Delong: From Central Bank to Central Planning?.

Brad Delong argues that "we still have not had enough central planning in finance." More particularly, he argues that the "Fed and the Treasury are walking down a road that ends with making the price of risk in financial markets, along with the price of liquidity, an administered price":

From central bank to central planning?, J. Bradford DeLong, Project Syndicate: For more than 170 years, it has been accepted doctrine that markets are not to be trusted when there is a liquidity squeeze. When the prices of even safe assets fall and interest rates climb to sky-high levels because traders and financiers collectively want more liquid assets than currently exist, it is simply not safe to let the market sort things out.

At such a time, central banks must step in and set the price of liquidity at a reasonable level – make it a centrally-planned and administered price – rather than let it swing free in response to private-sector supply and demand. This is the doctrine of "lender-of-last-resort."

For more than half that time – say, 85 years – it has been accepted doctrine that markets are also not to be trusted even in normal times, lest doing so lead to a liquidity squeeze or to an inflationary bubble. So, central banks must set the price of liquidity in the market day in and day out. ...

[A]s social democracy, government guideposts, and centralized planning waxed and waned elsewhere in the economy, social democracy in short-term finance went from strength to strength. First, central banks suspended the rules of the free market in liquidity squeezes. Then they set the price of liquidity as an administered price in normal times. Then they freed themselves of all but the lightest contact with their political masters: they became independent technocrats, a monetary priesthood that spoke in Delphic terms obscure to mere mortals.

The justification for this system was that it seemed to work well – or at least less badly than central banking that blindly adhered to the gold standard or no central banking at all. ...

But now it appears that, despite all this, we still have not had enough central planning in finance. For, even as the central banking authority administered the price of liquidity, the price of risk was left to the tender mercies of the market. And it is the price of risk that is the source of our current distress. ...

[T]he risk premia on non-Treasury assets have soared... And it is this rise in risk premia that threatens to send the global economy into a deep recession, and turn the financial markets from a spectacle of schadenfreude into a malign source of unemployment and idle factories worldwide. ...

The Treasury has asked for authority to purchase $700 billion of mortgages to get them off of the private sector’s books. Expanding the demand and reducing the supply of these risky assets is a way of manipulating their price. The Fed and the Treasury are walking down a road that ends with making the price of risk in financial markets, along with the price of liquidity, an administered price.

This was how central banking got started in the first place: letting the market and the market alone determine the price of liquidity was judged too costly for the businessmen who voted and the workers who could overthrow governments. Now it looks as though letting the market alone determine the price of risk is similarly being judged too costly for today’s voters and campaign contributors to bear.

Fed Watch: Rate Cuts Increasingly Likely.

Tim Duy says "the Federal Reserve is inching closer to lower interest rates":

Rate Cuts Increasingly Likely, by Tim Duy: This week’s data flow only confirms what was apparent last week – the US economy deteriorated as we headed into the third quarter. By now, there should be no doubt that the US consumer is devoid of resources to further propel spending. And without an active consumer, the US economy will undoubtedly stagnate, especially since the rest of the world appears equally reliant on the US consumer. Such persistent weakness would traditionally prompt additional rate cuts on the part of the Federal Reserve, but I suspect interest rate policy has largely lost effectiveness. Starting with the mortgage meltdown that began last year, credit channels have become increasingly impaired despite aggressive rate cuts. The credit explosion of this decade has proven unsustainable; you cannot borrow your way to prosperity. The US economy is undergoing a structural adjustment that the Fed can only cushion, not stop.

Monday brought the personal income and expenditure report for August, which indicated that consumption expenditures will be negative in Q3 for the first time since 1991, a point pounced upon by commentators (here and here). Interestingly, private wage and salary growth continued to defy gravity:

Over the last year, however, inflation has destroyed any nominal wage gains. Lacking sufficient savings to compensate for inflation, and cut off from the housing ATM, consumers are reduced to living within their real incomes for the first time in years. It hurts. Federal stimulus masked the damage during the second quarter, but the affect was only temporary – indeed, the economy deteriorated at a startling pace as soon as the checks stopped coming.

The ISM manufacturing surveyhighlighted the extent of the deterioration, with a plunge in the headline number from 49.9 to a recessionary level of 43.5 amid a stunning drop in new orders. With the exception of rapidly diminishing price pressure as commodity prices faltered, there is no positive spin one can place on this report. Indeed, this is the type of report that traditionally triggered rate cuts; the lack of such weakness has been an anomaly in the current policy cycle. Manufacturing weakness is aggravated to no small extent bythe collapse in auto sales. Again, a stunning decline, but not entirely unexpected given the strains on household budgets. As long as your existing car still runs, a new car is one of the easiest items to forego.

If you are counting on a housing rebound to cure the nation’s economic ills, you were once again disappointed with theCase-Shiller report. The decline in housing prices continues seemingly unabated. I am amazed by the number of commentators who believe that fixing the nation’s economy is as simple as restoring confidence in the housing market. I very much dislike the argument that confidence is the problem. It makes me feel like I am in Oz, and that all that we need to do is collectively click our heels together, saying “I want to go home,” and suddenly it will be 2004 and we can expect our homes will appreciate 15% a year risk free. A more likely reality: Housing prices will contract until those prices are consistent with traditional underwriting conditions and incomes. HereI agree with Barry Ritholtz – policy should not be focused on trying to raise asset prices, but instead to cushion the blow from the reversion of those asset prices to the values determined by social conventions, which, in this case, is ability to repay the mortgage.

In the wake of this week’s no vote on the bailout package, the Federal Reserve is inching closer to lower interest rates, although such a move is more likely to occur at the October or December meeting rather than in the intermeeting period. I doubt the Fed ever expected to cut rates further; they were hoping for a rapid passage of a bailout package to bring quick relief to credit markets. No such luck; each day that passes more damage is done. Atlanta Fed President Dennis Lockhartsummed up the situation with a rather dour assessment:

Overall, the outlook for inflation may have improved, but prospects for growth have weakened. Importantly, I believe problems in our financial system add significant risk to the downside for the economy.

He did note that he was assuming the bailout plan was dead, although such predictions appear to be premature given tonight’s Senate vote. But the recent market upheavals have already done significant damage regardless of the bailout; comprehensive action is mostly about containing the damage at this point. And note that the August data that started trickling in the end of last week was largely pre-most recent crisis. Adding to Lockhart, arch-hawk Philadelphia Fed President Charles Plosser shifted his position notably and opened the door to a rate cut. FromMarketWatch:

A Federal Reserve official who twice voted against interest-rate cuts earlier this year said he'd be open to supporting further decreases in the Fed's federal funds rate target if required. In an exclusive interview with Market News International, Philadelphia Fed President Charles Plosser said he believes the economy is "more resilient" than many believe in the face of the worst post-war financial crisis, adding that people need to "take a step back and take a deep breath." But he did indicate that if credit conditions worsen to the point that the economy is imperiled, he'd vote to cut rates.

That’s right – a collective deep breath and our confidence will return. And the bad assets will suddenly disappear. And we all wake up in the morning back in Kansas.

Bottom Line: If Plosser is willing to consider rate cuts, it is a fair bet most of the FOMC is already there. Still, a cut at this juncture may just be doing something to do something. If the Fed sits tight through the rest of this year, they simply have come to the conclusion that rate cuts are ineffective at this point. Does anyone really believe that another 50bp will have anything more than a marginal impact? As long as the credit markets are impaired, rate cuts are almost a sideshow. Without a mechanism to channel large amounts of dollars to consumers, or some other sector of the economy, the Fed can drop rates to zero with little impact. The price of money only matters if you can get some, and getting some is hard to do when the financial sector is deleveraging in an attempt to save itself.

Stiglitz: Bailout Blues.

