- 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
Sunday, August 31, 2008
Risk Factors For A 2008 Recession
Here are the top risk factors for 2008 US Recession:
Saturday, August 30, 2008
Why the Stock Market Had a Terrible Day
The big surprise is why anyone should be surprised the stock market dropped 3 percent today. The immediate trigger was the price of oil moving above $140 a barrel for the first time. A secondary trigger was yesterday's decision by the Fed not to reduce interest rates. (Some conservatives maintain it was the Fed's failure to RAISE them that caused today's ruckus on Wall Street, because global investors took it as a sign they could do better by investing elsewhere than the U.S., which caused the dollar to drop. They're wrong. The recession is the biggest worry for everyone, including global investors.) Another was the implosion of the US autos sector, and additional writedowns by major Wall Street banks.
But behind all of this is the one fundamental fact that economic analysts would rather not dwell on: American consumers are at the end of their ropes. High energy prices have contributed to it, as have high food prices. Consumer confidence is plunging. Housing prices are still dropping, which means the piggy banks of home equity and refinancing are closing.
But without consumers, there's no one to buy all the goods and services we create. Sure, big American companies are doing fine abroad, but foreign sales can't sustain them. Nor can exports. Hence, bond defaults by companies are up. Earnings are down.
What to do? Two things. We need an expansive fiscal policy that stimulates the economy with infrastructure spending -- especially mass transit, levees, and bridges, as well as investments in green technologies.
We also need a more progressive tax system that puts more money into the hands of the middle class and working class -- which will spend it. Economists Thomas Saez and Thomas Piketty have recently calculated that even excluding capital gains, 75 percent of the pretax income growth between 2002 and 2006 went to the best-off 1 percent of American families. Had they had more recent data, I'm sure they'd find the same or more through 2008. But the rich don't and won't put their burgeoning incomes back into the U.S. economy. They don't consume at nearly the same rate as everyone else because they already have most of what they need. And they don't necessarily invest their growing income in America. To the contrary, they invest it around the world wherever it can get the highest returns. And because consumer purchases are slowing here, there's less money to be made by investing here. Full circle.
But behind all of this is the one fundamental fact that economic analysts would rather not dwell on: American consumers are at the end of their ropes. High energy prices have contributed to it, as have high food prices. Consumer confidence is plunging. Housing prices are still dropping, which means the piggy banks of home equity and refinancing are closing.
But without consumers, there's no one to buy all the goods and services we create. Sure, big American companies are doing fine abroad, but foreign sales can't sustain them. Nor can exports. Hence, bond defaults by companies are up. Earnings are down.
What to do? Two things. We need an expansive fiscal policy that stimulates the economy with infrastructure spending -- especially mass transit, levees, and bridges, as well as investments in green technologies.
We also need a more progressive tax system that puts more money into the hands of the middle class and working class -- which will spend it. Economists Thomas Saez and Thomas Piketty have recently calculated that even excluding capital gains, 75 percent of the pretax income growth between 2002 and 2006 went to the best-off 1 percent of American families. Had they had more recent data, I'm sure they'd find the same or more through 2008. But the rich don't and won't put their burgeoning incomes back into the U.S. economy. They don't consume at nearly the same rate as everyone else because they already have most of what they need. And they don't necessarily invest their growing income in America. To the contrary, they invest it around the world wherever it can get the highest returns. And because consumer purchases are slowing here, there's less money to be made by investing here. Full circle.
Friday, August 29, 2008
Thursday, August 28, 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, August 27, 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, August 26, 2008
Why the Fed Blew It Today
The Fed blew it today. It should have reduced short-term interest rates -- at least by 25 basis points (a quarter of a percent) to send a clear signal to the market that it knows the threat of recession is bigger than any threat from inflation.
Inflation itself is almost never a problem. The problem comes with accelerating inflation. When does inflation accelerate? Not just because oil prices or food prices rise. Those price increases are largely the result of demand outrunning supply (see below).
No, inflation accelerates when companies have to continue to raise prices because wages are rising and productivity isn't. But these days American employees have no bargaining leverage to raise wages. Only 7.8 percent of private-sector workers are unionized. Besides, unemployment is on the rise. Under these circumstances, employers won't continue to raise prices, especially now that competition for every consumer dollar is increasing. They'll only raise prices to cover the increasing costs of supplies -- mainly energy. But this won't cause inflation to accelerate. It will just result in a price increase.
The Fed blew it. Consumer confidence is plummeting. Employment is falling. 1.2 million homes are already foreclosed upon, and banks are tightening the noose around a trillion dollars of credit-card debt. The Fed could have helped a small bit by cutting rates and sending a clear signal it would continue to do so in order to avoid recession.
But it didn't. I fear we're in for a bad one.
Inflation itself is almost never a problem. The problem comes with accelerating inflation. When does inflation accelerate? Not just because oil prices or food prices rise. Those price increases are largely the result of demand outrunning supply (see below).
No, inflation accelerates when companies have to continue to raise prices because wages are rising and productivity isn't. But these days American employees have no bargaining leverage to raise wages. Only 7.8 percent of private-sector workers are unionized. Besides, unemployment is on the rise. Under these circumstances, employers won't continue to raise prices, especially now that competition for every consumer dollar is increasing. They'll only raise prices to cover the increasing costs of supplies -- mainly energy. But this won't cause inflation to accelerate. It will just result in a price increase.
