrics.
"The sluggishness is apparent in the retail sector, where 70 percent of chain stores posted weaker-than-expected October sales results, according to research firm Retail Metrics.
"We expect the challenging retail environment to continue for the foreseeable future," Mike Ullman, chairman and chief executive officer of department store chain J.C. Penney (JCP.N: Quote, Profile, Research), said last week. He added that the company would keep inventory levels tight through 2008."
Respected economist Nouriel Roubini writes "Any recession call for the U.S. is clearly dependent on US consumption faltering. Since residential investment is only 5% of even a worsening housing recession cannot – by itself – trigger an economy-wide recession. Rather, since private consumption is over 70% of aggregate demand a sharp and persistent slowdown in consumption growth – below 1% or even negative - is necessary to trigger a full blown recessionTuesday, June 17, 2008
The Biggest Bailout in History: And Why American Taxpayers Should Get Some of the Upside
So JP Morgan is raising its offer for Bear Stearns, hmm? Well, it still may be a good deal for old JP, because the worst that can happen is JP loses $1 billion. If losses turn out to be more than $1 billion, the Fed – that is, you and I and every other American taxpayer – will make it up to JP. Who knows what the assets are really worth? They may be worth 80 cents on the dollar, in which case Bear’s stocks are a huge value even at $10 a share (remember, their market price before the panic was around $70 a share). They may be worth 90 cents on the dollar – even better for JP. Or they may eventually (in the long run, when the crisis is over and housing values start trending upward again) be worth far more --- maybe, just maybe, even approaching $70 a share. JP doesn’t know. Bear doesn’t know. The Fed doesn’t know. Everyone is guessing. Bear shareholders are playing a giant game of “chicken.” They’re threatening to go into bankruptcy – that is, liquidate the firm and essentially sell off their assets in an auction – if they don’t get a better deal from JP than the $2 per share JP originally offered.
But it's not just Bear's shareholders who should be asking for more. You and I as taxpayers ought to be asking for more, too. I mean, we're bearing the big downside losses if everything goes to hell and Bear’s assets are worth less than zilch. But we don’t get any of the upside gain if any of the bets pay off. That’s what I call a lousy deal.
A similar lousy deal is brewing in Congress where Democrats are readying a bill to guarantee the price of securities containing bad mortgage debt, if investors will buy them and restructure the securities so homeowners have a better chance of repaying their mortgages (stabilizing the interest rates and lengthening the terms of repayment, for example). The betting here is that, by doing this, the underlying assets will be worth more than the investor buyers are paying for them. In other words, once these mortgages are restructured, more homeowners will be able to keep paying them, so houses will be generating real money for mortgage lenders once again. But it’s a gamble for a potential investor buyer. And if Congress takes the downside risk out of the gamble, it seems only appropriate that taxpayers should get a portion of the upside gain. (The Dodd-Frank bill would in fact give taxpayers a portion of any homeowner equity gain.)
We as taxpayers are chumps if we bear all the downside losses but get none of the upside gains.
Here’s a better idea: When the Fed bails out a Wall Street bank in danger of collapsing or when government (under the Democrats’ bill) guarantees the price of securities that have an unknown amount of bad debt wrapped up in them, the government should retain a stake. That way, if Bear Stearns stock eventually bounces back, or if JP Morgan shows a big profit on its purchase of Bear, or if buyers of any securities guaranteed by the government make a profit – whatever the upside gain turns out to be -- taxpayers that are footing the bill for potential losses get some of that money. And these upside profits cover us in cases where the gamble turns out bad and we’re left holding the bag.
I’m not suggesting anything so draconian and ideologically objectionable as public ownership. Perish the thought. Let the Brits bail out their big bank and nationalize it, and get any upside gain when and if the bank’s shares become worth something again and the UK sells off the bank. No, I’m making a much more modest suggestion. We should arrange our own bailout deals so that American taxpayers get a portion of the profits on bets that turn out good, in order to compensate us for the bets that turn out bad.
The idea is as American as apple pie: Nothing ventured, nothing gained.
But it's not just Bear's shareholders who should be asking for more. You and I as taxpayers ought to be asking for more, too. I mean, we're bearing the big downside losses if everything goes to hell and Bear’s assets are worth less than zilch. But we don’t get any of the upside gain if any of the bets pay off. That’s what I call a lousy deal.
A similar lousy deal is brewing in Congress where Democrats are readying a bill to guarantee the price of securities containing bad mortgage debt, if investors will buy them and restructure the securities so homeowners have a better chance of repaying their mortgages (stabilizing the interest rates and lengthening the terms of repayment, for example). The betting here is that, by doing this, the underlying assets will be worth more than the investor buyers are paying for them. In other words, once these mortgages are restructured, more homeowners will be able to keep paying them, so houses will be generating real money for mortgage lenders once again. But it’s a gamble for a potential investor buyer. And if Congress takes the downside risk out of the gamble, it seems only appropriate that taxpayers should get a portion of the upside gain. (The Dodd-Frank bill would in fact give taxpayers a portion of any homeowner equity gain.)
We as taxpayers are chumps if we bear all the downside losses but get none of the upside gains.
Here’s a better idea: When the Fed bails out a Wall Street bank in danger of collapsing or when government (under the Democrats’ bill) guarantees the price of securities that have an unknown amount of bad debt wrapped up in them, the government should retain a stake. That way, if Bear Stearns stock eventually bounces back, or if JP Morgan shows a big profit on its purchase of Bear, or if buyers of any securities guaranteed by the government make a profit – whatever the upside gain turns out to be -- taxpayers that are footing the bill for potential losses get some of that money. And these upside profits cover us in cases where the gamble turns out bad and we’re left holding the bag.
I’m not suggesting anything so draconian and ideologically objectionable as public ownership. Perish the thought. Let the Brits bail out their big bank and nationalize it, and get any upside gain when and if the bank’s shares become worth something again and the UK sells off the bank. No, I’m making a much more modest suggestion. We should arrange our own bailout deals so that American taxpayers get a portion of the profits on bets that turn out good, in order to compensate us for the bets that turn out bad.
The idea is as American as apple pie: Nothing ventured, nothing gained.
Monday, June 16, 2008
Who's Paying For Your Fix?
by Kate Duncan
May/Jun 2003 Issue
Unless your morning latte was a fair trade blend, it probably cost more than what the farmer who picked the beans earns in a day.
Conventional coffee prices are at their lowest in a century, even below the cost of production. Farmers have been leaving the fruit to rot on the tree, pulling the kids out of school, abandoning the family land and pouring into the cities to find non-existent work. That’s why, as the most heavily traded commodity after oil, and the most common beverage after water, coffee is a major focus of the fair trade movement.
If your morning latte was a fair trade brew, it means the person who farmed the beans is earning enough to support his family. This is all well and good, but the way fair trade is usually explained - with prices, numbers and statistics - ignores it’s lasting benefits. The true point of fair trade is the cultural, communal, and environmental stability it bolsters.
A farmer who sells through fair trade is a member of a cooperative that is a vehicle for community empowerment. And not just a neighborhood watch: The people typically organized via fair trade are those whom the free market has filtered to the lowest economic stratum. Rather than maneuvering them into a position where they’re forced to take what they can get, fair trade recognizes farmers as equal partners, a platform from which they can command more control over their business and lives.
'Fair trade is a different kind of business relationship between the producer and buyer, which has been an inspiration to help these communities pull together instead of caving to the pressure of all the things trying to blow them apart,' says Monika Firl. Monika heads up producer relations for Cooperative Coffees, and as such, led half a dozen coffee roasters and me (as a grateful representative of Idyll Development Foundation, one of Cooperative Coffee’s funders) on a buying trip to farmers’ co-ops in Nicaragua, Guatemala, and Mexico in February, where we were able to see the effect for ourselves. [Clamor]
Sunday, June 15, 2008
A bash for confidence indexes
Every month the University of Michigan and the Conference Board conduct a survey of households’ confidence on the state of the economy. Each pollster asks several questions and summarizes the results with an index, which is closely watched for signs of consumer distress. Last November, the Michigan index fell by 4.8 points from October; the Conference Board Index dipped by 7.9 points. Supposedly this is bad news because worried consumers are thrifty consumers. Don’t let the surveys fool you: they are almost complete rubbish — unless you know how to use them.
