Joseph Stiglitz on Charlie Rose

Definitely worth watching. (how is it that TV has so many bad shows when stuff like this is on?)

What'll it be? Inflation or deflation? Or both?

Lost in the fear of inflation that has gripped many for months, is the reverse and almost silent bull market killer, deflation. In recent days however we have seen that deflation has again made the news.

In Japan it was reported that "

."..wholesale prices fell a record 6.6 percent in the year to June, as the world's No.2 economy slides deeper into deflation",

In Ireland, the TimesOnline reports that

"Ireland sunk further into deflation in June as the cost of living fell at the fastest rate since the Great Depression, raising the prospect of a prolonged recession"it is deflation that is the problem.

The prospect of deflation has even hit the pages of the US's WSJ Wall Street Journal:"

... falling commodity prices swept away lingering fears of inflation and fueled fresh economic concerns....Contracts on the 30-year bond saw bigger price gains, closing nearly two full points higher with yields seen below 4.25% at contract expiration. "The participants looked around and saw deflation everywhere," said James Barrett, a market strategist ...who cited falling prices in grains and metals alongside energy Wednesday

Most of us know the traditional (and well documented) truth that higher money supply growth leads to inflation rule. How can their be deflation with such a growth in the money supply?

There is no simple answer but when you couple the fact that banks are not making as many loans as they did previously and consumers are not buying as much as they did previously, you have at least the right conditions for deflation.

To make matters worse, the money being spend under the Fed stimulus packages may not be having as large of impact as had been hoped/expected. For instance consider the following article that Charlie a former student of mine sent:

Debt and Deflation - John Mauldin's Outside the Box - InvestorsInsight.com | Financial Intelligence, Advice & Research / Investment Strategies & Planning for Individual Investors.:

"...week, the most important question that an investor can ask is whether we are in for deflation or inflation. And this week we read a well reasoned piece on deflation. ...Van Hoisington and Dr. Lacy Hunt give us a few thoughts on why they think it is deflation that will ultimately be the problem and not inflation we are dealing with today....

...Barro and Perotti are saying that each $1 increase in government spending reduces private spending by about $1, with no net benefit to GDP. All that is left is a higher level of government debt creating slower economic growth."

"....a paper written at the University of California Berkeley entitled The Macroeconomic Effects of Tax Changes: Estimates Based on a new Measure of Fiscal Shocks, by Christina D. and David H. Romer (March 2007). (Christina Romer now chairs the president's Council of Economic Advisors). This study found that the tax multiplier is 3, meaning that each dollar rise in taxes will reduce private spending by $3."

So what do you think? Inflation? Or Deflation.

This is the new poll question I included on the blog: which is more likely Inflation or Deflation?" It's off on the left. Right now Inflation is ahead 58% to 42%.

And if you are not confused enough, one scenario worth considering is short term deflation (due to lower demand), and then longer term inflation (due to higher money supply growth) when the Fed has a difficult time withdrawing money from the system.

Thanks Charlie!

Tim Geithner inteview on CNN

Here is the video from the CNN interview with Treasury Secretary Geithner that I mentioned on Twitter.

Here's How The Community Reinvestment Act Led To The Housing Bubble's Lax Lending

The following is John Carney's explanation of how he now believes the Community Reivestment Act of 1977 helped lead to the housing bubble.

Here's How The Community Reinvestment Act Led To The Housing Bubble's Lax Lending: "Contrary to my initial conclusion, the evidence is overwhelming that the CRA played a significant role in creating lax lending standards that fueled the housing bubble."

It is fairly complex piece (even if named a "quick" guide), but will give a few look-ins.

"Let's begin:

• How could a piece of 1977 legislation be significant to the deterioration of mortgage standards 25 years later?

The CRA was not a static piece of legislation. It evolved over the years from a relatively hands-off law focused on process into one that focused on outcomes ...Regulators, beginning in the mid-nineties, began to hold banks accountable in serious ways. Banks responded to this new accountability by increasing the CRA loans they made, a move that entailed relaxing their lending standards"

Another peek:

"Regulators instructed banks to consider alternatives to traditional credit histories because CRA targeted borrowers often lacked traditional credit histories. The banks were expected to become creative, to consider other indicators of reliability.