The Fed blew it. Consumer confidence is plummeting. Employment is falling. 1.2 million homes are already foreclosed upon, and banks are tightening the noose around a trillion dollars of credit-card debt. The Fed could have helped a small bit by cutting rates and sending a clear signal it would continue to do so in order to avoid recession.
But it didn't. I fear we're in for a bad one.
Monday, August 25, 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, August 24, 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, August 23, 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, August 22, 2008
"No" to Further Offshore Drilling
As predicted, Bush and McCain and their cohorts are responding to $4 a gallon gas by urging that more federal land and offshore rights be available for oil drilling. This makes no sense because:
First, the crude oil market is global. Oil companies sell all over the world. The price of crude is established by global supply and demand. So even if 3 million additional barrels a day could be extruded from lands and seabeds of the United States (that sum is the most optimistic figure, after all exploration is done), that sum is tiny compared to 86 million barrels now produced around the world. In other words, even under the best circumstances, the price to American consumers would hardly budge.
Second, whatever impact such drilling might have would occur far in the future anyway. Oil isn't just waiting there to be pumped out of the earth. Exploration takes time. Erecting drilling equipment takes time. Getting the oil out takes time. Turning crude into various oil products takes time. According the the federal energy agency, if we opening drilling where drilling is now banned, there'd be no significant impact on domestic crude and natural gas production until 2030.
Third, oil companies already hold a significant number of leases on federal lands and offshore seabeds where they are now allowed to drill, and which they have not yet fully explored. Why then would they seek more drilling rights? Because they want more leases now, when the Bushies are still in office. Ownership of these parcels would serve to to pump up their balance sheets even if no oil is pumped.
Last but by no means least, environmental risks are still significant.
First, the crude oil market is global. Oil companies sell all over the world. The price of crude is established by global supply and demand. So even if 3 million additional barrels a day could be extruded from lands and seabeds of the United States (that sum is the most optimistic figure, after all exploration is done), that sum is tiny compared to 86 million barrels now produced around the world. In other words, even under the best circumstances, the price to American consumers would hardly budge.
Second, whatever impact such drilling might have would occur far in the future anyway. Oil isn't just waiting there to be pumped out of the earth. Exploration takes time. Erecting drilling equipment takes time. Getting the oil out takes time. Turning crude into various oil products takes time. According the the federal energy agency, if we opening drilling where drilling is now banned, there'd be no significant impact on domestic crude and natural gas production until 2030.
Third, oil companies already hold a significant number of leases on federal lands and offshore seabeds where they are now allowed to drill, and which they have not yet fully explored. Why then would they seek more drilling rights? Because they want more leases now, when the Bushies are still in office. Ownership of these parcels would serve to to pump up their balance sheets even if no oil is pumped.
Last but by no means least, environmental risks are still significant.
Thursday, August 21, 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, August 20, 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, August 19, 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, August 18, 2008
Why is Gas at $4 a Gallon?
Conspiracy theories abound, but the soaring price of crude oil (today around $137 a barrel) is related to four more mundane forces:
(1) growing demand from developing nations, especially China and India. This is the main reason for the price rise over the last six years.
(2) the dropping dollar. As it drops, because of our trade imbalance and overall indebtedness to the rest of the world as well as our slowing economy, everything we buy from abroad -- including much of the oil we import -- costs more; everything we sell to foreigners -- including much of the oil we produce -- costs less to them. I attribute half of oil's price rise since January to this.
(3) Global investors (including, perhaps, your own pension fund) are anxious about the American economy, and looking to hedge their bets against future declines. Oil is one of the commodities that looks like a good bet. Hence, there's speculation in oil futures. This isn't a nefarious plot. It's the way the market works. A bit of a speculative bubble is forming, so beware. I attribute a big part of oil's price rise over the last few weeks to this.
(4) Instability in the Middle East. Israel's recent bellicose statements about Iran have generated fears about the continuing capacity and willingness of Middle Eastern oil producers to generate oil (about a third of world oil production). OPEC refuses to produce more. Some of oil's price rise over the last week is attributable to this.
In other words, a perfect storm. Given the US recession and slowing of European economies, I expect oil to fall to around $125 a barrel but then be pushed up by speculators and the falling dollar to around $135 over the next several weeks. Wall Street investment houses are talking about $150 by July but that's their way of stoking more speculation (in which they have a financial interest).
Bottom line: The days of cheap energy are over, folks. Gas may go down to $3.50 a gallon by this time next year, but you'd be wise to trade in your SUV for an economy car. And you'd be wise to avoid building that new addition to your home and put the money instead into better insulation.
(1) growing demand from developing nations, especially China and India. This is the main reason for the price rise over the last six years.
(2) the dropping dollar. As it drops, because of our trade imbalance and overall indebtedness to the rest of the world as well as our slowing economy, everything we buy from abroad -- including much of the oil we import -- costs more; everything we sell to foreigners -- including much of the oil we produce -- costs less to them. I attribute half of oil's price rise since January to this.
(3) Global investors (including, perhaps, your own pension fund) are anxious about the American economy, and looking to hedge their bets against future declines. Oil is one of the commodities that looks like a good bet. Hence, there's speculation in oil futures. This isn't a nefarious plot. It's the way the market works. A bit of a speculative bubble is forming, so beware. I attribute a big part of oil's price rise over the last few weeks to this.