At first glance, both the Michigan index (MI) and the Conference Board index (CI) are correlated with the business cycle: they sink around the beginning of a recession and rebound near the end (see chart nearby, originally published by the Wall Street Journal). They even seem to track the quarter-to-quarter growth of consumption expenditures. Look a bit closer, however, and you’ll see that confidence and reality get out of synch sometimes. For instance, both the MI and the CI were abnormally low relative to consumption growth in 1992-1993, and again during 2002 and 2003. The indices dipped during the Asian crisis of 1998, but consumption growth didn’t budge; conversely, expenditure growth fell dramatically in early 1995 even though sentiment didn’t change.
Formal statistical analyses have found that consumer sentiment says very little that forecasters don’t know already. That is, once this quarter’s spending, interest rates, etc. are known, it does not help much to predict future spending growth. Confidence and expectations matter. The issue, I reckon, is that these particular indices fail to capture them.
A cursory look at the guts of the MI and the CI will convince you that they are literally meaningless. Each of them is a mishmash of five opinions — which, by the way, are not the same for both surveys (see table below). The questionnaires represent but the pollster’s guess of what determines spending. There’s no guarantee that the questions are the ones that actually matter.
For instance, the MI doesn’t include questions on job security, whereas the CI doesn’t ask about present personal finances. The potential irrelevance of the surveys becomes painfully clear when one examines the first question of the MI: “Do you think now is a good or bad time for people to buy major household items?” With such a specific wording, that question should predict expenditures on cars, appliances, furniture and such, i.e. durable goods. But once past purchases are included into the forecasting model, confidence and expenditures are barely correlated. [1]
Even if one of the indexes had the right composition, there’s no reason why all the questions should be given equal weights. Personal finances and availability of jobs, for example, may influence a consumer’s expenditures more than overall business conditions; short-term prospects should matter more than distant ones. In both the MI and the CI, however, every question counts the same.
Despite my bashing of the indexes, the surveys are worth keeping. Each of them contains some question that can help predict one or other component of expenditures. More specifically, the Conference Board’s questions about job prospects help forecast expenditures on durable goods: sentiment about the current job situation (question number two in the table) significantly predicts purchases of vehicles and other durables; expectations about future jobs (question four) predicts expenditures on vehicles only. [1] The Michigan survey, on the other hand, contains questions which are not used in the indexes. It would be worth exploring whether they are useful for forecasters.
Unfortunately, the component questions are not accessible to most people. If they are, it’s only with significant delay. And even if they were published timely, most people wouldn’t be able to use them because they can’t handle the number crunching. So here’s my advice for the everyday news consumer. First, don’t draw any conclusions from month-to-month changes of the indexes, no matter how large they are. Start believing them only after several months of consecutive rises or declines. Second, the Conference Board index is a better predictor than the Michigan index, because the latter doesn’t include any question about jobs. Third, rather than sentiment indicators, pay attention to data on the labor market: the unemployment rate and the payroll numbers, for example, averaged over at least three months. Not only do they gauge consumers’ confidence more accurately than the confidence indexes themselves: they influence spending decisions directly (the more unemployment, the less disposable income).
In all fairness, the intention of the MI and the CI was never to forecast any specific variable. They were designed over 40 years ago as a rough measure of the households’ view of the state of the economy. Even if the surveys captured expectations correctly, it should be up to economists, not statisticians, pollsters or newspapers, to figure out how those expectations translate into realized outcomes. Some day we’ll know how to do it. I’m pretty confident.
References and further reading:
[1] Bram and Ludvigson (1998) Does consumer confidence forecast household expenditure? A sentiment index horserace (pdf)
[2] Carroll, Fuhrer and Wilcox (1994) Does consumer sentiment forecast household spending? If so, why? (pdf)
[3] Croushore (2006) Consumer confidence surveys: can they help us forecast consumer spending in real time? (pdf)
Technorati tags: economics, consumer confidence, consumer sentiment, forecasting, expectations
At first glance, both the Michigan index (MI) and the Conference Board index (CI) are correlated with the business cycle: they sink around the beginning of a recession and rebound near the end (see chart nearby, originally published by the Wall Street Journal). They even seem to track the quarter-to-quarter growth of consumption expenditures. Look a bit closer, however, and you’ll see that confidence and reality get out of synch sometimes. For instance, both the MI and the CI were abnormally low relative to consumption growth in 1992-1993, and again during 2002 and 2003. The indices dipped during the Asian crisis of 1998, but consumption growth didn’t budge; conversely, expenditure growth fell dramatically in early 1995 even though sentiment didn’t change.
Formal statistical analyses have found that consumer sentiment says very little that forecasters don’t know already. That is, once this quarter’s spending, interest rates, etc. are known, it does not help much to predict future spending growth. Confidence and expectations matter. The issue, I reckon, is that these particular indices fail to capture them.
A cursory look at the guts of the MI and the CI will convince you that they are literally meaningless. Each of them is a mishmash of five opinions — which, by the way, are not the same for both surveys (see table below). The questionnaires represent but the pollster’s guess of what determines spending. There’s no guarantee that the questions are the ones that actually matter.
Click to enlarge
For instance, the MI doesn’t include questions on job security, whereas the CI doesn’t ask about present personal finances. The potential irrelevance of the surveys becomes painfully clear when one examines the first question of the MI: “Do you think now is a good or bad time for people to buy major household items?” With such a specific wording, that question should predict expenditures on cars, appliances, furniture and such, i.e. durable goods. But once past purchases are included into the forecasting model, confidence and expenditures are barely correlated. [1]
Even if one of the indexes had the right composition, there’s no reason why all the questions should be given equal weights. Personal finances and availability of jobs, for example, may influence a consumer’s expenditures more than overall business conditions; short-term prospects should matter more than distant ones. In both the MI and the CI, however, every question counts the same.
Despite my bashing of the indexes, the surveys are worth keeping. Each of them contains some question that can help predict one or other component of expenditures. More specifically, the Conference Board’s questions about job prospects help forecast expenditures on durable goods: sentiment about the current job situation (question number two in the table) significantly predicts purchases of vehicles and other durables; expectations about future jobs (question four) predicts expenditures on vehicles only. [1] The Michigan survey, on the other hand, contains questions which are not used in the indexes. It would be worth exploring whether they are useful for forecasters.
Unfortunately, the component questions are not accessible to most people. If they are, it’s only with significant delay. And even if they were published timely, most people wouldn’t be able to use them because they can’t handle the number crunching. So here’s my advice for the everyday news consumer. First, don’t draw any conclusions from month-to-month changes of the indexes, no matter how large they are. Start believing them only after several months of consecutive rises or declines. Second, the Conference Board index is a better predictor than the Michigan index, because the latter doesn’t include any question about jobs. Third, rather than sentiment indicators, pay attention to data on the labor market: the unemployment rate and the payroll numbers, for example, averaged over at least three months. Not only do they gauge consumers’ confidence more accurately than the confidence indexes themselves: they influence spending decisions directly (the more unemployment, the less disposable income).
In all fairness, the intention of the MI and the CI was never to forecast any specific variable. They were designed over 40 years ago as a rough measure of the households’ view of the state of the economy. Even if the surveys captured expectations correctly, it should be up to economists, not statisticians, pollsters or newspapers, to figure out how those expectations translate into realized outcomes. Some day we’ll know how to do it. I’m pretty confident.
References and further reading:
[1] Bram and Ludvigson (1998) Does consumer confidence forecast household expenditure? A sentiment index horserace (pdf)
[2] Carroll, Fuhrer and Wilcox (1994) Does consumer sentiment forecast household spending? If so, why? (pdf)
[3] Croushore (2006) Consumer confidence surveys: can they help us forecast consumer spending in real time? (pdf)
Technorati tags: economics, consumer confidence, consumer sentiment, forecasting, expectations
Saturday, June 14, 2008
Housing Bubble Sites
National Sites
Regional Sites
- The Housing Bubble
- The House Bubble
- Housing Panic
- Paper Economy a US Real Estate Bubble Blog
- Housing Doom Housing Bubble
- Doctor Housing Bubble
- Bubble Markets Inventory Tracking
- Priced Out Fovever
- HousingTracker
- Matrix
- The Real Estate Bloggers
- The Mortgage Lender Implode-O-Meter
- Housing Bubble Casualty
- Housing Bubble Bust
- Bubble Pictures
- Bubble News Network
- Lawrence Yun Watch
- Is There a Housing Bubble
- Real Estate Comments
Regional Sites
- DC Home Prices
- Greater Northern VA Housing Bubble Fallout
- Frankly Realty (Virginia)
- Baltimore Metro Area Housing Blog
- Baltimore Housing Bubble
- Chicago Bubble Blog
- Irvine Housing Bubble
- The Jersey Shore RE Bubble
- New Jersey Real Estate Report
- Socket Site (San Francisco)
- Patrick.net (San Francisco)
- Bay Area Real Estate Blog
- Burbed (San Francisco)
- Marin Real Estate Bubble
- Sonoma Housing Bubble
- Seattle Bubble
- Calgary Contrarian
- Vancouver Housing Market Blog
- SoCal Real Estate Bubble Blog
- Flippers in Trouble (Sacramento)
- Portland Housing
- Proffesor Piggington (San Deigo)
- Pacific Beach Bubble
- Boston Bubble
- California Housing Forecast
- Massachusetts Housing Market
- Vancouver Condo Info
- New York City Housing Bubble
Friday, June 13, 2008
Moral Hazard Redux
In light of all the blather about "moral hazard" in recent days, several of you have suggested I re-publish my blog from last September 07, on the issue of moral hazard. Herewith:
One day while sitting on a beach last summer I overheard a father tussle with his young son about whether the child was old enough to take out a small sailboat. The father finally relented. "Go ahead, but I’m not gonna save you," he said, picking up his newspaper. A while later, the sailboat tipped over and the child began yelling for help, but father didn’t budge. When the kid sounded desperate I put down my book, walked over to the man, and delicately told him his son was in trouble. "That’s okay," he said. "That boy’s gonna learn a lesson he’ll never forget." I walked down the beach to notify a lifeguard, who promptly went into action.