Joseph Stiglitz hopes we can tread water until a new administration takes over:

Bailout Blues, by Joseph E. Stiglitz, Project Syndicate: It doesn’t take a genius to figure out that the United States’ financial system – indeed, global finance – is in a mess. ...

As global markets plummet, ... Congress ... may rescue Wall Street, but what about the economy? What about taxpayers, already beleaguered by unprecedented deficits, and with bills still to pay for decaying infrastructure and two wars? In such circumstances, can any bailout plan work? ...

[T]he rescue plan that was just defeated ... remained critically flawed. First, it relied – once again – on trickle-down economics: somehow, throwing enough money at Wall Street would trickle down to Main Street, helping ordinary workers and homeowners. Trickle-down economics almost never works...

Moreover, the plan assumed that the fundamental problem was one of confidence. That is no doubt part of the problem; but the underlying problem is that financial markets made some very bad loans.

There was a housing bubble... That bubble has burst. House prices probably will fall further, so there will be more foreclosures.. The bad loans ... have created massive holes in banks’ balance sheets, which have to be repaired. Any government bailout that pays fair value for these assets will do nothing to repair that hole. ...

We could do more with less money. ... The Scandinavian countries showed the way two decades ago. .... By issuing preferred shares with warrants (options), one reduces the public’s downside risk and ensures that they participate in some of the upside potential.

This approach is not only proven, but it also provides both the incentives and wherewithal needed for lending to resume. ...

At the same time, several steps can be taken to reduce foreclosures. First, housing can be made more affordable for poor and middle-income Americans by converting the mortgage deduction into a cashable tax credit. ... Second, bankruptcy reform is needed to allow homeowners to write down the value of their homes and stay in their houses. Third, government could assume part of a mortgage, taking advantage of its lower borrowing costs. ...

There is a growing consensus among economists that any bailout based on Paulson’s plan won’t work. ...

But it is impossible for politicians to do nothing in such a crisis. So we may have to pray that an agreement crafted with the toxic mix of special interests, misguided economics, and right-wing ideologies that produced the crisis can somehow produce a rescue plan that works – or whose failure doesn’t do too much damage.

Getting things right – including a new regulatory system that reduces the likelihood that such a crisis will recur – is one of the many tasks to be left to the next administration.

Rogoff: Significant Reasons to Doubt Wisdom of Bail-Out.

Kenneth Rogoff thinks that the bailout plan "might end up doing more for profits and bonuses in the financial sector than for the rest of the economy":

Significant reasons to doubt wisdom of bail-out, by Kenneth Rogoff, Project Syndicate: With minds concentrated by fears of another 1930s-style Great Depression, America’s politicians have adopted, virtually overnight, a $700bn bail-out plan...

The final deal is an elaborate piece of financial and political engineering whose ultimate effect is almost impossible to predict. There are good reasons, however, to be skeptical...

The plan’s central conceit is that government ingenuity can disentangle the trillion-dollar “subprime” mortgage loan market, even though Wall Street’s own rocket scientists have utterly failed to do so. To boot, we are told that the government is so clever it might even make money... Perhaps, but ... a lot of very smart people in the financial industry thought the same thing until quite recently. ...

This brings us back to the US treasury’s plan to spend hundreds of billions of dollars to unclog the subprime mortgage market. The idea is that the US government will serve as buyer of last resort for the junk debt that the private sector has not been able to price. Who, exactly, does the treasury plan to employ to figure all this out? Why, unemployed investment bankers, of course! ...

Little wonder that academics across the political spectrum have expressed considerable skepticism. True, the treasury will take equity stakes in some firms, so there is some upside potential. But the main concern centers on the treasury’s apparent intention to pay more than double the current market price (20c-30c on the dollar) on the premise that the treasury’s success in untangling the mortgage market will make any discount seem like a bargain.

Does such nitpicking fail to recognize the urgency of fixing the financial system? Isn’t any plan better than none? I, for one, am not convinced. Efficient financial systems are supposed to promote growth in the real economy, not impose a huge tax burden. And the US financial sector, in greasing the wheels of the real economy, has been soaking up an astounding 30% of corporate profits and 10% of wages. ... Isn’t it possible, then, that rather than causing a Great Depression, significant shrinkage of the financial sector, particularly if facilitated by an improved regulatory structure, might actually enhance efficiency and growth?

I am not suggesting that the government should sit on its hands. It needs to provide an expanded form of deposit insurance... That was a big lesson of the 1930s. The government may also need to consider injecting funds more directly into the mortgage sector while the private sector reconstitutes itself. Certainly, the government must also find better ways to help home owners and their lenders work out efficient bankruptcy proceedings. ...

Eventually, ... the US will emerge from its epic financial crisis. But there is a significant risk that this latest step, however grand, might end up doing more for profits and bonuses in the financial sector than for the rest of the economy.

Financial Intermediation and the Financial Crisis.

This discusses the difference between direct and indirect finance, and how indirect finance through financial intermediaries increases economic efficiency. The relationship between financial intermediation and the crisis is also noted.

In particular, I use a simple numerical example to talk about pooling and diversifying risk, pooling over time (i.e. borrowing short and lending long), and pooling small deposits to make large loans, and then relate the risk pooling and time pooling functions to the insolvency and illiquidity issues we are seeing in financial markets. I also briefly note two other functions of intermediaries, reducing transactions costs and reducing default risk, and note the failure of intermediaries to effectively assess default risk is a factor in the crisis.

It's fairly classroom like and somewhat elementary, but I hope it's useful to some of you. My main goal was to show how intermediaries pool and diversify risk (and how that makes the economy more efficient), how the mispricing of risk led to insolvency and liquidity issues, and how this disrupted the time pooling function making things far worse.

I also give an example (taken from here) at the very end of how mortgages can be sliced and diced into different risk categories.

"The Fires are Becoming More Frequent and More Serious".

Michael Spence:

The Bailout: Yea or Nay, Michael Spence: We are dealing with risk and risk reduction. No one would reasonably argue that a credit lockup of extended duration will definitely occur absent the bill. The Treasury and the Federal Reserve have been, in the view of many including me, an extraordinarily effective fire department. But the fires are becoming more frequent and more serious. The risk of a credit lockup with a huge amount of collateral damage has risen.

The bill if passed and implemented skillfully will reduce the risk substantially, but not eliminate it. The risk reduction will occur in part when the bill passes because of the intention to act and more substantially over time as the treasury and its appointed agents buy damaged, hard to value mortgage related assets injecting capital into the system. They will also be able to reset the mortgage terms, helping homeowners and avoiding an inefficient foreclosure process in some cases. Experts like Warren Buffet and Bill Gross have stated that they believe that with skillful implementation, the program could not only have the desired effect but produce a decent return on investment. This is hard for Congress and the Presidential Candidates. People are understandably angry and confused. The leadership from the Administration and the Congress and the Federal Reserve, in these very risky conditions has in my judgment been exemplary.

After Lehman, the phrase "extraordinary effective fire department" as it relates to the Treasury doesn't quit ring true. Nor does the last sentence. Exemplary? But I hope he's right about the substantial reduction in risk if the bailout plan is implemented.

"What's Wrong with Economic Theory as Presented to the Public?".

Robert Waldmann:

What's Wrong with Economic Theory as Presented to the Public?, by Robert Waldmann: I have a very low opinion of economic theory. I think that its survival is the result of a bait and switch where the core principles (roughtly Nash equilibrium) can't be proven false, because they have no implications, and, given the fact that they have not been proven false, economists attempt to convince people of the joint implications of the core principles and further assumptions which are known to be false. Fortunately, very few people pay much attention to economic theory.