(4) Instability in the Middle East. Israel's recent bellicose statements about Iran have generated fears about the continuing capacity and willingness of Middle Eastern oil producers to generate oil (about a third of world oil production). OPEC refuses to produce more. Some of oil's price rise over the last week is attributable to this.
In other words, a perfect storm. Given the US recession and slowing of European economies, I expect oil to fall to around $125 a barrel but then be pushed up by speculators and the falling dollar to around $135 over the next several weeks. Wall Street investment houses are talking about $150 by July but that's their way of stoking more speculation (in which they have a financial interest).
Bottom line: The days of cheap energy are over, folks. Gas may go down to $3.50 a gallon by this time next year, but you'd be wise to trade in your SUV for an economy car. And you'd be wise to avoid building that new addition to your home and put the money instead into better insulation.
Sunday, August 17, 2008
Friday, August 15, 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
Thursday, August 14, 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.
Wednesday, August 13, 2008
Why We Need a Real Fiscal Stimulus Package, Pronto
Make no mistake. We're in a recession. Today's unemployment report showing nonfarm payrolls falliing by 49,000 jobs, is the fifth month in a row in which payrolls declined. Over the past six months, the economy has shed 411,000 private sector jobs. You will hear some cheerleaders tell you to disregard all this, pointing out that the economy continues to grow at a healthy pace. Baloney. Those growth numbers are illusory, based partly on the fact that, with fewer employees, productivity per employee has obviously grown. And partly on the temporary effect of the little stimulus package now in place.
What to do? Monetary policy is frozen. Bernanke and company don't dare to cut rates now, for fear of spurring inflation. They're wrong -- the inflation isn't coming from inside the United States. Employees have no power to demand higher wages, and companies have no power to raise prices. Inflation is coming from outside the US. Demand from China and India is pushing up commodity prices. And the dollar is dropping, which makes everything we buy from abroad more expensive. The Fed is correct to worry about only one thing when it comes to cutting rates -- that investors will be even less enthusiastic about returns they can get in the U.S., and will move more of their money into euros, yen, and a basket of other currencies. This will drive the dollar down further and thereby push up the prices of much that we buy from abroad, spurring inflation. But the chain of cause-and-effect here is not so powerful or direct as to suggest that no rate cut is warranted now. The Fed should cut rates again. If we the economy gets moving again, and investors will flock back.
Fiscal policy is a surer bet, but Congress -- especially the fiscally-conservative followers of Herbert Hoover called "blue-dog Democrats" -- is still hung up about budget deficits. Now is the time to exhume John Maynard Keynes and understand that government must be the spender of last resort when there's inadequate domestic demand. And the best and most urgent government spending now is for infrastructure -- especially public transit (see my postings below). Dems should move quickly.
More basically, the problem is weak consumer spending, which is directly related to the failure of jobs and wages to keep up. This problem, as I've indicated, has been long coming, although masked by the housing bubble that allowed consumers to borrow against their homes. If the middle class is to continue to provide adequate spending to keep the economy going, taxes must be reduced on the middle class and the fiscal gap filled (deficits have to be filled eventually) by marginal tax increases on the highest incomes. Because their incomes are so high, the rich don't spend nearly as high a percentage of their incomes as moderate-income and poor people (after all, the definition of being rich is having most of what you already want). The rich will not and cannot keep the American economy going on their own.
What to do? Monetary policy is frozen. Bernanke and company don't dare to cut rates now, for fear of spurring inflation. They're wrong -- the inflation isn't coming from inside the United States. Employees have no power to demand higher wages, and companies have no power to raise prices. Inflation is coming from outside the US. Demand from China and India is pushing up commodity prices. And the dollar is dropping, which makes everything we buy from abroad more expensive. The Fed is correct to worry about only one thing when it comes to cutting rates -- that investors will be even less enthusiastic about returns they can get in the U.S., and will move more of their money into euros, yen, and a basket of other currencies. This will drive the dollar down further and thereby push up the prices of much that we buy from abroad, spurring inflation. But the chain of cause-and-effect here is not so powerful or direct as to suggest that no rate cut is warranted now. The Fed should cut rates again. If we the economy gets moving again, and investors will flock back.
Fiscal policy is a surer bet, but Congress -- especially the fiscally-conservative followers of Herbert Hoover called "blue-dog Democrats" -- is still hung up about budget deficits. Now is the time to exhume John Maynard Keynes and understand that government must be the spender of last resort when there's inadequate domestic demand. And the best and most urgent government spending now is for infrastructure -- especially public transit (see my postings below). Dems should move quickly.
More basically, the problem is weak consumer spending, which is directly related to the failure of jobs and wages to keep up. This problem, as I've indicated, has been long coming, although masked by the housing bubble that allowed consumers to borrow against their homes. If the middle class is to continue to provide adequate spending to keep the economy going, taxes must be reduced on the middle class and the fiscal gap filled (deficits have to be filled eventually) by marginal tax increases on the highest incomes. Because their incomes are so high, the rich don't spend nearly as high a percentage of their incomes as moderate-income and poor people (after all, the definition of being rich is having most of what you already want). The rich will not and cannot keep the American economy going on their own.
Tuesday, August 12, 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]
Monday, August 11, 2008
The fiscal stimulus: ineffective or wrong?