Letting children bear the consequences of their risky behavior -- what some parents call "tough love" -- is equally applicable adults, and conservatives have made something of a fetish out of it. A few weeks ago, as George W. announced a paltry plan to help out a few of the millions of homeowners who got caught in the sub-prime loan mess, he reiterated the credo: "It’s not government’s job to bail out ... those who made the decision to buy a home they knew they could not afford."
It’s true that people tend to be less cautious when they know they’ll be bailed out. Economists call this "moral hazard." But even when they’re being reasonably careful, people cannot always assess risks accurately. Many of the mostly poor home buyers who got into trouble did NOT in fact know they couldn’t afford the mortgage payments they were signing on to. The banks and mortgage lenders that pulled out all the stops to persuade them to the contrary were in a far better position to know; after all, they had lots of experience at this game. So did the credit-rating agencies that gave these loans solid credit ratings, as did the financiers who bundled them with less-risky loans and sold them to other financial institutions, and the hedge fund managers who quietly tucked them into their portfolios.
The real moral hazard in this saga started when Fed Chair Ben Bernanke cut the Fed’s discount rate (charged on direct federal loans to banks) and announced that the Fed would take whatever action was needed to "promote the orderly financing of markets." Translated, this means that lenders, credit-rating agencies, financial intermediaries, and hedge funds will be bailed out, one way or another, because they’re simply too big to fail. Note that behind every one of these institutions lie thousands of well-paid executives who would have lost big if the Fed didn’t come to their rescue. Even though they had more information and experience at risk-taking than the suckers who borrowed their money, and even though executives at the top of these instutions typically earn more in a day than the borrowers do in a year, moral hazard somehow doesn’t apply to them.
When it comes to risky behavior in the market, America has a double standard. We’re told that economic risk-taking as the key to entrepreneurial success, but when big entrepreneurs take big risks that fail it’s amazing how often they get bailed out. Indeed, the history of modern American business is littered with federal bailouts, loan guarantees, and no-questions-asked reorganizations. Some are well known, such as the Chrylser bailout of 1979, the savings and loan bailout of 1989, and the airline bailout of 2001. Most occur in the relative dark, such as the 1998 bailout of giant hedge fund Long-Term Capital Management (courtesy of former Fed chair Alan Greenspan), the not infrequent bailouts of under-funded corporate pension plans by the government’s Pension Benefit Guarantee Corporation, price supports for big agribusinesses facing market downturns, or the current bailout of Wall Street being engineered by Ben Bernanke’s Fed. Behind every one of these bailouts are CEOs or financial executives who were rescued from their bad bets.
CEOs get away with stupid mistakes all the time. Some, like Robert Nardelli, the former CEO of Home Depot, drive their company’s stock low that their boards eventually oust them. But they leave with eye-popping going-away presents nonetheless. (Nardelli got several hundrd million dollars on his departure.) If you’re an average American who gets canned from his job, even through no fault of your own, you probably won’t even get unemployment insurance (only 40 percent of job-losers qualify these days). Conservatives tell us that unemployment insurance reduces their incentive to find a new job quickly. In other words, moral hazard.
Some CEOs use bankruptcy as a means of getting out from under pesky labor contracts they might have "known they could not afford" when they agreed to them (Northwest Airlines most recently, for example). Others use it as a cushion against bad bets. Donald ("you’re fired!") Trump’s casino empire has gone into bankruptcy twice -- most recently, last November, when it listed $1.3 billion of liabilities and $1.5 million of assets -- with no apparent diminution of the Donald’s passion for risky, if not foolish, endeavor. After all, his personal fortune is protected behind a wall of limited liability, and he collects a nice salary from his casinos regardless. But if you’re an ordinary person who has fallen on hard times, just try declaring bankruptcy to wipe the slate clean. A new law governing personal bankruptcy makes that route harder than ever. Its sponsors argued -- you guessed it -- moral hazard.
Bush’s "ownership society" has proven a cruel farce for poor people who tried to become home owners, and his minuscule response to their plight just another example of how conservatives use moral hazard to push their social-Darwinist morality. The little guys get tough love. The big guys get forgiveness.
One day while sitting on a beach last summer I overheard a father tussle with his young son about whether the child was old enough to take out a small sailboat. The father finally relented. "Go ahead, but I’m not gonna save you," he said, picking up his newspaper. A while later, the sailboat tipped over and the child began yelling for help, but father didn’t budge. When the kid sounded desperate I put down my book, walked over to the man, and delicately told him his son was in trouble. "That’s okay," he said. "That boy’s gonna learn a lesson he’ll never forget." I walked down the beach to notify a lifeguard, who promptly went into action.
Letting children bear the consequences of their risky behavior -- what some parents call "tough love" -- is equally applicable adults, and conservatives have made something of a fetish out of it. A few weeks ago, as George W. announced a paltry plan to help out a few of the millions of homeowners who got caught in the sub-prime loan mess, he reiterated the credo: "It’s not government’s job to bail out ... those who made the decision to buy a home they knew they could not afford."
It’s true that people tend to be less cautious when they know they’ll be bailed out. Economists call this "moral hazard." But even when they’re being reasonably careful, people cannot always assess risks accurately. Many of the mostly poor home buyers who got into trouble did NOT in fact know they couldn’t afford the mortgage payments they were signing on to. The banks and mortgage lenders that pulled out all the stops to persuade them to the contrary were in a far better position to know; after all, they had lots of experience at this game. So did the credit-rating agencies that gave these loans solid credit ratings, as did the financiers who bundled them with less-risky loans and sold them to other financial institutions, and the hedge fund managers who quietly tucked them into their portfolios.
The real moral hazard in this saga started when Fed Chair Ben Bernanke cut the Fed’s discount rate (charged on direct federal loans to banks) and announced that the Fed would take whatever action was needed to "promote the orderly financing of markets." Translated, this means that lenders, credit-rating agencies, financial intermediaries, and hedge funds will be bailed out, one way or another, because they’re simply too big to fail. Note that behind every one of these institutions lie thousands of well-paid executives who would have lost big if the Fed didn’t come to their rescue. Even though they had more information and experience at risk-taking than the suckers who borrowed their money, and even though executives at the top of these instutions typically earn more in a day than the borrowers do in a year, moral hazard somehow doesn’t apply to them.
When it comes to risky behavior in the market, America has a double standard. We’re told that economic risk-taking as the key to entrepreneurial success, but when big entrepreneurs take big risks that fail it’s amazing how often they get bailed out. Indeed, the history of modern American business is littered with federal bailouts, loan guarantees, and no-questions-asked reorganizations. Some are well known, such as the Chrylser bailout of 1979, the savings and loan bailout of 1989, and the airline bailout of 2001. Most occur in the relative dark, such as the 1998 bailout of giant hedge fund Long-Term Capital Management (courtesy of former Fed chair Alan Greenspan), the not infrequent bailouts of under-funded corporate pension plans by the government’s Pension Benefit Guarantee Corporation, price supports for big agribusinesses facing market downturns, or the current bailout of Wall Street being engineered by Ben Bernanke’s Fed. Behind every one of these bailouts are CEOs or financial executives who were rescued from their bad bets.