To continue the diatribe, the implications of economic theory as presented by right wing economists are the implications of models which are about 50 years old now. They depend on assumptions which no one claims are approximately valid. In particular, the traditional application to finance of economic theory, that is general equilibrium theory, (generically) gives the standard results only if markets are complete -- that is there is a contingent claim for every conceivable contingency (including say this pays 1 unit of numeraire good if it is snowing on Mars or if Robert Waldmann stubs his toe between 6:55 EST of October 3 2008 and 7 EST).

With incomplete markets, the market outcome is generically (that is except for a set of economies with measure zero) constrained Pareto inefficient (that means that there are legal restrictions on peoples positions in financial markets which make everyone better off).

Also, there is no claim based on economic theory that financial market prices reflect fundamentals. A large set of general equilibrium economies *with complete markets* have multiple equilibria. Which equilibrium occurs is not determined by fundamentals (tastes and technology). With incomplete markets payoff irrelevant signals (sunspots) can affect prices in general (I think generically).

The conclusions of economic theory as presented by many or perhaps most economists do not follow from current economic theory, but rather from the 50 year old efforts at mathematical economic theory.

Thus the New York Times Op-ed page is not to be blamed for publishingan op-ed full of false claims about economic theory written by Mark Buchanan a physicist. I won't excerpt, read it if you want.

Bachman has no idea what he is talking about.

First he has no idea of what economists mean when we say "equilibrium". He just assumes that we mean stable steady state (which is what we used to mean 50 years ago). Now we mean Nash equilibrium or Walrasian General equilibrium which is nothing of the kind. He should check on recent developments in general equilbrium theory in the past 30 years. He will find the word "sunspot". He will find that general equilbrium theorists argue that there are "equilibria" in which market prices jump around ... based on irrelevant news that has nothing to do with tastes or technology... That is, the view of general equilibrium theorists is the exact opposite of the view Buchanan attributes to them.
 
He will also note that general equilibrium theorists conclude that market equilbria are generically not constrained Pareto efficient -- the theorists who showed that are Herakles Polimarchakas and John Geanokoplos (hey where did I just read that name ?).
 
Finally the bit about how economists don't use computer simulations is, if possible, even more wrong than the rest of the op-ed. It is like saying economists refuse to use mathematics or have no use for the theory of statistics.
 
I'd say that Buchanan demonstrates complete ignorance about what economic theorists have been doing in the ... past 30 to 50 years. ...

The problem is, I think, that when they talk to non economists, many economists pretend that traditional economic theory is a good approximation to reality. By "traditional" I mean 50 year old. The fact that the conclusions are the result of strong assumptions made for tractability and are known to not hold without these assumptions is irrelevant. In the case of financial market equilibrium, the assumptions are not just the core assumptions of rationality and old assumptions of perfect competition but the totally crazy assumption of complete markets....

Buchanan should have talked more to Geanakoplos before shooting his keyboard off. The Times should have checked claims about current economic theory with an economist before printing them, but I think the worse problem is that economists who are also libertarian ideologues are lying about the current state of economic theory, not only its very weak scientific standing, but the fact that, even if it were all absolutely true, their policy recommendations do not at all follow from current economic theory.

Paul Krugman: Edge of the Abyss.

Can we buy enough time to implement a real solution to the financial crisis?:

Edge of the Abyss, by Paul Krugman, Commentary, NY Times: As recently asthree weeks ago it was still possible to argue that the state of the U.S. economy, while clearly not good, wasn't disastrous... But that was then.

The financial and economic news since the middle of last month has been really, really bad. And what's truly scary is that we're entering a period of severe crisis with weak, confused leadership. ...

There's growing evidence that the financial crunch is spreading to Main Street, with small businesses having trouble raising money and seeing their credit lines cut. And leadingindicators for both employment and industrial production have turned sharplyworse, suggesting that ... the economy, which has been sagging since last year, was falling off a cliff.

How bad is it? Normally sober people ... say that the economy seems to be on “the edge of the abyss.” And the people who should be steering us away from that abyss are out to lunch.

The House will probably vote on Friday on the latest version of the $700 billion bailout plan..., ... now ... the Paulson-Dodd-Frank-Pork plan (it's been larded up since the House rejected it...). I hope that it passes, simply because ... another no vote would make the [financial] panic even worse. But that's just another way of saying that the economy is now hostage to the Treasury Department's blunders.

For the fact is that the plan ... is a stinker - and inexcusably so. The financial system has been under severe stress for more than a year, and there should have been carefully thought-out contingency plans ready ... Obviously, there weren't: the Paulson plan was clearly drawn up in haste and confusion. And Treasury officials have yet to offer any clear explanation of how the plan is supposed to work, probably because they themselves have no idea what they're doing.

Despite this, as I said, I hope the plan passes, because otherwise we'll probably see even worse panic... But at best, the plan will buy some timeto seek a real solution...

And that raises the question: Do we have that time?

A solution ... will ... almost surely involve the U.S. government taking partial, temporary ownership of [the financial] system, the way Sweden'sgovernment did in the early 1990s. Yet it's hard to imagine the Bush administrationtaking that step.

We also desperately need an economic stimulus plan to push back againstthe slump in spending and employment. And this time it had better be a seriousplan that doesn't rely on the magic of tax cuts, but instead spends money whereit's needed. (Aid to cash-strapped state and local governments, which areslashing spending at precisely the worst moment, is also a priority.) Yet it's hardto imagine the Bush administration, in its final months, overseeing thecreation of a new Works Progress Administration.

So we probably have to wait for the next administration, which should bemuch more inclined to do the right thing - although even that's by no means asure thing, given the uncertainty of the election outcome. (I'm not a fan of Mr. Paulson's, but I'd rather have him at the Treasury than, say, Phil "nationof whiners" Gramm.)

And ... it will be almost fourmonths until the next administration takes office. A lot can - and probably will -go wrong in those four months.

One thing's for sure: The next administration's economic team had betterbe ready to hit the ground running, because from day one it will find itself dealing with the worst financial and economic crisis since the GreatDepression.

"We are Going over the Edge".

After this news:

A grim morning: Double plus ungood news on multiple fronts this morning. The credit crunch is getting worse: LIBORjumped again, theTED spread is at a new record. Bad news onemployment: payrolls down 159,000, average work week down, official unemployment rate flat at 6.1 percent but broad measure (U6) up from 10.7 to 11.

We are going over the edge.

The track record: This chart shows U6, the broadest measure of unemployment and underemployment from the Bureau of Labor Statistics. (No data available before 1994.) ...

Feel the boom

I was glad to see this:

House Approves Bailout on Second Try

FRBSF: Oil Prices and Inflation.

Do changes in oil prices impact core inflation? That is, do changes in oil prices - which are excluded from core measures - pass through over time and raise prices generally? According to this, the answer is no, at least in the U.S.:

Oil Prices and Inflation, by Michele Cavallo, FRBSF Economic Letter: As oil prices have climbed over the last several years, the memory of the 1970s and early 1980s has not been far from the minds of the public or of monetary policymakers. In those earlier episodes, rising oil prices were accompanied by double-digit overall inflation in the U.S. and in several other developed economies. Indeed, central bankers say they are determined not to let this experience recur, emphasizing that they intend to maintain their credibility with the public in securing low inflation and achieving stable and well-anchored inflation expectations. In pursuing these goals, a key measure policymakers often focus on is core inflation; this may seem surprising, since core inflation excludes energy prices, among other things. However, one justification for looking at a measure that excludes energy prices is that they are typically quite volatile; for example, after rising steadily and hitting a record of about $145 per barrel in July, oil prices then fell to under $100 per barrel in September. Temporary oil price increases do not tend to pass through to the prices of non-energy goods and services when the central bank is credible—that is, when inflation expectations are well-anchored—and, therefore, will not result in persistently higher overall inflation.

This Economic Letter examines the impact of rising oil prices on core inflation over the last decade for four economies: the U.S., the euro area, Canada, and the U.K. I find some evidence that rising oil prices have had a positive and significant effect on core inflation in the euro area, but I find no systematic evidence that rising oil prices have had a significant impact on core inflation in the U.S., Canada, or in the U.K.