The latest economic data show that output growth has weakened and unemployment is creeping up. The government is worried, with good reason, that the economy is going through a pronounced slowdown, perhaps even a recession. To limit the damage, Congress yesterday approved a battery of fiscal measures. By my reckoning, however, the plan will at best provide a short-lived nudge to consumption, but not employment; at worst, it’ll do nothing.
Starting in May, the government will send $600 checks to individuals ($1,200 for couples and an extra $300 for each child). People who earn too little to pay income taxes, but make more than $3,000, will receive a $300 payment. Payments will total $106 billion and will add to the budget deficit.
Cash outlays are supposed to boost private consumption expenditures and accelerate overall growth. $106b may seem a small stimulus for a $14 trillion economy, but the payments are expected to have a “multiplier effect”: higher demand will prompt businesses to hire more workers, and increased employment will further stimulate private consumption, which in turn will induce more hiring. The process continues ad infinitum. The outlays, therefore, can have a final effect on aggregate demand that is many times bigger than the initial stimulus —hence the name “multiplier.”
The effectiveness of the measure hinges on two factors. First, the fraction of the government outlays that will be spent immediately. According to Bruce Bartlett, previous experiences with tax rebates in 1975 and 2001 indicate that it's small. The recent study by Elmendorf and Furman indicates that it's a 50 percent.
The second requirement, which has received less attention, is that businesses will respond to the initial surge in demand by hiring new workers. If they don’t, then the fiscal package will have no second-round impact on demand, and the stimulus to consumption will total just $50b.
Because the first two quarters of 2008 will be marked by considerable uncertainty about the course of the economy in the medium term, the announcement of the fiscal plan will not have an immediate effect on hiring. Manufacturers may ratchet up their inventories, in anticipation of the small jolt of demand in May, but they will do so by using overtime and temp workers, rather than hiring permanent employees. In the services sector, we won’t see any change in employment until the late spring, and even then employers will similarly meet spikes in demand with overtime hours and temp workers, at least initially. If, come June, forecasts have improved, we may see employment pick up over the fall. But by then the effect of the government checks will have played out. In conclusion, the fiscal package won’t provide any significant boost to employment.
A less obvious reason to reject the stimulus is that the slowdown in aggregate demand is necessary, even healthy. Most of the growth experienced between 2002 and 2006 was based on low interest rates, over-valued real estate, and loose lending standards.
Chart 1, from a story by Michael Mandel at BusinessWeek, tells it all. Mandel estimates that, “if consumer spending had tracked the overall economy over the past decade as it has in the past, Americans today would be spending about $600 billion less a year. The extra spending has amounted to a total of about $3 trillion since 2001.” That extra spending was financed with debt. Quite literally, Americans were borrowing their prosperity from the future —not exactly a sustainable growth path.
Chart 1 (left) and 2 (right). Click to enlarge.
The growth of productivity, the value of output per hour worked, confirms the hypothesis that consumer expenditures were out of line with real income gains, at least over the last five years. Robert Gordon of Northwestern University estimates that trend productivity growth peaked in 2002, and has slowed down ever since (see Chart 2, via Michael Mandel’s blog). The gap between long-term growth of GDP and consumption, on the other hand, has widened over the same period.
So, if the recent growth rate of expenditures was excessive, why is Congress rushing to prop it up? More importantly given that the stimulus will be financed with future tax increases: why are legislators borrowing even more from future prosperity? The answers to these questions have a lot to do with politics and very little with economics.
Notice the hodgepodge of enigmatic measures included in the fiscal package. Congress grants payments of $300 to low-income seniors and disabled veterans, but not to other disabled people. It allows federal housing agencies to insure jumbo mortgages, as if subsidies to the purchase of expensive homes was going to parachute the economy. And it includes specific provisions to prevent illegal immigrants from claiming payments, precluding illegals from contributing to the consumption surge, however small that may be. So, if you think about it for a minute, what Congress did is give itself a votes-buying package, which does stimulate something: re-election.
Technorati tags:
economics, macroeconomics, fiscal policy, fiscal stimulus, stabilization policy
Starting in May, the government will send $600 checks to individuals ($1,200 for couples and an extra $300 for each child). People who earn too little to pay income taxes, but make more than $3,000, will receive a $300 payment. Payments will total $106 billion and will add to the budget deficit.
Cash outlays are supposed to boost private consumption expenditures and accelerate overall growth. $106b may seem a small stimulus for a $14 trillion economy, but the payments are expected to have a “multiplier effect”: higher demand will prompt businesses to hire more workers, and increased employment will further stimulate private consumption, which in turn will induce more hiring. The process continues ad infinitum. The outlays, therefore, can have a final effect on aggregate demand that is many times bigger than the initial stimulus —hence the name “multiplier.”
The effectiveness of the measure hinges on two factors. First, the fraction of the government outlays that will be spent immediately. According to Bruce Bartlett, previous experiences with tax rebates in 1975 and 2001 indicate that it's small. The recent study by Elmendorf and Furman indicates that it's a 50 percent.
The second requirement, which has received less attention, is that businesses will respond to the initial surge in demand by hiring new workers. If they don’t, then the fiscal package will have no second-round impact on demand, and the stimulus to consumption will total just $50b.