CEOs get away with stupid mistakes all the time. Some, like Robert Nardelli, the former CEO of Home Depot, drive their company’s stock low that their boards eventually oust them. But they leave with eye-popping going-away presents nonetheless. (Nardelli got several hundrd million dollars on his departure.) If you’re an average American who gets canned from his job, even through no fault of your own, you probably won’t even get unemployment insurance (only 40 percent of job-losers qualify these days). Conservatives tell us that unemployment insurance reduces their incentive to find a new job quickly. In other words, moral hazard.
Some CEOs use bankruptcy as a means of getting out from under pesky labor contracts they might have "known they could not afford" when they agreed to them (Northwest Airlines most recently, for example). Others use it as a cushion against bad bets. Donald ("you’re fired!") Trump’s casino empire has gone into bankruptcy twice -- most recently, last November, when it listed $1.3 billion of liabilities and $1.5 million of assets -- with no apparent diminution of the Donald’s passion for risky, if not foolish, endeavor. After all, his personal fortune is protected behind a wall of limited liability, and he collects a nice salary from his casinos regardless. But if you’re an ordinary person who has fallen on hard times, just try declaring bankruptcy to wipe the slate clean. A new law governing personal bankruptcy makes that route harder than ever. Its sponsors argued -- you guessed it -- moral hazard.
Bush’s "ownership society" has proven a cruel farce for poor people who tried to become home owners, and his minuscule response to their plight just another example of how conservatives use moral hazard to push their social-Darwinist morality. The little guys get tough love. The big guys get forgiveness.
Thursday, June 12, 2008
Sugar Giants Shove Their Sweetener
by Chris Tenove
Jul/Aug 2003 Issue
What does anybody know about the sugar industry? The people who put the frosting on the frosted flakes keep a low profile and are happy when folks are too busy eating to ask a lot of questions. Now, though, a dust-up with the World Health Organization (WHO) has flushed them into the limelight, where they're pitting profits against public health.
The conflict was inflamed by a new set of dietary guidelines drawn from two years of research by the WHO and the UN Food and Agricultural Organization. The guidelines are part of a worldwide strategy to tame the swelling epidemic of obesity, diabetes, osteoporosis and cardiovascular diseases. One recommendation is that free sugars (i.e. sugar added to foods) should make up no more than 10 percent of our daily caloric intake. The sugar lobby reacted to that suggestion like a toddler asked to hand back his Halloween booty...
'It was particularly stupid for them to put in writing that they're going to try to get Congress to take away WHO's money,' says Michael Jacobsen, executive director of the Center for Science in the Public Interest. 'It gave consumers a chance to see the kind of bullying that is usually done behind closed doors.' [Adbusters]
Wednesday, June 11, 2008
The burden of spending
Over the 12 months to October 2007, home prices in the 20 largest metropolitan areas declined by 6.1 percent. And they have fallen every month since January. With less equity to borrow from, homeowners could cut their spending. As a second whammy, a large volume of adjustable rate mortgages are scheduled to reset to higher interest rates between 2008 and 2012. The burden of higher monthly payments could force households to reduce their expenditures too.
Economic growth and consumer debt are inextricably connected in the U.S. And it’s been that way for so long that it’s easy to forget why and what that implies.
Spending has outpaced personal income since the mid 1980s. Households saved ten percent of disposable income in 1985, five percent in the mid 1990s, and then nothing in 2005. (See chart 1, maroon series, scale on the left axis.)
Chart 1 (click to enlarge)
Economic growth and consumer debt are inextricably connected in the U.S. And it’s been that way for so long that it’s easy to forget why and what that implies.
Spending has outpaced personal income since the mid 1980s. Households saved ten percent of disposable income in 1985, five percent in the mid 1990s, and then nothing in 2005. (See chart 1, maroon series, scale on the left axis.)
Chart 1 (click to enlarge)
Low interest rates motivated the consumption ramp-up. Loose monetary policy played its part, but it would be incorrect to blame it all on the Fed. The massive accumulation of wealth by developing countries lowered the opportunity cost of spending, as Alan Greenspan has explained.
Interest rates motivated it, but the borrowing spree was made possible by innovations in the financial sector that increased the supply of debt. The introduction of the FICO score in the early 1990s improved the assessment of a borrower’s creditworthiness – or at least lenders believe so. By pegging interest rates to an index, instead of offering fixed rates, lenders transferred some financial risk to borrowers. Securitization of debt balances shifted some more of that risk off the lenders’ balance sheets.
The problem with a growth path based on borrowing and spending is that it has a natural end. An individual’s debt limit is determined by her creditworthiness, income capacity and collateral. That limit may be high relative to current income, and it may even be unknown to the borrower — after all, it’s up to the lender to draw the line. But once debt balances reach that limit, spending can grow only as fast as income (minus debt payments). Consumption is pinned to the vagaries of income. At the aggregate level, that means that economic growth is more vulnerable to unemployment and to the swings of the stock and real estate markets.
For instance, back in 2001 unemployment was rising, investment fell sharply, and share prices crashed. But overall the economy held up better than expected. Why? One explanation lies in real estate wealth. That year house prices rose by nine percent and consumers borrowed against home equity.
As a gauge of the current level of indebtedness, households now spend almost 15 percent of their disposable income on interest payments, including mortgages. (See chart 1, blue series, scale on the right axis.) If you include repayment of principal, the fraction of debt payments is much larger. Debt repayments are linked to interest rates, and hence subject to unforeseeable increases. Hence the worry about mortgage resets.
The main variables that determine spending and access to debt are outside the policymaker’s control. The cost of borrowing depends on the world level and distribution of savings. Lenders will continue to improve their assessment and management of risk, thus reducing the cost of credit. And central banks are capable of controlling inflation, but not of preventing asset bubbles or stimulating long-run growth.
But don’t despair: tax policy can mend our spending ways. First of all, do no harm. Tax laws can distort the cost of borrowing. The Tax Reform Act of 1986 partially addressed this issue by getting rid of the deduction for interest paid on consumer debt (credit card and uncollateralized loans). The deduction for mortgage interest should go next. I concede that there’s a (weak) case for subsidizing home ownership. But these days a house is much more than a place to live: it’s a piggy bank to draw from. There is no reason why the government should subsidize that.
Second, replace the personal income tax with a tax on consumption. A basic tenet of economics is that if you tax something you get less of it. An income tax punishes work. Instead, the government could levy a tax on the difference between income and contributions to savings. The new tax could be progressive, rather than flat, and could include personal deductions, just like the current personal income tax.
The main obstacle to those tax policies is political. The mortgage interest deduction is popular, and a consumption tax is still regarded as an oddity. No presidential candidate who actually cares about being elected would make such proposals. Perhaps in 2012, if the then incumbent president can afford it. Changing the nature of American economic growth is a cause worthy of spending political capital on.
Technorati tags: economics, consumption, consumer debt, consumer expenditures, economic growth
Tuesday, June 10, 2008
More Americans Expecting Recession in The Next Year
More Americans are expecting a recession in the next year. Consumers are waking up to the reality that the economy has a significant chance of recession next year.
Recession times are increasingly being expected. The coming holiday spending season will likely provide important clues to where consumer spending is headed. Consumer spending is about 70% of the US's GDP. Consumer spending is a key factor in a forecasting a recession.
The economic mood took a sharp turn for the worse over the past month, with 40 percent of Americans expecting a recession in the next year, according to a Reuters / Zogby poll released Wednesday.
That was a big rise from a month earlier, when 31 percent of the likely voters polled predicted a recession. The darker mood came as mounting concerns about housing and credit markets pounded Wall Street, and oil prices approached $100 per barrel.
That was a big rise from a month earlier, when 31 percent of the likely voters polled predicted a recession. The darker mood came as mounting concerns about housing and credit markets pounded Wall Street, and oil prices approached $100 per barrel. (CNBC 1/21/07)
Recession times are increasingly being expected. The coming holiday spending season will likely provide important clues to where consumer spending is headed. Consumer spending is about 70% of the US's GDP. Consumer spending is a key factor in a forecasting a recession.
Monday, June 9, 2008
More Americans Expecting Recession in The Next Year
More Americans are expecting a recession in the next year. Consumers are waking up to the reality that the economy has a significant chance of recession next year.
Recession times are increasingly being expected. The coming holiday spending season will likely provide important clues to where consumer spending is headed. Consumer spending is about 70% of the US's GDP. Consumer spending is a key factor in a forecasting a recession.
The economic mood took a sharp turn for the worse over the past month, with 40 percent of Americans expecting a recession in the next year, according to a Reuters / Zogby poll released Wednesday.
That was a big rise from a month earlier, when 31 percent of the likely voters polled predicted a recession. The darker mood came as mounting concerns about housing and credit markets pounded Wall Street, and oil prices approached $100 per barrel.