How do rising oil prices affect the inflation rate?

Rising oil prices tend to affect the overall consumer price index (CPI) directly by raising its energy cost component, which includes the prices of energy-related items, such as household fuels, motor fuels, gas, and electricity. Among these, gasoline and fuel oil are directly derived from crude oil, so their prices follow oil prices very closely. An increase in the price of oil may also affect energy costs through the prices of other items that are close substitutes; for example, households and businesses may switch from oil-related energy items to natural gas, thus leading to an increase in its price. The extent to which rising oil prices translate into higher overall inflation through higher energy costs depends on their persistence. If they continue to rise, they may lead to sustained increases in the overall price level, that is, to an increase in the overall inflation rate.

Rising oil prices tend also to affect the core portion of the CPI indirectly, because energy prices represent a considerable portion of the production cost for many of the items in it, such as transportation services. In addition, if workers have to pay higher energy prices themselves, they may bargain for compensating wage increases, which also increases the production costs of items in the core CPI. The extent to which rising oil prices translate into higher core inflation through higher production costs depends, among other things, on how much they break into the overall inflation expectations of those who set prices and wages. In fact, if rising oil prices lead to higher inflation expectations over the longer term, rising energy and wage costs are more likely to be passed through in terms of rising consumer prices. In this case, rising oil prices may lead to sustained increases in the core portion of the CPI, that is, to an increase in core inflation.

However, once oil prices stabilize, as they have in recent months, the corresponding inflationary pressures will dissipate. As a result, both overall and core measures of inflation may decline, with the overall inflation rate likely to fall towards the lower rate of core inflation.

Why focus on core inflation?

In their efforts to secure a low and stable inflation environment, and therefore limit the impact of inflationary pressures emanating from rising oil prices, monetary policymakers pay close attention to core inflation for several reasons. One is that the exclusion of the volatile food and energy components makes it a more reliable indicator of the underlying trend in inflation. Fluctuations in the prices of food and energy may reflect exogenous shocks, that is, developments that are not inherent to the dynamics of the economy—for example, a drought may decrease the supply of grains, or a political conflict in an oil-producing country may decrease the supply of energy. Such developments often turn out to be only temporary and, therefore, are not typically reflected in the underlying trend in inflation, which represents the persistent component of inflation. In fact, over extended periods, the quantitative contribution of temporary fluctuations to the persistent component of inflation tends to disappear.

Because core inflation reflects more closely the persistent component of inflation, it also is a reasonably good predictor of future overall inflation. Blinder and Reis (2005) provided formal evidence of this property for the U.S. Specifically, using monthly data from 1987 to 2005, they found that core inflation predicts future overall inflation better than overall inflation itself. This property is particularly important for the management of monetary policy and for the timing of monetary policy actions. Typically, there is a delay between monetary policy actions and their effects on the economy; in addition, these effects normally show a certain degree of persistence. Therefore, when policymakers look at core inflation, they find a reliable and transparent indicator that helps them understand what the path of inflation is likely to be when their actions start taking effect.

The Federal Open Market Committee, which includes both core and overall inflation in its quarterly forecasts, is not the only policymaking body to pay attention to core inflation, even among banks that may use overall inflation as their main measure. For example, the Bank of Canada openly uses core inflation as its operational monetary policy target, even though CPI inflation is its explicit monetary policy target.

A further reason for policymakers to focus on core inflation is that it helps focus the public's attention on this measure as an indicator of what future overall inflation is likely to be. In this sense, those who set prices and wages can find core inflation to be a useful benchmark for their inflation expectations. For policymakers, therefore, focusing on core inflation may help influence long-run inflation expectations.

In light of these considerations, examining the impact of rising oil prices on core inflation helps understand how much, if at all, they have become embodied both in the underlying trend in inflation and in long-run inflation expectations, and, therefore, to what extent that may lead to persistently higher inflation.

Assessing the effects of oil price increases on inflation

One way to examine the impact of rising oil prices on core inflation is to estimate a Phillips curve model. According to this widely used statistical relationship, current inflation depends on lagged inflation, on the lagged unemployment gap, and on a lagged measure of output supply shocks. Lagged inflation captures the degree of inflation persistence. The unemployment gap, defined as the deviation of the unemployment rate from its baseline value, measures inflationary pressures emanating from the labor market. The measure of output supply shocks captures inflationary pressures emanating from factors, such as oil price increases. Hooker (2002) estimated such a model for the U.S. with core inflation as the dependent variable using data from 1962 to 2000 and found that, while oil price increases had a substantial impact on core inflation until 1981, they had little impact thereafter.

To examine the impact of recent oil price increases on core inflation for the U.S., the euro area, Canada, and the U.K., I use two simple variants of the Phillips curve model specified by Hooker. Core inflation, the dependent variable, is defined as the percent change in core CPI over the past 12 months. Two explanatory variables are lags of core inflation and of the unemployment gap. Because some of these data series for the four economies are available only from the second half of the 1990s, the estimation sample is shorter than Hooker's and covers the period from January 1997 through May 2008. (The documentation for the estimations reported here is available upon request.)

The first variant includes as an explanatory variable lagged local-currency oil-price inflation, which is measured by the change in the local-currency price of West Texas intermediate (WTI) crude oil—this captures inflationary pressures arising from oil price increases. For the U.S, this variable is simply the change in the price of oil, given that the price of oil is denominated in dollars in global oil markets; for the other three economies, it is the difference between changes in the dollar price of oil and in the exchange rate of the local currency relative to the dollar. One implication of this is that exchange rate changes affect inflationary pressures arising from oil price increases. For example, with the euro, the Canadian dollar, and the British pound all appreciating relative to the dollar over much of the last few months, the increases in the corresponding exchange rates have dampened the increases in the local-currency prices of oil originating from the rise in the dollar price of oil. The second variant includes the lag of noncore inflation, which is computed as the difference between changes in overall CPI and core CPI. This variable represents an alternative measure of inflationary pressures emanating from both food and energy prices.

I find that for the U.S., Canada, and the U.K., both local-currency oil-price inflation and noncore inflation have had a small and statistically insignificant effect on core inflation. In contrast, for the euro area, noncore inflation has had a positive and statistically significant effect on core inflation. Specifically, the estimated coefficient relative to the lag of noncore inflation implies that a 10% increase in noncore inflation has led to an increase in core inflation a year later of a little more than 1%.

Why have recent oil price increases, as measured by noncore inflation, had a significant impact on core inflation in the euro area and not in the other three economies? One potential explanation may have to do with the lower degree of competition in European labor and consumer-goods markets. For example, workers' unions represent a larger share of the labor force in the euro area, so they typically command more influence in bargaining wages with employers. As a result, in response to higher energy prices, workers are more likely to obtain larger wage increases, inducing, in turn, higher costs for businesses. As for consumer-goods markets, businesses in the euro area face a lower degree of competition, so they enjoy stronger price-setting power. Therefore, they may have fewer hesitations to pass on increases in production costs to consumer prices, leading to a more significant impact on core inflation.

Conclusions

This Economic Letter has examined the impact of oil price increases on core inflation for four economies during recent years. The estimation results lend support to the view that rising oil prices have had some impact on core inflation in the euro area, while having a limited impact on core inflation in the U.S., Canada, and in the U.K. While these results are not conclusive, they do lend some support to the notion that the strong emphasis that monetary policymakers in these economies have placed on maintaining their inflation-fighting credibility has been working. Specifically, in the face of the recent oil price increases, these results suggest that their efforts have been quite successful in anchoring long-run inflation expectations and securing a low-inflation environment.

References

[URL accessed September 2008.]