Because the first two quarters of 2008 will be marked by considerable uncertainty about the course of the economy in the medium term, the announcement of the fiscal plan will not have an immediate effect on hiring. Manufacturers may ratchet up their inventories, in anticipation of the small jolt of demand in May, but they will do so by using overtime and temp workers, rather than hiring permanent employees. In the services sector, we won’t see any change in employment until the late spring, and even then employers will similarly meet spikes in demand with overtime hours and temp workers, at least initially. If, come June, forecasts have improved, we may see employment pick up over the fall. But by then the effect of the government checks will have played out. In conclusion, the fiscal package won’t provide any significant boost to employment.
A less obvious reason to reject the stimulus is that the slowdown in aggregate demand is necessary, even healthy. Most of the growth experienced between 2002 and 2006 was based on low interest rates, over-valued real estate, and loose lending standards.
Chart 1, from a story by Michael Mandel at BusinessWeek, tells it all. Mandel estimates that, “if consumer spending had tracked the overall economy over the past decade as it has in the past, Americans today would be spending about $600 billion less a year. The extra spending has amounted to a total of about $3 trillion since 2001.” That extra spending was financed with debt. Quite literally, Americans were borrowing their prosperity from the future —not exactly a sustainable growth path.
Chart 1 (left) and 2 (right). Click to enlarge.
The growth of productivity, the value of output per hour worked, confirms the hypothesis that consumer expenditures were out of line with real income gains, at least over the last five years. Robert Gordon of Northwestern University estimates that trend productivity growth peaked in 2002, and has slowed down ever since (see Chart 2, via Michael Mandel’s blog). The gap between long-term growth of GDP and consumption, on the other hand, has widened over the same period.So, if the recent growth rate of expenditures was excessive, why is Congress rushing to prop it up? More importantly given that the stimulus will be financed with future tax increases: why are legislators borrowing even more from future prosperity? The answers to these questions have a lot to do with politics and very little with economics.
Notice the hodgepodge of enigmatic measures included in the fiscal package. Congress grants payments of $300 to low-income seniors and disabled veterans, but not to other disabled people. It allows federal housing agencies to insure jumbo mortgages, as if subsidies to the purchase of expensive homes was going to parachute the economy. And it includes specific provisions to prevent illegal immigrants from claiming payments, precluding illegals from contributing to the consumption surge, however small that may be. So, if you think about it for a minute, what Congress did is give itself a votes-buying package, which does stimulate something: re-election.
Technorati tags:
economics, macroeconomics, fiscal policy, fiscal stimulus, stabilization policy
Sunday, August 10, 2008
Nouriel Roubini: "clear by now that a severe U.S. recession is inevitable in next few months."
Nouriel Roubini, a leading economist at New York University, is now saying that a US Recession is almost here:
"It is increasingly clear by now that a severe U.S. recession is inevitable in next few months. Those of us who warned for the last 12 months about a combination of a worsening housing recession, a severe credit crunch and financial meltdown, high oil prices and a saving-less and debt-burdened consumers being on the ropes causing an economy-wide recession were repeatedly rebuffed the consensus view about a soft landing given the presumed resilience of the US consumer."Roubini is a smart economist who often goes against the consensus view."But the evidence is now building that an ugly recession is inevitable."
Saturday, August 9, 2008
A Personal Reflection on Why Obama Should Not Choose HRC as his VP
The question that dominates the news tonight, as it will undoubtedly dominate the news tomorrow and the day after that, and perhaps longer, is whether Obama should make HRC his vice president. She has clearly signaled her desire to be so, and her surrogates have suggested that for Obama to do otherwise risks alienating her legions of supporters. Put to one side whether this is correct; we have no way of knowing. The more significant reality is this: at the very time when Obama should finally be free to make make his case to the American public for why he should be president, he is engaged in another diversionary and distracting fight with her for the public's attention.
I have known and admired the Clintons for decades and I have no doubt that Hillary could do an excellent job as Vice President. But this current spectacle illustrates why he should not choose her. Hillary and Bill Clinton are masters at claiming the public limelight even at the expense of larger public purpose. Media attention puts her unflagging ambition center stage and his unbridled (although sometimes misdirected) charm on full display. Were Obama to make her his Vice President, she would turn the tables and make him her President, just as she has turned the tables this week and transformed his remarkable victory into her audacious dare.
I have known and admired the Clintons for decades and I have no doubt that Hillary could do an excellent job as Vice President. But this current spectacle illustrates why he should not choose her. Hillary and Bill Clinton are masters at claiming the public limelight even at the expense of larger public purpose. Media attention puts her unflagging ambition center stage and his unbridled (although sometimes misdirected) charm on full display. Were Obama to make her his Vice President, she would turn the tables and make him her President, just as she has turned the tables this week and transformed his remarkable victory into her audacious dare.
Friday, August 8, 2008
Thursday, August 7, 2008
Recession buzz
Chart 1 (click to enlarge)
It’s been hard for news readers to avoid the word “recession” this January. The number of newspaper stories mentioning it has certainly been overwhelming (see Chart 1). Weak economic data might seem to justify the gloom. Growth has slowed down and the labor market has weakened. Still, we haven’t seen a single quarter of negative growth, and the employment figures have been equivocal, and certainly not recessionary. So, given what we know about the state of the economy, is all this recession chatter justified, or are journalists getting carried away?