That was a big rise from a month earlier, when 31 percent of the likely voters polled predicted a recession. The darker mood came as mounting concerns about housing and credit markets pounded Wall Street, and oil prices approached $100 per barrel. (CNBC 1/21/07)
Recession times are increasingly being expected. The coming holiday spending season will likely provide important clues to where consumer spending is headed. Consumer spending is about 70% of the US's GDP. Consumer spending is a key factor in a forecasting a recession.
Sunday, June 8, 2008
Why the Fed's Bailout Won't Work (Part 2)
The Fed bailout of Wall Street keeps getting larger and larger. Not only has the Fed lent J.P. Morgan thirty billion to take over Bear Stearns, but starting today, securities dealers can borrow money from the Fed on about the same low terms as member banks. The Fed also lowered the rate charged on such loans, and extended the repayment deadline to three months (from one). We haven’t witnessed this scale of bailout since the 1930s.
Will it work? The immediate goal is to stop the runs – runs on banks, runs on securities dealers, and the biggest run of all, the run on the dollar. Stampedes occur when lenders lose confidence that borrowers can pay them back – and worry that all OTHER lenders are losing confidence, too. So everyone runs to get their money out before everyone ELSE gets their money out.
Viewed in large terms, these runs are a consequence of how indebted America and Americans have become. We’ve been living beyond our means for some time now, borrowing to the hilt. This had to end at some point. Even the US dollar has become encumbered with so much international debt that – as the nation’s IOU – it has become endangered. Investors are getting out of dollars because they think everyone else is getting out of dollars.
Can the Fed pour enough money into the system to assure all lenders, domestic and foreign, that their own money (including money left in dollars) will be safe? It’s a tricky dance. If the Fed scares everyone into thinking that the crisis is larger than they otherwise thought, then the stampede gets worse. And by pouring money into the system, the Fed also may create the impression that the dollar could inflate away – losing its value because so many other dollars are on the market. That would only cause investors to dump more of their dollars and switch to euros or yen or sterling or gold or whatever else they can find to put their money into.
The speculative bubble that began to grow in 2003 when Alan Greenspan and company cut short-term interest rates to 1 percent and made money so cheap that every lender pushed money into the hands of any borrower who could stand up straight triggered all this. Housing prices have to drop another 10 percent, and big banks have to write off another $200 billion in worthless assets, if we have a prayer of getting through it – bailouts or not.
Will it work? The immediate goal is to stop the runs – runs on banks, runs on securities dealers, and the biggest run of all, the run on the dollar. Stampedes occur when lenders lose confidence that borrowers can pay them back – and worry that all OTHER lenders are losing confidence, too. So everyone runs to get their money out before everyone ELSE gets their money out.
Viewed in large terms, these runs are a consequence of how indebted America and Americans have become. We’ve been living beyond our means for some time now, borrowing to the hilt. This had to end at some point. Even the US dollar has become encumbered with so much international debt that – as the nation’s IOU – it has become endangered. Investors are getting out of dollars because they think everyone else is getting out of dollars.
Can the Fed pour enough money into the system to assure all lenders, domestic and foreign, that their own money (including money left in dollars) will be safe? It’s a tricky dance. If the Fed scares everyone into thinking that the crisis is larger than they otherwise thought, then the stampede gets worse. And by pouring money into the system, the Fed also may create the impression that the dollar could inflate away – losing its value because so many other dollars are on the market. That would only cause investors to dump more of their dollars and switch to euros or yen or sterling or gold or whatever else they can find to put their money into.
The speculative bubble that began to grow in 2003 when Alan Greenspan and company cut short-term interest rates to 1 percent and made money so cheap that every lender pushed money into the hands of any borrower who could stand up straight triggered all this. Housing prices have to drop another 10 percent, and big banks have to write off another $200 billion in worthless assets, if we have a prayer of getting through it – bailouts or not.
Saturday, June 7, 2008
There Was a Reason They Called It... The Casino Economy
by Thomas Croft
02 Jul 03
In the last three years, a 'perfect storm' of rising energy costs, record consumer and corporate debt and massive trade and current account deficits joined with unsustainable investment practices, and resulted in an economic collapse. The first recession since 1929 to be primarily caused by over-investment, these 'collateral damage' investing schemes-in overseas boondoggles and sweatshops, extreme mergers, absurd dot-coms and derivative scams-all came home to roost. Enron used all of these investment tricks and more. The corruption scandals of 2001-2 completed the melt-down. Now, the world is probably in a double-dip recession, thanks partly to the scandal and continuing international disruptions.
The problem with casino bets and Russian Roulette is that somebody always loses. [CounterPunch]
Friday, June 6, 2008
EZer taxes
Imagine if you didn’t have to file a tax return. Imagine if, come T-day, the only thing you needed to do to comply with your tax obligations was to sign a form and mail it. And imagine if this could be done without changing a comma of the tax code. This is not a pipe dream—millions of citizens in different parts of the world already do it.
Austan Goolsbee, professor at the University of Chicago Graduate School of Business and head economic adviser to Barack Obama, is proposing to let the Internal Revenue Service, America’s tax man, put together drafts of individual tax returns and mail them to taxpayers. Experts know the system as “Tax Agency Reconciliation” (TAR). Goolsbee has had the good sense to re-baptize as “Simple Return.”
Tax collection agencies receive all the information they need to fill out the returns of many taxpayers. By law, employers and financial institutions send the data to them. The time spent by filers collecting statements, putting the numbers in the right boxes of the tax form, figuring out the standard deductions and exemptions, and calculating the tax bill--not to mention the fees paid to tax prepapers--are thus a waste.
Sweden and Denmark use the system. In Spain, with seven years of TAR experience, some filers can even request and confirm their pre-filled tax returns by sending a text message. Some Spaniards don’t even have to sacrifice precious TV time: they can do their taxes through their interactive, digital TV sets. (I encourage readers who know of other countries in the EZer Club to let me know in the comments or by e-mail. I’d like to make a list. If you respond, please specify whether the country does TAR or exact withholding.)
The obvious benefit of pre-filled tax returns is the time savings for filers. In the U.S., the average compliance time for the 1040EZ form, the simplest there is, is three hours and 46 minutes. The other types of tax form take over ten hours. Goolsbee estimates that, if his Simple Return applied to 40% of taxpayers, it would save 225 million hours and more than $2 billion in fees.
The fiercest opposition to TAR would thus come from tax preparers. Thousands of jobs, they’ll clamor, will be lost. For an economist, this is the easiest criticism to counter. Those jobs are not providing any service other than helping to comply with a pointlessly dense tax code. Let tax shops fold, and their workers will find jobs producing goods and services that actually add to social welfare. Creating employment by keeping an unwieldy tax code makes as little sense as digging a hole in the desert and then employing jobless people to fill it. If only Congress were brave enough to hold this argument against lobbyists… (Regarding this topic, I believe there was a lively discussion in the comments following Steven Levitt’s post . Read my own rant about the broken windows fallacy.)
Mailing pre-filled tax returns is not an intrusion on private business either. As Goolsbee argues, governments allow online filing and provide printed tax tables, and nobody opposes to those services on the grounds that they undermine the tax preparation business.
Receiving a pre-filled return in the mail does feel a bit imposing though. Some people will see TAR as an intrusion on individual freedom. It doesn’t need to be. Individuals will be allowed to scrap the return prepared by the government and fill out a new one. And if the taxpayer ignores the pre-filled return, and doesn’t fill out her own, her taxes won’t be filed, so TAR doesn’t infringe on voluntary compliance. The key is to disclose, every year and to every taxpayer, that the return sent by the government is not a tax bill, but a draft that can be turned into a final return if the individual chooses to do so.
To be sure, TAR would not eliminate the need to file a tax return for everybody. People who itemize their deductions, or who don’t have all their earnings reported to the government by a third party, cannot use the pre-filled form. Goolsbee estimates that, at most, 40% of all taxpayers could benefit from a TAR system; and that’s only if the Alternative Minimum Tax is reformed. In Spain, 30 to 40 percent are eligible. Taxpayers who don’t qualify tend to file more complicated tax returns, and thus spend more time and money on filing, than those who are eligible. So the benefits of TAR go mostly to people with low-to-middle income or simple household finances, who spend most of their tax preparation time (or money) gathering and filling out documents, not mining the tax code for deductions.