Blinder, Alan S., and Ricardo Reis. 2005. "Understanding the Greenspan Standard." In The Greenspan Era: Lessons for the Future. A Symposium sponsored by the Federal Reserve Bank of Kansas City, pp. 11-96. http://www.kc.frb.org/PUBLICAT/SYMPOS/2005/PDF/Blinder-Reis2005.pdf

Hooker, Mark A. 2002. "Are Oil Shocks Inflationary? Asymmetric and Nonlinear Specifications versus Changes in Regime." Journal of Money, Credit and Banking 34 (May), pp. 540-561.

Hal Varian on Short Selling.

This is from March 10, 2005:

Five Years After Nasdaq Hit Its Peak, Some Lessons Learned, by Hal Varian, NY Times: On  March 10, 2000, five years ago today, the Nasdaq composite index hit its high, 5,132.52, at the peak of the dot-com bubble. It is fitting to commemorate this anniversary with a column about what financial economists have learned from this episode.

Perhaps the most fundamental question one can ask about the bubble is how it could have happened in the first place. How could stock prices be pushed up to such irrational and unsustainable levels?

Few economists would deny that fools and gamblers participate in the stock market. But the participation of such irrational traders does not necessarily imply that stock prices themselves should be irrational.

In principle, irrational exuberance should be self-correcting. If overly optimistic investors bid up the price of a stock, rational investors should step in and sell shares, moving the price back down to a realistic level.

This adjustment process does not even require that sellers own shares of the overpriced stock. Someone who thinks that the price of a stock will fall but does not own any shares can borrow shares to sell, a practice known as selling short.

If an investor sells short and the stock price does indeed fall, he can buy shares to pay back the loan and pocket the difference as profit. As with other sorts of borrowing, the borrower typically has to pay interest on the loan.

But, in the case of the Internet boom, short selling was apparently not strong enough to damp the stock price increases during the Internet bubble. The question is, Why not?

Owen A. Lamont, a professor of finance at the Yale School of Management, reviews some recent work in the economics of short selling in the latest issue of the NBER Reporter (available at www.nber.org).

As he points out, there were striking examples of apparent overpricing of stocks in 2000. For example, in March of that year, 3Com sold a fraction of its holding of Palm; it announced that by the end of the year it would disburse the rest of its holdings by giving 3Com shareholders 1.5 shares of Palm for each share of 3Com they owned.

One would expect that 3Com shares would be worth at least 1.5 times the value of Palm shares. But on the first day of trading after the announcement, Palm shares were worth $95.06 a share while 3Com shares fell to $81.81. The market was valuing the non-Palm part of 3Com's business at minus $63.

This pricing anomaly was widely reported in the financial press. The most likely explanation was that day traders and other overly optimistic investors bid up the price of Palm stock to excessive levels. These traders were presumably unaware that they could acquire Palm indirectly by buying 3Com stock.

The apparent mispricing created a low-risk arbitrage opportunity. A savvy investor could buy some 3Com shares outright, borrow some Palm shares, sell them, and repay the borrowed Palm stock in a few months when 3Com issued the Palm shares.

Indeed, many investors did exactly that. At one point, the number of Palm shares borrowed to sell short was 147 percent of the shares outstanding. (The number could exceed 100 percent since shares could be borrowed only to be lent out again.)

Even this additional supply of shares was not enough to quell the Palm enthusiasts. According to Professor Lamont and his co-author on one paper, Richard H. Thaler, a big part of the problem is that the market for borrowing shares is not a centralized market with quoted prices, but rather a highly disaggregated market.

In many cases, it was quite difficult to find shares of Palm that could be sold - and when they could be found, the interest rate charged to borrow them was quite high.

Short selling was not the only way to bet against Palm. One could also buy put options, which allowed the stock to be sold for a fixed price. But the options were also mispriced during this period, making such investments unattractive.

So the anomaly persisted for many months. Eventually, of course, it disappeared: a few weeks before 3Com issued its remaining Palm shares, the prices reflected the appropriate ratio. But the short selling constraints seemingly allowed the mispricing to persist for an awfully long time.

Many intelligent investors believe that short selling is a strong signal of subsequent price declines. Professor Lamont's work and that of several other academics find that this is so: stocks that are subject to large short selling tend to have lower subsequent returns.

One might ask why short selling is not immediately reflected in the price of a stock. The reason appears to be related to the basic problem with short selling: there is no centralized market for borrowing stock, so it can take time to find shares to sell short. Typically, there is no problem in finding shares of large companies that are traded frequently. But shares of small companies, whose stock is lightly traded, may be hard to find.

This finding suggests that the total amount of short selling might be a good predictor of stock market movements in general. Somewhat surprisingly, this turns out not to be true. In fact, during the bubble years, the aggregate amount of short selling declined as stock prices were bid up. As Professor Lamont and his co-author on another paper, Jeremy C. Stein, remark, "Short selling does not play a particularly helpful role in stabilizing the overall stock market."

But again one must ask why not. One suggested answer is that short selling arbitrage has more risk than appears at first glance. For example, the owner of the shares can force the borrower to return them under certain conditions. Hence, the short seller might find his position unwound at an inconvenient time. This risk factor means that short sellers may want to take smaller positions than they would otherwise prefer.

It appears that at least on some occasions, short selling constraints can disrupt the normal operation of supply and demand: when supply is constrained, stock prices end up being determined by those who are overly optimistic.

What Caused the Financial Crisis?.

An article in the NY Times, "Pressured to Take on Risk, Fannie Hit a Tipping Point," is causing many people to wonder if Fannie and Freddie caused the financial crisis.

First, let me clarify the question. We are asking what caused the housing bubble, and, by definition, the cause cannot be explained by changes in an underlying market fundamental. I don't mean that we can't point to, say, a rumor that led to a rapid increase in the price of some good as speculators rush in, just that bubbles - by definition - are divorced from market fundamentals.

I think a more interesting question is what sets the stage for a bubble to emerge - what allows the rumor, irrational exuberance, etc., to express itself as a bubble? One thing that is needed is liquidity and credit, some way of substantially increasing demand. This is the air that inflates the bubble. Even if all the other conditions for a bubble to emerge are present, if there is no way to inflate the bubble - no way for speculators to rush in and drive up the price - then it won't inflate.

We already know that there was enough available liquidity to inflate a housing bubble. So something went wrong in these markets that allowed the bubble to emerge and then pop, and this is causing us immense problems right now, but what was it?

I think the most important factors are agency problems, the mis-pricing of risk, and the failure of securitization to distribute risks across the financial system.

With respect to the agency issues, there is a long chain between the home buyer, the mortgage broker, and, ultimately, the sliced and diced complex securities that nobody fully understands. Let's take one step in the chain, that of a a bank or mortgage broker, either one. Suppose they are paid a fee, i.e. by the number of mortgages that pass through their hands each month (as, essentially, they were). The more mortgages they can push through, the higher their income. They are required to meet certain guidelines as they do this, but so long as their income depends upon the number of mortgages passing through their hands and not what happens to the mortgages later on - so long as it is a fee-based system - they have every incentive to push the guidelines as hard as they can and to find a way around them whenever possible.

If mortgage brokers had done their job and only made loans to people who could pay them back (i.e. with "reasonable" levels of default), we wouldn't have a financial crisis. So right away, in nearly the first step of the chain, we have to ask what went wrong, why they were willing to take so many questionable loans. The problem is what economists call an agency issue. The brokers had no stake in the outcome once the mortgages left their hands. The same with banks, all they had to do was process the mortgages, package them up, then sell them and collect their fee.

Think about the incentives here. Suppose you are a mortgage broker and you begin to suspect that the bubble will pop soon, that all this lucrative business might end. To protect the business, should you get worried and start checking mortgages more carefully to make sure that things don't get further out of hand? No, you should accelerate what you are doing, write even more mortgages - nothing you can do can stop the bubble from popping, you are just one of many, many brokers far down the chain - so why not collect as many fees as possible before the gravy train ends? What if everyone thinks this way, and they all rush to sell as many of these things as they can? Mania.