To answer that question, I have put together data on the tone of economic reporting in the newspapers, as well as on indicators of the health of the real economy. Then I have estimated a statistical model and compared the level of pessimism of the newspapers with the actual mood that one would expect based on the known state of the economy. The results are pretty exciting. So exciting, in fact, that I plan on updating and reporting my calculations every month, here on EconWeekly.
My measure of usage of the word “recession” is The Economist’s R-word index: the number of stories containing that word in the New York Times and the Washington Post. The index is a surprisingly good indicator of economic slowdowns. It never fails to rise sharply at the beginning of recessions. (See Chart 2.) And in spite of its simplicity, it captures the sentiment of the newspapers pretty well. Mark Doms and Norman Morin, of the Federal Reserve Board, constructed a much fancier recession index for a research project on the subject, containing dozens of media sources and carefully filtering the search terms. And yet, the difference between their measure and The Economist’s R-word index is almost always small. (See Figure 4.1 in Doms and Morin’s paper.)
Chart 2 (click to enlarge)
To gauge the present and immediate future of the economy, I include the following variables in my statistical model: the unemployment rate, the growth of the S&P500 index, the growth of the price of oil, the growth of personal consumption expenditures, and the spread between the ten-year bond and the one-year Treasury bill. (Econometrics jocks can find the details of the statistical model below.)
My model shows that newspapers have indeed been too gloomy this past month. In January, known economic conditions would have justified about 200 stories mentioning the word “recession”; the actual count was around 300. Up until December, however, newspaper mood was approximately in line with the actual state of the economy. (See Chart 3.) Why did newspaper sentiment diverge from economic fundamentals last month?
Chart 3 (click to enlarge)
In January we witnessed a sequence of unusual events. There was ongoing talk about the fiscal stimulus package, which is being introduced precisely to avoid an economic slowdown. The President sketched a plan on January 18, then the House of Representatives announced theirs a week later, and then the Senate considered changing it. Then there was a mini crash in the stock market, followed by the surprise cut of the Federal Reserve’s target interest rate on January 22, and then another cut at the Fed’s scheduled meeting on the 30th. Every newspaper story that reported any of these events most likely included the word “recession.”
But, at least in part, I believe that the buzz has to do with incentives in the news industry. Even when reporting facts, every media outlet strives to agree with the views of its audience. Fox News would lose its parish if it started “showing” that the Iraq surge was wrong and ineffective, and the Wall Street Journal would clash against the opinions of its readers if it started “proving” that the Bush tax cuts were a bad idea. Maintaining an audience depends vitally on conforming to their prior expectations. (Note to self: what do EconWeekly readers expect?)
Economics reporting is a bit different because the state of the economy can be measured and verified more objectively. As a result, views are more homogeneous across audiences. Still, media outlets need to take into account three factors which determine the views news consumers, and therefore the choice of tone and volume of economic reports: intrinsic pessimism, past reports on the state of the economy, and reports from other media outlets.
Bryan Caplan of George Mason University has identified pessimism as one of the four capital biases of the average Joe. (Read this summary.) People routinely see negative trends in long-term living standards, wages, inequality, etc. The gloom extends to the state of the economy at any given moment. About half of Americans have been thinking that we are in a recession, or on the brink of one, since October! Where that pessimism comes from, I have no idea. David Hume, Caplan says, thought that “the humour of blaming the present, and admiring the past, is strongly rooted in human nature.” It sounds appealing. But whichever the reason, the media recognize the appeal of worrying reports about the economy —and deliver.
Inherent pessimism influences the interpretation that the media put on any given piece of hard data. But once the newspapers set clouds in the horizon, their incentives to deliver negative news become stronger, because they need to conform to the readers’ expectations. A newspaper that changed its view on the state of the economy would go against the prior views —plus, it would be accused of the horrible crime of flip-flopping. A newspaper has therefore an incentive to keep a certain mood even on something as relatively objective as the state of the economy. Past negative reports will lead to more negative reports in the future, feeding a cycle of pessimism, unless new hard data against such views are so strong that the paper is forced to tone it down over time.
Finally, people are exposed to reports from more than one source of information, even if it’s secondhand. Any newspaper that strayed from the average mood of all other newspapers would conflict with the established view, alienating itself. Any given outlet has thus an incentive to stay in line with the tone of all the major media, resulting in “herd behavior”: the tendency to base decisions (in this case the tone of the news) on the behavior of the rest of the community (other media outlets).
The combination of natural pessimism and the need to conform to the public’s views, therefore, explains why sometimes reporting on the economy is not consistent with actual events, as is the case now. Only policymakers, animal spirits and time can determine whether we’ll see a recession in 2008. For now, skip the editorials on economics.
Statistical model:
VAR, with monthly data, from January of 1976 through the latest month available. Each equation includes six lags. The variables are: the R-word index, the unemployment rate, the change in nonfarm payrolls, the slope of the yield curve (10-year minus 1-year), the growth of personal consumption expenditures on durable goods accumulated over the current and previous two months, and the growth of the industrial production index, also accumulated over the same period. I also include a set of monthly dummies and a dummy variable that equals 1 if the NBER announced a decline in real GDP. The unemployment rate is the first release reported by the BLS. The change in payrolls mimics the one reported by the BLS, that is, it is equal to the first estimate of payrolls for month t, minus the revised (first update) figure for month t-1. Both unemployment and payroll figures come from ALFRED. The yields on the ten-year bond and the one-year Treasury bill are monthly averages, from FRED. Durable expenditures come from the NIPA accounts, via FRED, and the industrial production index is from the Federal Reserve, also via FRED.