The best way to reduce the cost of compliance for everyone is to simplify the tax code. This can be done by scrapping the income tax as we know it today, or by eliminating tax deductions, exemptions, and exceptions for special groups. But such changes face even taller political obstacles than TAR. So, since the tax-instructions booklet is not going to get thinner any time soon, let your tax man deliver a pre-filled return—and spend some more quality time with your TV.
Technorati tags:
economics, tax agency reconciliation, TAR, tax compliance, taxes
Austan Goolsbee, professor at the University of Chicago Graduate School of Business and head economic adviser to Barack Obama, is proposing to let the Internal Revenue Service, America’s tax man, put together drafts of individual tax returns and mail them to taxpayers. Experts know the system as “Tax Agency Reconciliation” (TAR). Goolsbee has had the good sense to re-baptize as “Simple Return.”
Tax collection agencies receive all the information they need to fill out the returns of many taxpayers. By law, employers and financial institutions send the data to them. The time spent by filers collecting statements, putting the numbers in the right boxes of the tax form, figuring out the standard deductions and exemptions, and calculating the tax bill--not to mention the fees paid to tax prepapers--are thus a waste.
Sweden and Denmark use the system. In Spain, with seven years of TAR experience, some filers can even request and confirm their pre-filled tax returns by sending a text message. Some Spaniards don’t even have to sacrifice precious TV time: they can do their taxes through their interactive, digital TV sets. (I encourage readers who know of other countries in the EZer Club to let me know in the comments or by e-mail. I’d like to make a list. If you respond, please specify whether the country does TAR or exact withholding.)
The obvious benefit of pre-filled tax returns is the time savings for filers. In the U.S., the average compliance time for the 1040EZ form, the simplest there is, is three hours and 46 minutes. The other types of tax form take over ten hours. Goolsbee estimates that, if his Simple Return applied to 40% of taxpayers, it would save 225 million hours and more than $2 billion in fees.The fiercest opposition to TAR would thus come from tax preparers. Thousands of jobs, they’ll clamor, will be lost. For an economist, this is the easiest criticism to counter. Those jobs are not providing any service other than helping to comply with a pointlessly dense tax code. Let tax shops fold, and their workers will find jobs producing goods and services that actually add to social welfare. Creating employment by keeping an unwieldy tax code makes as little sense as digging a hole in the desert and then employing jobless people to fill it. If only Congress were brave enough to hold this argument against lobbyists… (Regarding this topic, I believe there was a lively discussion in the comments following Steven Levitt’s post . Read my own rant about the broken windows fallacy.)
Mailing pre-filled tax returns is not an intrusion on private business either. As Goolsbee argues, governments allow online filing and provide printed tax tables, and nobody opposes to those services on the grounds that they undermine the tax preparation business.
Receiving a pre-filled return in the mail does feel a bit imposing though. Some people will see TAR as an intrusion on individual freedom. It doesn’t need to be. Individuals will be allowed to scrap the return prepared by the government and fill out a new one. And if the taxpayer ignores the pre-filled return, and doesn’t fill out her own, her taxes won’t be filed, so TAR doesn’t infringe on voluntary compliance. The key is to disclose, every year and to every taxpayer, that the return sent by the government is not a tax bill, but a draft that can be turned into a final return if the individual chooses to do so.
To be sure, TAR would not eliminate the need to file a tax return for everybody. People who itemize their deductions, or who don’t have all their earnings reported to the government by a third party, cannot use the pre-filled form. Goolsbee estimates that, at most, 40% of all taxpayers could benefit from a TAR system; and that’s only if the Alternative Minimum Tax is reformed. In Spain, 30 to 40 percent are eligible. Taxpayers who don’t qualify tend to file more complicated tax returns, and thus spend more time and money on filing, than those who are eligible. So the benefits of TAR go mostly to people with low-to-middle income or simple household finances, who spend most of their tax preparation time (or money) gathering and filling out documents, not mining the tax code for deductions.
The best way to reduce the cost of compliance for everyone is to simplify the tax code. This can be done by scrapping the income tax as we know it today, or by eliminating tax deductions, exemptions, and exceptions for special groups. But such changes face even taller political obstacles than TAR. So, since the tax-instructions booklet is not going to get thinner any time soon, let your tax man deliver a pre-filled return—and spend some more quality time with your TV.
Technorati tags:
economics, tax agency reconciliation, TAR, tax compliance, taxes
Wednesday, June 4, 2008
Googling "recession" from United States has Tripled in the Past Year
Graph of the number of times the word "recession" was googled from United States over the last year. As one can tell it has triple in the past year.
Tuesday, June 3, 2008
Are We Heading Toward Depression (Part 3)?
Retail sales fell again in February. Unemployment continues to rise. After rallying yesterday, stocks continue to drop. Even though the Fed has taken the extraordinary step of bailing out Wall Street banks and taking over their troubled mortgage loans, Wall Street is still unhappy. The Treasury Department is readying new proposals for helping stranded homeowners, which are expected to be unveiled later today.
What's going on? Let me explain as clearly as I can.
American consumers are coming to the end of their ropes and don't have the buying power they need to absorb the goods and services the U.S. economy is capable of producing. This is likely to mean fewer jobs, which will force Americans to pull in their belts even tighter, leading to still fewer jobs – the classic recipe for recession. That recession may turn into a full-fledged Depression if fiscal and monetary policies can't make up for consumers' lack of buying power. And there's reason to worry they cannot because consumers are in a permanent bind. They're deep in debt, their homes are losing value, and their paychecks are shrinking.
Under these circumstances, the usual remedies won't work. Wall Street bailouts have no effect because housing prices continue to fall, and the Street is sitting on a giant pile of bad debt. Tax breaks for business won't generate more investment in factories or equipment because demand for their products what emerges from the factories is dropping. Temporary fixes like a stimulus package that give households a one-time cash infusion won't get consumers back to the malls because they know the assistance is temporary and their problems are permanent. They're likely to pocket the extra money instead of spending it. Additional Fed rate cuts might give consumers access to somewhat cheaper loans, but there's no going back to the easy money of a few years ago. Lenders and borrowers have been badly burned. The values of houses and other major assets are dropping even faster than interest rates can be lowered. Growing numbers of homeowners owe more on their mortgages than their homes are now worth on the market.
We're reaping the whirlwind of many years during which Americans have spent beyond their means and most of the benefits of an expanding economy have gone to a relatively small group at the very top. Adjusted for inflation, the median wage is below where it was in 1999. The nation's median hourly wage is barely higher than it was 35 thirty-five years ago. The income of a man in his 30s is now 12 percent below that of a man his age three decades ago. The rich, meanwhile, can't keep the economy going on their own because they devote a smaller percentage of their earnings to buying things than the rest of us: After all, they're rich, and they already have most of what they want. Instead of buying, they're more likely to invest their earnings wherever around the world they can get the highest return.
Some say well and good. They think our consumer society is unsustainable as it is. They argue Americans should learn to accept a lower standard of living and American business must adjust to a smaller domestic economy. This argument leaves out one salient fact: Considered as a whole, the nation has enough productive capacity to provide a higher standard of living for its citizens and also be sustainable. With the right incentives, we could dramatically reduce energy use and carbon emissions while continuing to grow at a rate that provided most people with good jobs at good wages. The problem isn't economic growth per se. It's unbalanced growth – too much consumption of goods and services that utilize too much energy and generate too much carbon into the atmosphere. Balanced growth is surely possible. But if the economy heads into a severe recession or Depression, there's almost no way to achieve more balance. Hard-pressed Americans will be unwilling to sacrifice anything.
The debate over widening economic inequality of income and wealth in America usually pits fairness against growth. Conservative supply-siders contend that the people at the top not only deserve to be richly rewarded because such rewards encourage them to invest and innovate, and thereby benefit everyone else. Liberals concede that some inequality may be necessary to encourage growth but that we have long passed the point where it is either necessary or fair. But the reality we're now facing poses a different question: Can we have any growth at all when income and wealth are so unequal that most Americans can no longer buy what they produce?
The answer is likely to be no. Go back to the years just before the Great Depression and you see the same pattern. As I've noted before, Marriner S. Eccles, who served as Franklin D. Roosevelt's Chairman of the Federal Reserve from 1934 to 1948, noted this in his memoir "Beckoning Frontiers":
"As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth -- not of existing wealth, but of wealth as it is currently produced -- to provide men with buying power equal to the amount of goods and services offered by the nation's economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped."
Is the game about to stop again?
What's going on? Let me explain as clearly as I can.