A solution to this is to give each person in the chain a stake in the future outcome of the mortgage. If mortgage brokers' income had been connected to a financial instrument that pays off according to the future performance of the mortgages they write, would they have behaved differently? Probably. (What about homeowners, why didn't they say no? Don't they have a stake in the future price of the home? Homeowners in non-recourse states - and more generally - were basically granted cheap options on their homes. The downside was protected and they had no reason to effectively monitor risk. If prices fell, they could just walk away and know that their other assets remained safe and that their credit reputations could be restored with time. Of course, if everyone walks away other assets such as retirement savings don't remain safe, but that doesn't change the incentive on an individual level.)

Ah, you say, but as you go up the chain why didn't people refuse to take the financial paper, why didn't they conclude it was too risky? The risky mortgages don't have to be stopped at the bottom, this is a linked chain, so why weren't they stopped higher up in the chain where the stakes are higher? Isn't that where Fannie, Freddie, and moral hazard rear their ugly heads? Did they encourage and allow this risky paper to pass through the system?

The mis-pricing and mal-distribution of risk played a key role here (along with poor management decisions in cases where alarms were raised). The agency issues above, and the consequences of the failure to predict and distribute risk are much more important than any moral hazard issues arising from the implicit government guarantee granted to Fannie and Freddie.

Institutions in the shadow banking sector were willing to take large volumes of risky loans as they came up through the system. Why?

The people at the top of this complex chain did not fully understand the risks the were assuming when they took on the subprime business, or, rather, when they took on the complex securities derived from the subprime business. When the bubble popped, it shouldn't have been a big problem if the risk assessment models they relied upon had been correct, and if securitization had distributed the risk as promised. As Brad DeLongnotes:

• There is $11T if U.S. mortgages
• There is $60T of global financial assets
• Even if we had $2T of losses on mortgage-backed securities that shouldn't pose a big problem for Wall Street--actually 48th and Park Avenue

So if the risks had been distributed fairly evenly, it's much less likely that we'd be in this mess (the losses of 2T - an intentionally high-balled number - are only 1/30th of global financial assets). It wasn't the misprediction of the level of risk that was the biggest problem, the losses could have been absorbed, it was the (unintended) concentration of risk through the failure of securitization that was the most problematic.

Fundamentally, then, it was the agency problems and the failure of risk prediction and distribution models that allowed the bubble to inflate and then cause big problems after it popped. But back to Fannie and Freddie. The willingness of the non-traditional banking sector - the shadow banking system - to take on these risky assets and still pay investors a relatively high return put tremendous pressure on Fannie and Freddie to follow suit. And their response was unwise - Fannie and Freddie followed the shadow banking sector downward. There is lots to fault in the behavior of Fannie and Freddie and in government oversight of them - the decisions of management, the lobbying efforts that were funded by their ability to extract a premium from the implicit government guarantee - all of this was a big problem. The bubble, and later the financial crisis expressed itself in these institutions, and they may have also contributed to it to some extent as they took on more risky securities when their business began to go elsewhere. But the agency issues and the failures of risk models and securitization would have created problems in the largely unregulated shadow banking sector even if these two institutions had taken on nothing but the safest of mortgages. The bubble still would have inflated in the shadow banking system - maybe it's a little smaller, I don't know - but it still would have been large enough to cause big problems when it burst. The best behavior of Fannie and Freddie would not have been enough to stop the bubble from inflating in other parts of the financial sector, and then turning into a full fledged financial crisis as housing prices plunged.

The problems we are having were caused when lots of available liquidity rushed past the checks and balances that proper agency provides in pursuit of promises that risk models and complex securities did not deliver. The unexpected losses alone might not have caused a crisis had the losses been widely distributed, but, the losses were concentrated and hidden in ways that created widespread fear and threatened the entire system. Getting rid of that fear is not going to be easy.

[Update: Given some of the responses elsewhere to this post and others like it, let me add one more thing. Asking the question "what caused the financial crisis," thinking about it, and then arguing that Fannie and Freddie were not the primary driving forces behind the financial meltdown (though they could have affected the size of the problem as noted above) is not the same as defending Fannie and Freddie. Whether are not Fannie and Freddie are performing a useful function, and if they are performing a useful function how they should be structured going forward is not a question I've fully resolved. The market failure they are addressing is not entirely evident to me, and until I understand how they improve the efficiency of these markets, I won't take a position. They certainly should not operate as private entities with an implicit government guarantee as before - that's what set up the situation where the implicit guarantee could be exploited profitably and used to fund lobbyists and ad campaigns to make sure the golden goose kept laying eggs. However, I have posted arguments from other people arguing for their existence, and I am thinking about those as well as arguments against their continuation. In any case, something to guard against, I think, is to inappropriately blame Fannie and Freddie for the financial crisis and then use that as a reason to shut them down irrespective of any useful function they might serve. So when I see those with an agenda against government intervention trying to do just that - arguing honestly in some cases and dishonestly in others that Fannie and Freddie were a big factor in the crisis so they can use them as an example of government intervention gone awry and also shut them down - a double bonus in their eyes - I have tried to present evidence and arguments that the cause lies elsewhere. But as I said, that is not the same as defending their existence. My interest is in understanding the true cause of the financial crisis and in stopping it from happening again - and to avoid getting stuck on wrong arguments along the way - not in using the crisis to argue about whether Fannie and Freddie ought to continue as government supported institutions. That can wait for another day.]

Will a Tax Cut Solve the Crisis?.

FromEconomix:

With hardly anyone noticing, [Mr. Paulson] pushed through very technical and obscure changes to tax regulations that provide a “tax subsidy” for acquirers of troubled banks. Just as automakers stimulate car sales through rebate checks, the Treasury is providing a form of tax rebate to acquirers of troubled banks. Everyone can thank Hank Paulson and his stealth tax-driven fiscal stimulus for the astonishing news that Wachovia was being acquired by Wells Fargo and not Citigroup. It was Mr. Paulson’s tax subsidy to Wells Fargo that provided the fiscal grease to make this deal happen. Pundits who point to the deal and proclaim that the “free markets work without government help” don’t understand the motivating effect of several billion dollars of tax benefits to Wells Fargo.

[Note: The Wachovia deal with Wells Fargo is on hold until legal questions are resolved.]

Update: See fred, in comments.

Barry Ritholtz: What Caused the Financial Crisis?.

Here's Barry Ritholtz' view on the cause of the financial crisis.We agree on a lot of points regarding the cause, though I call the lending standards issue an "agency problem," and we agree that a source of liquidity was needed to inflate the bubble, though we disagree a bit on the source. He has the Fed playing a larger role than I do (though I agree low interest rates contributed), I would cite the importance of international sources of liquidity as well:

Fannie Mae and the Financial Crisis, by Barry Ritholtz: TheSunday New York Times has a very interesting article on Fannie Mae and the current financial crisis. They do a decent job at delving into the complexities of the GSEs, and the many factors that went into the decision making at the senior level of the company. This includes pressure from clients such as Coutrywide CEO Angelo Mozilla, pressure from Congress, and the demands from investors for the company to be more aggressive. Most of all, it looks at the ongoing competitive demands of the market place that Fanny was in.

The key to understanding the GSE story is grasping their role withinthe bigger picture of the economy and housing sector. While there aresome pundits who prefer talking points over reality (Charlies Gasparino, Lawrence Kudlow, James Pethoukoukis, and Jeff Sautall toed the GOP line) I prefer to keep all of my analyses based on thedata and facts. Rather than creating historical revisions for partisanreasons, I prefer to keep it reality based. (I'm an independent, andthat's how I roll).