Similarly, banks were expected by regulators to relax income requirements. Day labors and others often lack reportable income. Stated-income was a way of resolving the gap between actual income of borrowers and reported income. The problem, of course, comes when the con-artists and liars come into the game."

And lest you think this is just an attack on one political party, there is plenty of blame to go around. Note the following:

"George W. Bush was a major proponent of the kind of mortgages that banks had started making under the CRA. He urged low-to-no doc mortgages and the elimination of downpayments, just like the CRA regulators had long done. “We certainly don't want there to be a fine print preventing people from owning their home,” the President said in a 2002 speech. “We can change the print, and we've got to.”"

There is much more, but it is definitely an article that you should read. Even if you do not think you agree with all of his conclusions, it will serve all of us to see the often unintended consequences of relaxing standards.


Interestingly I have sort of gone through a similar metamorphosis. From September when people began saying this was a main cause to now I have come to realize the CRA did play more of a role than I thought. The fact that regulators evaluated banks on making these loans led to more of the loans. To me that has now become unarguable. Was it the only reason for the bubble? No, but it did play a large role. Or in Carney's words:

"Of course it wasn’t the CRA that caused everything. The CRA was a factor in lowering lending standards. This was a necessary, although not sufficient, cause for the mortgage mess"

(BTW the points he addresses are in many ways similar to those raised in academic circles that have led to grade inflation and high passing rates. But that could be a whole other topic for another day!)

Maybe the talk of run away inflation is just that, talk.

Martin Wolf responds to the fears that we are doomed by future inflation due to the large government expenditures and deficits.

His arguments are essentially that bond price drops are a reduction of the fear of DEFLATION and not necessarily a signal of high inflation. Additionally, to the degree that we see we are seeing is risk aversion levels drop (which is a another good thing!) and the safety premium that comes with Treasuries is reducing.

Evidence of this reduced premium can be seen looking at the VIX and in this this chart showing Treasuries vs corporates. Notice how the relative value of treasuries peaked during the worse of the uncertainty.


This flight to quality in bad times is normal and seeing it now ebb might well be a signal that the economy is returning to some semblance of normalcy and not a signal of higher inflation.

FT.com / Columnists / Martin Wolf - Rising government bond rates prove policy works:

"Is the US (and a number of other high-income countries) on the road to fiscal Armageddon? Are recent jumps in government bond rates proof that investors are worried about fiscal prospects? My answers to these questions are: No and No. This does not mean there is no reason for worry. It is rather that there are powerful arguments against fiscal retrenchment right now and strong reasons for welcoming recent moves in the bond markets."

And later

"What has happened is a sudden return to normality: after some turmoil, the yield on conventional US government bonds closed at 3.5 per cent last week, while the yield on Tips fell to 1.9 per cent. So expected inflation went to a level in keeping with Federal Reserve objectives, at close to 1.6 per cent"

and still later:

...the fear of inflation....is essentially the question of how to exit from current extreme policies. People need to believe that the extraordinarily aggressive monetary and fiscal policies of today will be reversed. If they do not believe this, there could well be a big upsurge in inflationary expectations long before the world economy has recovered....The exceptional policies used to deal with extreme circumstances are working....policymakers are walking a tightrope: on one side are premature withdrawal and a return to deep recession; on the other side are soaring inflationary expectations and stagflation. It is irresponsible to insist either on immediate tightening or on persistently loose policies"

Well said.

Thanks to RortyBomb at SeekingAlpha for pointing this article out

BTW does anyone know how to embed a Yahoo Finance graph, I can link to it, but not embed it. Any advice would be appreciated. :) thanks..

Swine flu fear catching fast in weak world economy - Yahoo! Finance

What will the economic impact of swine flu be? While it is WAY too early to say, it will have a negative impact. If the World Bank's study can be trusted, the impact may be less than I would have anticipated.

Swine flu fear catching fast in weak world economy - Yahoo! Finance:

"A report by the World Bank, updated last year, estimated that a severe pandemic -- like the Spanish flu outbreak in 1918 that killed between 40 million and 100 million people -- would cause a nearly 5 percent drop in global economic activity, costing the world about $3.1 trillion.