American consumers are coming to the end of their ropes and don't have the buying power they need to absorb the goods and services the U.S. economy is capable of producing. This is likely to mean fewer jobs, which will force Americans to pull in their belts even tighter, leading to still fewer jobs – the classic recipe for recession. That recession may turn into a full-fledged Depression if fiscal and monetary policies can't make up for consumers' lack of buying power. And there's reason to worry they cannot because consumers are in a permanent bind. They're deep in debt, their homes are losing value, and their paychecks are shrinking.
Under these circumstances, the usual remedies won't work. Wall Street bailouts have no effect because housing prices continue to fall, and the Street is sitting on a giant pile of bad debt. Tax breaks for business won't generate more investment in factories or equipment because demand for their products what emerges from the factories is dropping. Temporary fixes like a stimulus package that give households a one-time cash infusion won't get consumers back to the malls because they know the assistance is temporary and their problems are permanent. They're likely to pocket the extra money instead of spending it. Additional Fed rate cuts might give consumers access to somewhat cheaper loans, but there's no going back to the easy money of a few years ago. Lenders and borrowers have been badly burned. The values of houses and other major assets are dropping even faster than interest rates can be lowered. Growing numbers of homeowners owe more on their mortgages than their homes are now worth on the market.
We're reaping the whirlwind of many years during which Americans have spent beyond their means and most of the benefits of an expanding economy have gone to a relatively small group at the very top. Adjusted for inflation, the median wage is below where it was in 1999. The nation's median hourly wage is barely higher than it was 35 thirty-five years ago. The income of a man in his 30s is now 12 percent below that of a man his age three decades ago. The rich, meanwhile, can't keep the economy going on their own because they devote a smaller percentage of their earnings to buying things than the rest of us: After all, they're rich, and they already have most of what they want. Instead of buying, they're more likely to invest their earnings wherever around the world they can get the highest return.
Some say well and good. They think our consumer society is unsustainable as it is. They argue Americans should learn to accept a lower standard of living and American business must adjust to a smaller domestic economy. This argument leaves out one salient fact: Considered as a whole, the nation has enough productive capacity to provide a higher standard of living for its citizens and also be sustainable. With the right incentives, we could dramatically reduce energy use and carbon emissions while continuing to grow at a rate that provided most people with good jobs at good wages. The problem isn't economic growth per se. It's unbalanced growth – too much consumption of goods and services that utilize too much energy and generate too much carbon into the atmosphere. Balanced growth is surely possible. But if the economy heads into a severe recession or Depression, there's almost no way to achieve more balance. Hard-pressed Americans will be unwilling to sacrifice anything.
The debate over widening economic inequality of income and wealth in America usually pits fairness against growth. Conservative supply-siders contend that the people at the top not only deserve to be richly rewarded because such rewards encourage them to invest and innovate, and thereby benefit everyone else. Liberals concede that some inequality may be necessary to encourage growth but that we have long passed the point where it is either necessary or fair. But the reality we're now facing poses a different question: Can we have any growth at all when income and wealth are so unequal that most Americans can no longer buy what they produce?
The answer is likely to be no. Go back to the years just before the Great Depression and you see the same pattern. As I've noted before, Marriner S. Eccles, who served as Franklin D. Roosevelt's Chairman of the Federal Reserve from 1934 to 1948, noted this in his memoir "Beckoning Frontiers":
"As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth -- not of existing wealth, but of wealth as it is currently produced -- to provide men with buying power equal to the amount of goods and services offered by the nation's economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped."
Is the game about to stop again?
Monday, June 2, 2008
Sunday, June 1, 2008
On inflation expectations
With Federal Reserve and government doing their best to stimulate demand, people have started looking at inflation. The worry is that the economy is not as sick as our policymakers think, and so the fiscal and monetary medicines are excessive. Markets disagree.
Expected inflation is an important determinant of future inflation. If the public expects higher inflation, workers demand higher wages, prompting employers to raise the price of their goods, which results in higher actual inflation.
Markets in fixed-income securities provide timely information about inflation expectations. Treasury inflation-protected securities (TIPS) deliver interest and principal payments that are tied to inflation. Payments from regular Treasury notes, on the other hand, are not indexed to inflation. The difference between the yield rates of the two types of securities must be equal to the inflation rate expected by the markets—otherwise there would be an arbitrage opportunity. In practice, because of technical issues, the yield spread is only an approximation to expected inflation, and people call it the break-even inflation (BEI) instead. (More on this below.) From here on I use BEI and “expected inflation” interchangeably.
Because the Treasury has created notes with different maturities, we can use the spread between nominal and TIPS securities to gauge inflation expectations for different horizons. For example, today’s difference between the yield of five-year TIPS and that of five-year nominal notes is approximately equal to the inflation rate expected over the five years starting now (2008-2012).
The Fed is interested in long-term inflation expectations, because in the short term prices are affected by transitory or volatile factors, such as commodity prices. One measure of long-term expectations, which we can also derive from yields, is the five-year, five-year forward rate. That is an approximation to the rate of inflation expected for the five years starting five years from now. Today, that would be the period from 2013 through 2017.
Chart 1 (click to enlarge)
Earlier this month Greg Ip of the Wall Street Journal posted a graph showing the five-year, five-year forward BEI, which generated some discussion in the econ blogosphere. Felix Salmon and Greg Mankiw worried over signs of increasing inflation coming from that graph. Mankiw went as far as saying that the rise in expected inflation is “consistent with the hypothesis that policymakers are overreacting to some economic news with excessive monetary and fiscal stimulus.” Following up on knzn’s analysis (Feb. 3), I find that the worries about inflation in the far-future are overstated—and that inflation expectations over the near-future have been overlooked.
Using knzn’s back-of-the-envelope method, I have produced my own time series of forward BEI, which matches the one posted by Ip quite closely (see chart 1). The graph shows that starting on January 15, the rate of inflation expected for the far future (2013-2017) started increasing abruptly. By the time Ip’s graph was produced, January 30, the forward BEI had increased by 16 basis points.
That is not unusual. We have seen increases of similar or larger size in 2007: between March 9 and March 27 (15 b.p.), May 26 to June 13 (25 b.p.), and between September 11 and September 20 (16 b.p.). But each of those spikes partially reversed over time. In fact, after September 20, the time series began a protracted downward trend that left expectations at the end of 2007 below their level at the end of the summer.
Chart 2 (click to enlarge)
Let’s zoom in on the picture (chart 2). Expected inflation for the far future, the forward rate, did rise in the second half of January. Interestingly, most of the rise happened between January 16 and January 22, perhaps fueled by discussion of the fiscal stimulus package (the President made a call for tax relief on January 18). I guess markets don’t have much faith on the fiscal discipline of the government.
More relevant to the immediate future of the economy: over the second half of January the spot BEI—the rate of expected inflation for 2008-2012—went down. Inflation expectations briefly increased after the January 22 rate cut. But overall, between the 15th and the 30th, expected inflation for the near future fell slightly.
On January 30th and subsequent days the spot BEI fell, which is quite exceptional, because it tends to increase every time the Fed eases—just look at the record in chart 2. In February inflation expectations for the near-future have continued to abate.
Chart 3 (click to enlarge)
Just in case the leaves don't let me see the tree, let me now zoom out and smooth out the time series (see chart 3). The recent rise in inflation expectations for the far future (the forward rate) to which Mankiw and Salmon referred, barely registers. In fact, those expectations have remained quite stable throughout 2007. On the other hand, expected inflation for the near future (the spot rate) started a downward trend in mid-2006. And January certainly didn’t put an end to that trend.
What do we make of this? Worries about an economic slowdown have been simmering ever since house prices began falling, back in 2006. They have intensified as the credit crisis unfolds. Much like knzn, I think that markets expect a deceleration of demand, and hence of prices. Generally speaking, monetary policy has not convinced the public that the slowdown can be avoided, and neither has the fiscal stimulus package. Regarding the far future, inflation expectations are contained.
Addendum: why isn’t the break-even inflation (BEI) equal to expected inflation?
Earlier I wrote that the spread between TIPS and nominal notes is only an approximation to expected inflation. Here I include a list of reasons why the equality doesn’t hold exactly. Please let me know if I miss something.
1. Compound bias
From the Fisher identity
i – r = pi + pi*r
By taking the spread between nominal (i) and real (r) interest rates, we ignore the interaction term pi*r. The BEI rate therefore overestimates expected inflation. If we take the yield on TIPS as an estimate of r, it’s easy to correct for this (just divide the spread by (1+r)). This bias, however, is tiny in the US nowadays, since interest rates are in the one to five percent range most of the time.