The current housing and credit crises has many, many underlying sources. Its my opinion there were two primary causes leading to the boom and bust in Housing: A nonfeasant Fed, that ignored lending standards, and ultra-low rates.

This nonfeasance under Greenspan allowed banks, thrifts, and mortgage originators to engage in all manner of lending standard abrogations. We have detailed many times the I/O, 2/28, Piggy back, and Ninja type loans here. These never should have been permitted to proliferate the way they did.

The most significant element were the 2/28 APRs, and their put back provision. Just about all of these gave the securitizer/repackager the right to return the loans within 6 (or 12) months if they went into default. Hence, ourproposition that the 2002-07 period was unique in the history of finance. If any of these mortgages went bad within 6 months, the undewriter was on the hook.

HOW DIFFERENT WERE LENDING STANDARDS IF YOU ONLY NEED TO ENSURE THE BORROWER WOULDN'T DEFAULT FOR 6 MONTHS VERSUS FINDING BORROWERS WHO WOULDN'T DEFAULT FOR 30 YEARS.

In a rising price environment, 99% of the mortgages were not returned by the securitizers to the originator. From 2001 to 2005, the mortgage firms thrived. However, once prices peaked and reversed, things changed. From 2006-08, Wal Street began putting back mortgages to originators in greater numbers. This led to nearly 300 mortgage firms imploding.

We can blame the lenders, the securitizers, the borrowers, amd Fannie/Freddie, but it doesn't matter much.By the time Fannie and Freddie began changing their mortgage buying rules, the Housing boom was already in full gear, and the crash was all but inevitable.

[Update: Some people (especially the political hacks) are focusing their energies in the wrong places. According to a recent investigation by Barron's, Fannie's biggest problem was not the subprime mortgages they bought -- it was the better quality Alt A mortgages that caused their demise:

"As Freddie Mac Chairman and CEO Richard Syron recently put it, the GSEs have been hit by a "100-year storm" in the housing market, accentuated by some higher-risk mortgages that they were forced to buy to meet government affordable-housing targets.

The latter contention is more than disingenuous. A substantial portion of Fannie's and Freddie's credit losses comes from $337 billion and $237 billion, respectively, of Alt-A mortgages that the agencies imprudently bought or guaranteed in recent years to boost their market share. These are mortgages for which little or no attempt was made to verify the borrowers' income or net worth. The principal balances were much higher than those of mortgages typically made to low-income borrowers.

In short, Alt-A mortgages were a hallmark of real-estate speculation in the ex-urbs of Las Vegas or Los Angeles, not predatory lending to low-income folks in the inner cities."

Only pure partisans take as gospel the statements of an embattled CEO whose own words are belied by the firm's balance sheet and P&L statements.]

What about the ultra low rates? Consider that the Greenspan Fed maintained a1.75% Fed fund for 33 months (December 2001 to September 2004), a 1.25% for 21 months (November 2002 to August 2004), and lastly, a 1% Fed funds rate for 12+ months, (June 2003 to June 2004). That was fuel for the fire, and fed the boom even more, sending prices skyward.

Update: And not just here . . . As the central bank for the largest economy in the world, the Fed's rate action had repercussions in Housing markets everywhere. Rate cuts here richocheted around the world, sending home prices upwards globally.

Fed Fund Rates, 1974-2008

Note the circled area of detail is the chart above, in its historical context

Fed Fund Rates, 2000-2008

As to the credit crisis, it too, has many many proximate causes, but the two I focus upon as having the greatest impact was exempting CDOs from any sort of regulatory scrutiny (Commodities Futures Modernization Act of 2000) and the payola scandal of the rating agencies Moody's, Fitch, S&P slapping Triple AAA ratings on all manner of junk paper.

In order to fully understand the housing and credit crisis, one needs to understand a bit of history in the housing market. To that end consider this timeline:

1987 Federal Reserve cuts rates
1989 Housing Market peaks
1996  Prior purchases get to breakeven
1997  Housing Taxpayer Relief Act
1998 3 Rate Cuts
1995-2000 -- Big stock market gains
2001 Rate cuts from 6% down to 1.75%
2002 More rate cuts to 1.25%
2003 one final cut to 1% 

Follow the timeline: Home sales and prices cycled up post '87 market crash -- they peaked in 1989, and for the next 7 years, they slid down to sideways. A 1989 house buyer did not get back to break even until 1996/97. (See chart above)

A few other factors impacted housing: In 1997, the Taxpayer Relief Act that dropped capital gains to 20% from 28%, and also exempted the first $500,000 for married couples selling house (allowable once every two years). 

Around that time, the stock market boom and tech dot com bubble was in full throat.  That put A LOT of money in people's hands in 1997, 98, 99 and Q1 of 2000. In the late 1990s, I had many discussions with clients, real estate agents and traders about the equities into house rotation: Take some equity profits off the table and then trade up in real estate. Consider these S&P500 gains in the markets: 1995=34%, '96=20%, '97=31%, '98=27%, and from Oct '99 to March 2000, the Nasdaq was up 100%.

The folks who want to place the entire crisis at FNM/FRE 's doorstep miss the point -- and let me hasten to add that I was never a fan of the company, andwe were short FNM from over a year ago, at $42+ -- these people seem to miss all of the big picture issues, and are focusing on minor factor and outright irrelevancies. This was not a "social engineering" experiment, as the radical right has called it. This was extreme short sightedness.

Fannie Mae was not a government entity, they were an independent, publicly traded, private sector firm. They were allowed to borrow at better rates than banks as a GSE. They bought what they did in an attempt top grab share and profits. If they came under pressure from Congress -- or Angelo Mozilla, or hedge fund investors -- it was because they were trying to capture market share and profits and maintain an advantageous position in the marketplace.

Consider:

"The chief executive of the mortgage giant Freddie Mac rejected internal warnings that could have protected the company from some of the financial crises now engulfing it, according to more than two dozen current and former high-ranking executives and others.

That chief executive, Richard F. Syron, in 2004 received a memo from Freddie Mac’s chief risk officer warning him that the firm was financing questionable loans that threatened its financial health.

Now consider the key points from the NYT article today:

• Company was in disarray after an accounting scandal;

• New CEO came on board in 2004;

• Competitors were "snatching lucrative parts" and market share away;

• Between 2001-04, the subprime mortgage market grew from $160 to $540 billion

• Between 2005-08, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers. 

• By 2004, Fannie had lost 56% of its loan-reselling business to Wall Street;

• Angelo Mozilo, Countrywide Financial CEO, the nation’s largest mortgage lender, threatened to end their partnership unless Fannie started buying Countrywide’s riskier loans;

• Congress was pressuring for more loans to low-income borrowers;

• Hedge fund managers and other investors pressured Fannie executives that the company was not taking enough risk in pursuing profits;

• Like many other firms, Fannie’s computer systems did a poor job of analyzing risky loans;

• Between 2005-07 -- after the market's peak -- Fannie's acquisitions of mortgages with less than 10% down payments almost tripled;

• Fannie expanded in hot real estate areas like California and Florida;

• From 2004-06, Fannie operated without a permanent chief risk officer;

As I have said repeatedly, Fannie and Freddie were cogs in the great housing machinery, and they bear some responsibility for the current debacle.  But to argue they were the most significant factor misses the true tale of the Housing and credit debacle.

Fannie has been around since 1938, Freddie since 1968, the CRA has been around since 1977 -- suddenly, all of housing goes to hell in 2005, and then credit collapses 2 years after -- and the best explanation some people can come up with is Fannie, Freddie and CRA?  Gee, isn't that rather odd -- especially after 70 years?

Update: Then there is the international issue: If Fannie and Freddie and the 1977 CRA are to blame for the US boom and bust, how did the rest of the world end up with a housing boom too? Why did prices and sales go skyward in the UK, France, Spain, Ireland, Australia, etc.? They had no CRA, or a Fannie Mae, or a Freddie Mac, -- so then what caused their housing boom?