'Even a mild pandemic has significant consequences for global economic output,' a pair of Australian researchers wrote in a 2006 report cited by the World Bank."

That said, it is way too early to know and there are many variables we just do not know yet (how virulent will it be, how much it will spread, how fast it will spread).

THE FED: Big Banks Will Not Be Allowed To Fail, Bernanke Says

From CNN/Money: THE FED: Big Banks Will Not Be Allowed To Fail, Bernanke Says:

"Federal Reserve Board Chairman Ben Bernanke stressed Tuesday that major financial institutions would not be allowed to fail given the fragile state of financial markets and the global economy.

In a speech in Washington, Bernanke repeated that a sustainable economic recovery will 'remain out of reach' until the banking sector is stabilized....Bernanke said he hopes the view that the market can handle the failure of a systemically important firm is "no longer seriously maintained" given the power of the financial crisis in the wake of the collapse of Lehman Brothers and the government takeover of Fannie Mae and Freddie Mac last September. "It was the...collapse of banks and other institutions in late 1930 and early 1931 that made the Great Depression great...."

From the actual speech: FRB: Speech--Bernanke, Financial Reform to Address Systemic Risk--March 10, 2009:

"In a crisis, the authorities have strong incentives to prevent the failure of a large, highly interconnected financial firm, because of the risks such a failure would pose to the financial system and the broader economy. However, the belief of market participants that a particular firm is considered too big to fail has many undesirable effects. For instance, it reduces market discipline and encourages excessive risk-taking by the firm. It also provides an artificial incentive for firms to grow, in order to be perceived as too big to fail. And it creates an unlevel playing field with smaller firms, which may not be regarded as having implicit government support. Moreover, government rescues of too-big-to-fail firms can be costly to taxpayers, as we have seen recently. Indeed, in the present crisis, the too-big-to-fail issue has emerged as an enormous problem....

And later:

"In light of the importance of money market mutual funds--and, in particular, the crucial role they play in the commercial paper market, a key source of funding for many businesses--policymakers should consider how to increase the resiliency of those funds that are susceptible to runs. One approach would be to impose tighter restrictions on the instruments in which money market mutual funds can invest, potentially requiring shorter maturities and increased liquidity. A second approach would be to develop a limited system of insurance for money market mutual funds that seek to maintain a stable net asset value. For either of these approaches or others, it would be important to consider the implications not only for the money market mutual fund industry itself, but also for the distribution of liquidity and risk in the financial system as a whole.""

How the Crash Will Reshape America - The Atlantic (March 2009)

The current recession will have lasting impacts. That much is certain. No one knows for sure what that impact will be. We have seen what happens when all scenarios are not considered (remember "Real Estate prices can only go up"?), so the following by Richard Florida from the Atlantic is worth considering.

How the Crash Will Reshape America - The Atlantic (March 2009):

A bunch of look-ins, not in the same order as the article, but retaining the same message:

History teaches us:

"..most big economic shocks ultimately leave the economic landscape transformed..."

"Big international economic crises—the crash of 1873, the Great Depression—have a way of upending the geopolitical order, and hastening the fall of old powers and the rise of new ones."

Ouch, that hurts...

"“One thing seems probable to me,” said Peer Steinbrück, the German finance minister, in September 2008....“the United States will lose its status as the superpower of the global financial system.” You don’t have to strain too hard to see the financial crisis as the death knell for a debt-ridden, overconsuming, and underproducing American empire—"

NY City will be hurt, but it could be worse...

"All in all, most places in Asia and the Middle East are still not as inviting to foreign professionals as New York or London. Tokyo is a wonderful city, but Japan remains among the least open of the advanced economies, and admits fewer immigrants than any other member of the Organization for Economic Cooperation and Development, a group of 30 market-oriented democracies. Singapore remains for the time being a top-down, socially engineered society. Dubai placed 44th in a recent ranking of global financial centers, near Edinburgh, Bangkok, Lisbon, and Prague. New York’s openness to talent and its critical mass of it—in and outside of finance and banking—will ensure that it remains a global financial center....