Technorati tags:
economics, news, media bias, recession, media
Wednesday, August 6, 2008
Tuesday, August 5, 2008
Why Revenues from Cap-and-Trade Should Be Returned to Us As Dividends
Here's the original of a piece I sent to the Wall Street Journal, at their request(as you see, a more detailed version of my posting last week). Their published version left out two pertinent things, however, that, for the record, need to be included: the important feature of having the "dividend" checks paid monthly, just like Social Security checks are paid. And also Peter Barnes' important role pushing for this concept.
***
The Lieberman-Warner cap-and-trade bill is going nowhere. Even in the unlikely event Congress passes it, the President has said he will veto the measure, and there aren't nearly enough votes to override. So the real action commences January 20, 2009, when a new administration takes over. BarackObama is on record in favor of cap and trade. And so, significantly, is John McCain.
In fact, McCain has been among the strongest backers of the Lieberman-Warner bill, and the bill offers a good indication of where McCain will head He’s been pushing for a bill much like Lieberman’s for some time now, twice bringing it to a vote. In October last year, McCain said he was “bitterly disappointed” by US inaction on climate change so far. “The Europeans implemented a cap-and-trade system; they stumbled and had their problems but it is still the right thing to do,” he said. More
recently, McCain spoke of "the central facts of rising temperatures, rising waters and all the endless troubles that global warming will bring." Lieberman is, of course, a key McCain backer.
So it's a certainty that we'll have a president next year who wants to address global warming by imposing an overall cap on U.S. carbon emissions, which will drop annually. The "trade" part of the equation would allow companies finding efficient ways to cut emissions to sell the unused portions of their permits to others. Obama’s proposal is more ambitious than McCain’s in terms of how fast the overall cap would drop.
But the biggest difference between McCain and Obama is how the permits would be allocated. McCain’s proposal would initially give out most of them for free to the nation’s biggest emitters of greenhouse gases. This does have some logic to it: after all, as the overall cap tightens each year, the biggest polluters will face the largest challenges in cutting emissions.
By contrast, Senator Obama has proposed allocating the permits through an auction. Under his proposal, every company - large or small - would have to buy the rights to emit greenhouse gases. As a result, the biggest emitters would have to pay the most - thereby providing them with the greatest incentive to cut emissions right from the start. In economic terms, such a carbon auction is the equivalent of a carbon tax, and it make more sense than a system that allocates permits on the basis of how much greenhouse gas a company or industry already emits. Companies and industries that impose the largest social costs in terms of such emissions should be given the greatest incentives to cut costs right from the start.
Moreover, carbon auctions invite far less political maneuvering. Setting initial allocations by emissions, as McCain wants to do, invites every big corporation and industry to fight for the biggest possible allocation and claim the largest emissions. Despite John McCain’s avowed determination to reduce the influence of lobbyists in Washington, the resulting free-for-all would be a bonanza for K Street. And there’s no reason to suppose the outcomewould bear any resemblance to the public interest. In fact, one likely result would be the issuance ofso many permits as tobreak the overall cap. This is one reason whycap-and-trade hasn't worked very well in Europe so far. Since the EuropeanUnion adopted the system three years ago, carbon emissions are actually up by several percentage points. The EU gave initial permits away for free, and many companies discovered clever ways to grab even more of them than their previous emissions would warrant.
McCain hasn’t completely ruled out a carbon auction. Lieberman’s bill would auction off some permits – at first a few, and more as time goes on. Over the life of the bill, half of the permits would be handed out for free, half by auction. It seems likely that McCain, who supports the Lieberman bill, would follow the same model.
But carbon auctions raise another problem when it comes to Washington. Revenues from the auctions are likely to be fish bait to industries that might qualify for some of them. Lieberman estimates that the market value of all permits under his bill would be about $7 trillion by 2050. That sum would go into what Lieberman calls a Climate Change Credit Corporation, which, operating outside the budget process, would invest in various plans for developing alternative energy. You can bet that lobbyists for ethanol, nuclear, and so-called “clean” coal are already salivating at the prospect of a similar fund emerging from a bill sponsored by McCain or Obama.
That's why it's important that all revenues from carbon auctions be cycled back to citizens. And rather than launch another endless debate over how and to whom – a payroll tax cut for people earning under the median wage? a cut in capital gains? – it would be well to agree to the simplest possible formula: Every adult citizen should receive an equal share. If the carbon auction yields $150 billion in the first year, for example, each of America’s 150 million adult citizens should receive a Treasury check of $1000.
Such direct and simple repayments – what analyst Peter Barnes, who has been pushing this idea, wisely calls “dividends” – deal with another problem. Although the balance of economic studies suggest that the cost of a cap and trade system will be
modest, particularly to the extent it induces companies to reduce their emissions, inevitably some costs will be involved and be passed along to consumers. The cost of doing nothing about climate change will be far higher. But consumers Who are already walloped by high fuel and food costs will be in no mood to accept even modest additional price increases. Hence, the yearly dividend checks will be a welcome offset.
And to make the dividend checks really useful to people, they should be paid out on a monthly basis, the same as Social Security checks. Moreover, that way citizens can be continuously reminded of what they're giving away, and what they're getting back for it.