2. Inflation lag
Every day, the principal of TIPS is adjusted using the change in the Consumer Price Index. In principle, since the CPI is published only once a month, and with some delay, the adjusted principal would be updated using a lagged measure of inflation. Investors would require compensation for the difference between current and lagged CPI, and the BEI would overestimate (underestimate) expected inflation if lagged inflation were higher (lower) than current inflation.
In practice, we need not worry about this bias in the US, since the Treasury seems to have come up with daily inflation adjustments—I suppose by extrapolation of past CPI figures. Also, the bias is tiny, since monthly CPI increases are small, and not systematic, since the rate of inflation is not consistently increasing or decreasing month-to-month over long periods of time.
3. Protection against deflation
The principal of a TIPS is protected from deflation. At maturity, the investor receives the greatest between the original principal or the inflation-adjusted principal. Because this protection is valuable, the yield on TIPS is lower than otherwise, and the BEI overestimates expected inflation. In practice this bias is negligible, because the probability of deflation is extremely low.
4. Inflation risk
TIPS offer protection against inflation volatility. If investors are risk averse and inflation changes over time, TIPS are more valuable than securities whose value suffers from inflation risk. The yield will be lower, and the BEI will overestimate inflation expectations.
5. Liquidity premium
TIPS are less liquid than nominal notes. Because liquidity is valuable, the price of TIPS is lower and their yield is higher than if these securities were as liquid as nominal notes. For this reason the BEI underestimates expected inflation.
At times of high market volatility, some investors “fly” to liquid securities, in this case nominal Treasury notes, driving yields on those securities down, and introducing a negative bias to BEI as an estimator of inflation expectations.
6. Differences in the duration of the securities
In real terms, the payments from TIPS are constant, whereas the payments from a nominal note decline. The inflation-protected security has therefore a longer duration—sensitivity to interest rate changes—than the nominal security, with respect to the real interest rate.
Technorati tags:
economics, inflation expectations, expected inflation, inflation, TIPS
Expected inflation is an important determinant of future inflation. If the public expects higher inflation, workers demand higher wages, prompting employers to raise the price of their goods, which results in higher actual inflation.
Markets in fixed-income securities provide timely information about inflation expectations. Treasury inflation-protected securities (TIPS) deliver interest and principal payments that are tied to inflation. Payments from regular Treasury notes, on the other hand, are not indexed to inflation. The difference between the yield rates of the two types of securities must be equal to the inflation rate expected by the markets—otherwise there would be an arbitrage opportunity. In practice, because of technical issues, the yield spread is only an approximation to expected inflation, and people call it the break-even inflation (BEI) instead. (More on this below.) From here on I use BEI and “expected inflation” interchangeably.
Because the Treasury has created notes with different maturities, we can use the spread between nominal and TIPS securities to gauge inflation expectations for different horizons. For example, today’s difference between the yield of five-year TIPS and that of five-year nominal notes is approximately equal to the inflation rate expected over the five years starting now (2008-2012).
The Fed is interested in long-term inflation expectations, because in the short term prices are affected by transitory or volatile factors, such as commodity prices. One measure of long-term expectations, which we can also derive from yields, is the five-year, five-year forward rate. That is an approximation to the rate of inflation expected for the five years starting five years from now. Today, that would be the period from 2013 through 2017.
* * *
Chart 1 (click to enlarge)
Earlier this month Greg Ip of the Wall Street Journal posted a graph showing the five-year, five-year forward BEI, which generated some discussion in the econ blogosphere. Felix Salmon and Greg Mankiw worried over signs of increasing inflation coming from that graph. Mankiw went as far as saying that the rise in expected inflation is “consistent with the hypothesis that policymakers are overreacting to some economic news with excessive monetary and fiscal stimulus.” Following up on knzn’s analysis (Feb. 3), I find that the worries about inflation in the far-future are overstated—and that inflation expectations over the near-future have been overlooked. Using knzn’s back-of-the-envelope method, I have produced my own time series of forward BEI, which matches the one posted by Ip quite closely (see chart 1). The graph shows that starting on January 15, the rate of inflation expected for the far future (2013-2017) started increasing abruptly. By the time Ip’s graph was produced, January 30, the forward BEI had increased by 16 basis points.
That is not unusual. We have seen increases of similar or larger size in 2007: between March 9 and March 27 (15 b.p.), May 26 to June 13 (25 b.p.), and between September 11 and September 20 (16 b.p.). But each of those spikes partially reversed over time. In fact, after September 20, the time series began a protracted downward trend that left expectations at the end of 2007 below their level at the end of the summer.
Chart 2 (click to enlarge)
Let’s zoom in on the picture (chart 2). Expected inflation for the far future, the forward rate, did rise in the second half of January. Interestingly, most of the rise happened between January 16 and January 22, perhaps fueled by discussion of the fiscal stimulus package (the President made a call for tax relief on January 18). I guess markets don’t have much faith on the fiscal discipline of the government.
More relevant to the immediate future of the economy: over the second half of January the spot BEI—the rate of expected inflation for 2008-2012—went down. Inflation expectations briefly increased after the January 22 rate cut. But overall, between the 15th and the 30th, expected inflation for the near future fell slightly.
On January 30th and subsequent days the spot BEI fell, which is quite exceptional, because it tends to increase every time the Fed eases—just look at the record in chart 2. In February inflation expectations for the near-future have continued to abate.
Chart 3 (click to enlarge)
Just in case the leaves don't let me see the tree, let me now zoom out and smooth out the time series (see chart 3). The recent rise in inflation expectations for the far future (the forward rate) to which Mankiw and Salmon referred, barely registers. In fact, those expectations have remained quite stable throughout 2007. On the other hand, expected inflation for the near future (the spot rate) started a downward trend in mid-2006. And January certainly didn’t put an end to that trend.What do we make of this? Worries about an economic slowdown have been simmering ever since house prices began falling, back in 2006. They have intensified as the credit crisis unfolds. Much like knzn, I think that markets expect a deceleration of demand, and hence of prices. Generally speaking, monetary policy has not convinced the public that the slowdown can be avoided, and neither has the fiscal stimulus package. Regarding the far future, inflation expectations are contained.
Addendum: why isn’t the break-even inflation (BEI) equal to expected inflation?
Earlier I wrote that the spread between TIPS and nominal notes is only an approximation to expected inflation. Here I include a list of reasons why the equality doesn’t hold exactly. Please let me know if I miss something.
1. Compound bias
From the Fisher identity
i – r = pi + pi*r
By taking the spread between nominal (i) and real (r) interest rates, we ignore the interaction term pi*r. The BEI rate therefore overestimates expected inflation. If we take the yield on TIPS as an estimate of r, it’s easy to correct for this (just divide the spread by (1+r)). This bias, however, is tiny in the US nowadays, since interest rates are in the one to five percent range most of the time.
2. Inflation lag
Every day, the principal of TIPS is adjusted using the change in the Consumer Price Index. In principle, since the CPI is published only once a month, and with some delay, the adjusted principal would be updated using a lagged measure of inflation. Investors would require compensation for the difference between current and lagged CPI, and the BEI would overestimate (underestimate) expected inflation if lagged inflation were higher (lower) than current inflation.
In practice, we need not worry about this bias in the US, since the Treasury seems to have come up with daily inflation adjustments—I suppose by extrapolation of past CPI figures. Also, the bias is tiny, since monthly CPI increases are small, and not systematic, since the rate of inflation is not consistently increasing or decreasing month-to-month over long periods of time.
3. Protection against deflation
The principal of a TIPS is protected from deflation. At maturity, the investor receives the greatest between the original principal or the inflation-adjusted principal. Because this protection is valuable, the yield on TIPS is lower than otherwise, and the BEI overestimates expected inflation. In practice this bias is negligible, because the probability of deflation is extremely low.
4. Inflation risk
TIPS offer protection against inflation volatility. If investors are risk averse and inflation changes over time, TIPS are more valuable than securities whose value suffers from inflation risk. The yield will be lower, and the BEI will overestimate inflation expectations.
5. Liquidity premium
TIPS are less liquid than nominal notes. Because liquidity is valuable, the price of TIPS is lower and their yield is higher than if these securities were as liquid as nominal notes. For this reason the BEI underestimates expected inflation.
At times of high market volatility, some investors “fly” to liquid securities, in this case nominal Treasury notes, driving yields on those securities down, and introducing a negative bias to BEI as an estimator of inflation expectations.
6. Differences in the duration of the securities
In real terms, the payments from TIPS are constant, whereas the payments from a nominal note decline. The inflation-protected security has therefore a longer duration—sensitivity to interest rate changes—than the nominal security, with respect to the real interest rate.
Technorati tags:
economics, inflation expectations, expected inflation, inflation, TIPS
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