The crash's impact on the financial sector:

"Thomas Philippon, a finance professor at New York University, reckons that nationally, the share of GDP coming from finance will probably be reduced from its recent peak of 8.3 percent to perhaps 7 percent..."

And domestically:

"It is possible that the United States will enter a period of accelerating relative decline in the coming years, though that’s hardly a foregone conclusion—a subject I’ll return to later. What’s more certain is that the recession, particularly if it turns out to be as long and deep as many now fear, will accelerate the rise and fall of specific places within the U.S.—and reverse the fortunes of other cities and regions."

How much of this will come true? Will any of this come true? Only time will tell.

At the Supermarket Checkout, Frugality Trumps Brand Loyalty - WSJ.com

While many of you outside of SBU know I run BonaResponds, not nearly as many know I help out with my family grocery stores as well. In class we have mentioned several times that one way sales will decline as a result of the recession (and hence worsening it as well) is that customers will switch from more expensive items to cheaper store brand products. This trend has been noticeable at our four stores and now the WSJ provides more evidence of the same thing.

At the Supermarket Checkout, Frugality Trumps Brand Loyalty - WSJ.com:

"Sales of private-label detergent rose 12% over the 52-weeks ended Sept. 6, to $189 million, according to market-data company Information Resources Inc., or IRI. Lower-priced brand-names are posting gains, too. Last week, Procter & Gamble Co. reported that volume sales of its bargain-priced Gain detergent rose 10% in the quarter ended Sept. 30, offsetting weaker results for the market-leading and pricier Tide.

Meanwhile, estimated retail sales of value-oriented Purex fabric softener, owned by Henkel AG, rose more than 60% over the past six months, the company says. 'We view the economic slowdown as an opportunity for our brand,' says Greg Tipso"

At least at our stores, this seems to be partially a mental story as much as anything else. I have never done it, but it would be fascinating to examine store brand vs name brand sales on a daily basis and see if it is tied to economic news and/or stock market performance.

SSRN-Do Behavioral Biases Adversely Affect the Macro-Economy? by George Korniotis, Alok Kumar

Talk about ambitious! Korniotis and Kumar apparently have found a link between behavioral finance and economic difference across different US States.

SSRN-Do Behavioral Biases Adversely Affect the Macro-Economy? by George Korniotis, Alok Kumar: "

This study investigates whether the adverse effects of investors' behavioral biases extend beyond the domain of financial markets to the broad macro-economy. Our results demonstrate that risk sharing (RS) levels are higher in U.S. states in which investors have higher cognitive abilities and exhibit weaker behavioral biases"

A few look-ins:

"examine whether the systematic effects of behavioral biases extend beyond the domain of financial markets to the aggregate macro economy. Specifically, we investigate whether behavioral frictions adversely affect the level of interstate risk sharing (i.e., state-level income smoothing) that can be achieved using financial markets. To our knowledge, this is the first paper that examines whether systematic behavioral biases can in‡fluence broader macro-economic indicators such as state-level risk sharing"

Looking at cognitive abilities:

"Because direct measures of cognitive abilities of stock market participants are not available, we use the demographic characteristics of the brokerage investors (e.g., income, education, age, social networks, etc.) to define a cognitive ability or “smartness” proxy for each investor and use these imputed cognitive ability measures to obtain aggregated state-level measures of cognitive abilities."

The findings? That behavioral finance does seem to impact economic measures.

"The average RS in states with less sophisticated investors (= 0.131) is less than half of the average RS in states with greater investor sophistication (= 0.324). Collectively, our evidence indicates that the aggregate behavioral biases of individual investors infl‡uence the level of risk sharing across the U.S. states."

Which partially explains the finding that state's risk sharing is quite different from state to state.

"For example, states such as Iowa, South Dakota and Kentucky achieve very low (less than 10%) levels of risk sharing using financial assets. In contrast, states such as Delaware, New Mexico and Oregon attain risk sharing levels of about 50%.""

Interesting! Which is at least consistent with the view that behavioral finance does influence the economy. Surely not the last word on this one.

Citation: Korniotis, George M. and Kumar, Alok,Do Behavioral Biases Adversely Affect the Macro-Economy? (August 12, 2008).
Available at SSRN: http://ssrn.com/abstract=1219304

Big or small? Which is better?