Our atmosphere belongs to all of us. It seems only reasonable that corporations should have to pay to use it. The citizens of Alaska and Alberta, Canada get yearly dividends from the oil companies that take away their natural resources. Why shouldn't the same principle apply when industries use the biggest common resource of all?
***
The Lieberman-Warner cap-and-trade bill is going nowhere. Even in the unlikely event Congress passes it, the President has said he will veto the measure, and there aren't nearly enough votes to override. So the real action commences January 20, 2009, when a new administration takes over. BarackObama is on record in favor of cap and trade. And so, significantly, is John McCain.
In fact, McCain has been among the strongest backers of the Lieberman-Warner bill, and the bill offers a good indication of where McCain will head He’s been pushing for a bill much like Lieberman’s for some time now, twice bringing it to a vote. In October last year, McCain said he was “bitterly disappointed” by US inaction on climate change so far. “The Europeans implemented a cap-and-trade system; they stumbled and had their problems but it is still the right thing to do,” he said. More
recently, McCain spoke of "the central facts of rising temperatures, rising waters and all the endless troubles that global warming will bring." Lieberman is, of course, a key McCain backer.
So it's a certainty that we'll have a president next year who wants to address global warming by imposing an overall cap on U.S. carbon emissions, which will drop annually. The "trade" part of the equation would allow companies finding efficient ways to cut emissions to sell the unused portions of their permits to others. Obama’s proposal is more ambitious than McCain’s in terms of how fast the overall cap would drop.
But the biggest difference between McCain and Obama is how the permits would be allocated. McCain’s proposal would initially give out most of them for free to the nation’s biggest emitters of greenhouse gases. This does have some logic to it: after all, as the overall cap tightens each year, the biggest polluters will face the largest challenges in cutting emissions.
By contrast, Senator Obama has proposed allocating the permits through an auction. Under his proposal, every company - large or small - would have to buy the rights to emit greenhouse gases. As a result, the biggest emitters would have to pay the most - thereby providing them with the greatest incentive to cut emissions right from the start. In economic terms, such a carbon auction is the equivalent of a carbon tax, and it make more sense than a system that allocates permits on the basis of how much greenhouse gas a company or industry already emits. Companies and industries that impose the largest social costs in terms of such emissions should be given the greatest incentives to cut costs right from the start.
Moreover, carbon auctions invite far less political maneuvering. Setting initial allocations by emissions, as McCain wants to do, invites every big corporation and industry to fight for the biggest possible allocation and claim the largest emissions. Despite John McCain’s avowed determination to reduce the influence of lobbyists in Washington, the resulting free-for-all would be a bonanza for K Street. And there’s no reason to suppose the outcomewould bear any resemblance to the public interest. In fact, one likely result would be the issuance ofso many permits as tobreak the overall cap. This is one reason whycap-and-trade hasn't worked very well in Europe so far. Since the EuropeanUnion adopted the system three years ago, carbon emissions are actually up by several percentage points. The EU gave initial permits away for free, and many companies discovered clever ways to grab even more of them than their previous emissions would warrant.
McCain hasn’t completely ruled out a carbon auction. Lieberman’s bill would auction off some permits – at first a few, and more as time goes on. Over the life of the bill, half of the permits would be handed out for free, half by auction. It seems likely that McCain, who supports the Lieberman bill, would follow the same model.
But carbon auctions raise another problem when it comes to Washington. Revenues from the auctions are likely to be fish bait to industries that might qualify for some of them. Lieberman estimates that the market value of all permits under his bill would be about $7 trillion by 2050. That sum would go into what Lieberman calls a Climate Change Credit Corporation, which, operating outside the budget process, would invest in various plans for developing alternative energy. You can bet that lobbyists for ethanol, nuclear, and so-called “clean” coal are already salivating at the prospect of a similar fund emerging from a bill sponsored by McCain or Obama.
That's why it's important that all revenues from carbon auctions be cycled back to citizens. And rather than launch another endless debate over how and to whom – a payroll tax cut for people earning under the median wage? a cut in capital gains? – it would be well to agree to the simplest possible formula: Every adult citizen should receive an equal share. If the carbon auction yields $150 billion in the first year, for example, each of America’s 150 million adult citizens should receive a Treasury check of $1000.
Such direct and simple repayments – what analyst Peter Barnes, who has been pushing this idea, wisely calls “dividends” – deal with another problem. Although the balance of economic studies suggest that the cost of a cap and trade system will be
modest, particularly to the extent it induces companies to reduce their emissions, inevitably some costs will be involved and be passed along to consumers. The cost of doing nothing about climate change will be far higher. But consumers Who are already walloped by high fuel and food costs will be in no mood to accept even modest additional price increases. Hence, the yearly dividend checks will be a welcome offset.
And to make the dividend checks really useful to people, they should be paid out on a monthly basis, the same as Social Security checks. Moreover, that way citizens can be continuously reminded of what they're giving away, and what they're getting back for it.
Our atmosphere belongs to all of us. It seems only reasonable that corporations should have to pay to use it. The citizens of Alaska and Alberta, Canada get yearly dividends from the oil companies that take away their natural resources. Why shouldn't the same principle apply when industries use the biggest common resource of all?
Monday, August 4, 2008
Sunday, August 3, 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
Friday, August 1, 2008
Economy Slowing Says Calculated Risk
Great Blogger, Calculated Risk "Clearly the economy is slowing sharply"
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