Do you live in an area where politicians fight to attract new large firms to the area? Or have you read that small firms have been the main job creators over the past few decades?

If you said yes to either, then you should read The Role of Small and Large Business in Economic Development by Kelly Edmiston of the KC Fed.

A few look-ins:

* " The attribution of the bulk of new job creation to small business arises largely from relatively large job loses at large firms, not to especially robust job creation at small firms....

* "...from the perspective of society at large, aggressive courting of large firms can distort rational behavior, causing a waste of economic resources....While welfare in the winning region may improve (but not necessarily), welfare for the larger community encompassing the region will suffer."

* "The overarching question is whether promoting entrepreneurship and small business makes sense in an economic development strategy. The article concludes it probably does but with some caveats...."

*"...on average, large businesses offer better jobs than small businesses in terms of both compensation and stability....little convincing evidence to suggest that small businesses have an edge over larger businesses in innovation.""

Interesting and thought provoking.

Read the entire thing: The Role of Small and Large Business in Economic Development

(BTW I reordered the look-ins slightly, but did not change meanings.)

National Bankrutpcy debate?

Want to start a debate? Bring up the idea of national bankruptcy.

For instance James Kazoun writes over at ArabicNew.com that
Iraq and Lebanon should declare bankruptcy:

"I am not aware of any such bankruptcy laws for countries, but there should be one as well. But in such absence, setting precedence should do it. Now that Iraq supposedly have a democratic government, this government should declare bankruptcy and clear its citizens from all financial commitments they had no say in. Not doing so, would be highly irresponsible.

Such acts are usually discouraged by saying that a country reneging on its debts would not be able to get future loans from lenders. That is not likely to be the case, but if that is the case, that would be very healthy for Iraq."

The US experience aside (see Alexander Hamilton's arguments), the idea of a national bankruptcy does appear to make much economic sense and it is nothing new (for instance back in an old FinanceProfessor.com Newsletter the following was reported:

" The IMF endorsed a national bankruptcy law that would allow nations who are unable to make their debt payments the ability temporarily suspend their payments while they negotiate with creditors. (If you think about it, a bankruptcy is little different from a “time-out” in basketball-designed to allow the team to regroup). Several countries, most notably the US, is still opposed to the plan.
http://news.bbc.co.uk/2/hi/business/2638741.st"

FRB: Speech, Ferguson--Thoughts on Financial Stability and Central Banking--April 17, 2006

Fed Vice Chairman Roger Fergusons' remarks this morning are perfect for a Money and Banking or Financial Institutions class!

FRB: Speech, Ferguson--Thoughts on Financial Stability and Central Banking--April 17, 2006:

Some Highlights:

* "Few subjects are more important for central bankers than the efficiency and stability of our financial system....Ironically, our interest in financial stability seem to have increased in recent years even as real (that is, inflation-adjusted) variability in economic aggregates seems to have decreased. Since 1985, the volatility of real growth in gross domestic product (GDP) has been only about half of what it was during the preceding twenty-five years. In addition, as shown in a number of papers, the volatility of many components of GDP and of other measures of aggregate economic activity also declined sharply between these periods.

* "The source of the moderation in the real economy is unclear....The leading explanations of the moderation are that (1) economic shocks have been milder; (2) inventory management has improved; (3) financial innovations such as improved risk assessment and risk-based pricing have made credit more widely available, even during economic downturns; and (4) monetary policy has been better."

* "The first explanation--milder economic shocks--has seemed less persuasive following the events of the late 1990s and early 2000s. From the Asian financial crisis to the September 11 attacks to the corporate governance scandals to the surge in oil prices, powerful economic shocks have marked the past few years."

* "As for the second explanation--better inventory management--changes in inventory dynamics have indeed contributed significantly to the reduced volatility of GDP growth...."

* "Regarding the third explanation--better availability of credit--Karen Dynan, Doug Elmendorf and Dan Sichel, of the Board's staff, present evidence in a recent paper that financial innovation has been partly responsible for the reduced variability of real activity"

* As for the "fourth explanation, that monetary policy has been better. I think it has indeed been better. We are better at understanding how the economy operates (and therefore, at evaluating the appropriate stance of monetary policy) and we are more determined to pursue the goal of price stability. But secondarily, I think the greater dominance of market-based finance, combined with a greater transparency by the Federal Reserve, has made both the mechanism of monetary policy and the intentions of the central bank more understandable to market participants....The greater transparency of central banks also seems to have led to improved economic performance. Market expectations are more likely to remain anchored in the face of various shocks when investors can see more clearly that central bankers are committed to long-run objectives such as price stability and sustainable economic growth. This commitment feeds into the planning and execution of investments by firms and households."

Well worth reading! Even if you are not in a Money and Banking course! ;)

Does sentiment matter?

Does sentiment matter? By Anchada Charoenrook

Super Short version: Yes!


Slightly longer version:

Sentiment, as measured by the University of Michigan Consumer Sentiment Index, does affect stock prices. Charoenrook finds that “changes in consumer sentiment reliably predict excess stock market returns at one-month and one year horizons.


Long version:

This paper tries to settle the debate that exists in finance as to whether sentiment plays a role in asset pricing. This is interesting question for, as the paper states, in a purely rational market, sentiment would play no role.

Alternatively, sentiment plays a role in many behavioral finance markets: “Delong, Shleifer, Summers, and Waldman (1990) propose a model of asset pricing based on the idea that irrational investors guided by sentiment misprice stocks, and the unpredictability of investor sentiment impounds resale risk on assets that they trade. In other behavior-based asset-pricing models, investor sentiment or belief distorted by psychological attributes drives stock prices away from their fundamental valuations.”

Past empirical evidence does not provide a clear answer as to whether sentiment matters or even how to most efficiently measure sentiment. For instance, “in the closed-end fund literature, some researchers argue that small investor sentiment can be measured by change in the discount on closed-end fund equity returns.” Consequently, many finance papers have used closed end fund discounts as a proxy for market sentiment.

This proxy has occasionally led to conflicting conclusions. “Lee, Shleifer, and Thaler (1991) report empirical evidence that the discount on closed-end fund return is a factor in the stock return-generating process.” While on the other hand “Elton, Gruber, and Busse (1998) find that the discount on closed-end fund return is not priced and hence is unimportant in the return-generating process.”
In this current paper, Charenrook around the improper proxy problem relating changes in the widely reported University of Michigan Consumer Sentiment Index to changes in stock market returns.

She finds “that change in the consumer sentiment index is negatively related to future value-weighted and equal-weighted excess aggregate stock market returns at one-month and one-year horizons.” That is if investors are happy (higher sentiment) the returns one month and one year out, tend to be lower.

This relationship “remains a strong and consistent predictor of returns after controlling for other established predictors. [Such as] dividend yield, the book-to-market ratio of the Dow Jones Industrial Average (DJIA), the slope of the term structure, the yield spread between Baa and Aaa bonds, the short rate yield, lagged excess market returns, and the consumption-wealth ratio.”

The author disputes suggestions that such a relationship is due to ties to the business cycle: “Empirical test results…show that the predictability of change in consumer sentiment is unrelated to economic cycles measured by real gross domestic product growth or consumption growth. Moreover, change in consumer sentiment has incremental predictive power for aggregate stock return after controlling for lagged consumption-wealth ratio, which is a strong predictor of business cycles (Lettau and Ludvigson, 2001).”

It is important to note that this relationship is not just statistically significant but economically significant as well: “in the one-year returns sample, a one-standard deviation improvement in consumer sentiment predicts a 6 percentage points a year lower excess return relative to the unconditional mean. Moreover, change in consumer sentiment index performs better than the benchmark ARI model in out-of-sample forecasting.”

In conclusion the author identifies the paper’s main contributions: “First it uses a direct survey of sentiment instead of proxies such as closed-end fund discounts….Second, this study contributes to the debate on whether sentiment can cause systematic mispricing in the aggregate stock market….The results suggest that it is premature to reject a behavioral explanation.”

Very interesting and well done.

BTW the discussion of how the Sentiment Index is calculated in well worth your time!


http://207.36.165.114/NewOrleans/Papers/3301937.pdf