The short answer: Ultra low rates, securitization, and perhaps some of our homegrown, innovative lending standards.

While I understand that reducing the complexities of economic history into bumper sticker phrases is politically expedient, it does not help us understand the root cause of the problems. And, it gets in the way of helping us fashion a solution for the future. Hence, why I hold the weasels who are attempting to obscure reality and rewrite history in such disdain.

Update: For the non-partisan, non hacks amongst you, for the policy makers and academics and economists who are truly interested in how this came to pass, and what we can do to fix it, the bottom line remains: The CRA was irrelevant to the current crisis, and Fannie Mae and Freddie Mac are mere cogs in a complex machine.

But the primary cause of the mess? Not even close . . .

>

click for bigger graphic

>

Previously:
How Washington Failed to Rein In Fannie, Freddie (September 14, 2008)   
http://bigpicture.typepad.com/comments/2008/09/how-washington.html

Freddie's Risk Officer: CEO Ignored Warning Signs (August 05, 2008)   
http://bigpicture.typepad.com/comments/2008/08/freddies-risk-o.html

His Name is Mudd (August 20, 2008)
http://bigpicture.typepad.com/comments/2008/08/perilous-pursui.html

Fannie Mae Looks Like Hell (November 16, 2007)
http://bigpicture.typepad.com/comments/2007/11/fannie-mae-look.html

Sources:
Pressured to Take More Risk, Fannie Hit a Tipping Point
CHARLES DUHIGG
NYT, October 5, 2008
http://www.nytimes.com/2008/10/05/business/05fannie.html

At Freddie Mac, Chief Discarded Warning Signs
CHARLES DUHIGG
NYT,  August 5, 2008
http://www.nytimes.com/2008/08/05/business/05freddie.html

Nick Rowe: What Caused the Financial Crisis?.

On Steven Gordon's blog, Nick Rowe of Carleton University offers his thoughts on what caused the financial crisis/es along with the economics behind his thinking:

Some thoughts on the bubble/s and financial crisis/es, by Stephen Gordon: Nick Rowe provides us with some talking points on how we all got into this mess:

I am taking part in a roundtable on the financial crisis next week at Carleton (Wednesday 8 October 5.30-7.00 in 360 Tory, just in case anyone is interested in attending). The audience and other panel members will be mostly political scientists. I only get 10 minutes. This is what I am currently planning to say:

Opening Salvo: Could better regulation have prevented the financial crisis? Yes; restricting mortgages to less than 70% of the value of the home could have prevented the house price bubble and prevented the crisis. No; because that regulation could only have passed, in a democracy, if a majority of people had been convinced that disaster would happen if people borrowed more; and if a majority had been convinced of that, a bubble would never have happened anyway, and so regulation would not have been needed.

Politics: The left blames Bush, the Republicans, and deregulation. The right blames Obama, the Democrats, and the Community Reinvestment Act. Both sides sound convincing. But both sides are obviously wrong. The housing bubble is global; the financial crisis is global. Russia has a financial crisis, but the Republicans do not regulate Russian financial markets. England had a housing bubble, but does not have a CRA. The US bubble burst first, but other countries are following closely. Canadians watch too much US news. This is a global phenomenon, and needs a global explanation.

What is a bubble? Everybody talks about the house price bubble, but nobody defines what it means. Let me define it:

The amount you should rationally pay for a house, if you sell it one year later is:

1.    P = Annual Rent + [P one year later]/(1+r)

And if you (or the people you sell it to) sell it infinity years later, it is:

2.    P = Present Value of Rents to infinity + [P infinity years later]/[(1+r)^∞]

The second term on the right hand side is the bubble. If everybody expects, and expects future buyers to expect, that future prices will stay finite, the bubble term is zero, and they will not rationally pay bubble prices.

So why do bubbles happen, and why in so many countries at once?

Irrational herd instinct maybe? I don’t know, but I can say something about when they are more likely to happen:
If rents and house prices are growing at rate g, and g<r, then:

3.    P = Rent/(r-g) + P[(1+g)/(1+r)]^∞

If g gets close to r, very small changes in any of the terms have very big consequences for the price you should rationally pay for a house. The ratio between today’s prices and today’s rents becomes very fragile, and very sensitive to expectations about the future. It gets very hard to distinguish between prices that are high because of a bubble, and prices that are high because other people expect slightly higher growth rates. Maybe other people are right? Maybe houses really are worth that much? (And if g ever exceeds r, we enter the financial twilight zone of pure bubbles, where chain letters are stable, and Ponzi schemes really can make everybody rich.)

So why did bubbles happen in so many countries at about the same time? First, because world interest rates were low. And world interest rates were low not because Greenspan set them low (central banks cannot set interest rates below the natural rate without causing accelerating inflation), but because world savings were high. And world savings were high because the world’s population is getting older, and when people get older they save more for their retirement (note China). And second, because world GDP growth was high (note China and India), Ricardian rents on inelastically supplied land (for houses or oil) had a high growth rate too. So g was close to r. Which made it easier for bubbles to form, in many countries.

So why did bursting bubbles cause a global financial crisis? Why are financial markets so fragile? Because financial markets try to do the impossible. Ultimate savers/lenders want financial assets to be Short, Safe, and Simple. Ultimate investors/borrowers have projects which are Long, Risky, and Complex. Financial markets and financial institutions try to give both sides what they want. In normal times the magic works. Without that magic, people would only save gold or canned food, and there would be no investment, and we would still be in the Stone Age. But the price of that magic is an inherent instability. Each individual can liquidate his savings at any time, but we can’t all liquidate at once. Beliefs become self-fulfilling, and we can also get a second, bad equilibrium, with a bank run or stock market crash. Most people can hold safe assets, if uncorrelated risks are pooled, but some people must always hold the remaining, correlated risks. And if those people go bankrupt, the safe assets too become risky. Many people can hold simple assets, provided some other people do the complicated research. But if their research turns out to be wrong, the simple assets become complicated too.

Efficient financial markets give both sides what they want, but are inherently fragile. There is an inherent trade-off between efficiency and stability. Changes in regulation can move you along that trade-off. Good regulation might improve the trade-off. But it cannot be eliminated. Government bailouts are just the government acting as one more financial institution. Governments too can become illiquid, or insolvent, or get their research wrong.

What should Canada do? Our housing bubble is perhaps smaller than in other countries, and our financial institutions are perhaps more stable. But nevertheless this is a global crisis, and we ought to share in the global rescue. The Canadian government should borrow several hundred billion dollars, and use it to buy risky assets at fire-sale prices. Swap T-bills for toxic waste. We might also make a profit!

Hmmm. I don’t know if I can say all that in 10 minutes.

Comments? Criticisms? Useful advice? What did I get wrong?

Should Deregulation be Blamed?.

Sebastion Mallabysays deregulation is not the cause of the financial crisis. Jamie Galbraith would disagree (more direct disagreementhere andhere):

Goodbye, Conservatives. Hello, Predators, by James K. Galbraith: Back in the Reagan days, Republicans talked economics. We had problems; they had solutions. Tight money would cure inflation. Low taxes would stimulate saving and hard work. Small government would "crowd in" investment; free trade would make us efficient. Smart people believed this, and they had Milton Friedman to back them up. I never thought they were right-but they were serious. They were coherent. And they argued with passion and conviction, which commanded respect.

But now, real economic conservatives have disappeared from the Republican stage. ... Bush is a bread-and-circuses reactionary with a clientele of lobbies. McCain gets his economic ideas from Phil Gramm, the ultimate architect of the Enron culture, of libertine speculation and financial disaster. ... This crowd deregulates and privatizes not because they think it might work out for the public... What they care about is putting their friends in charge.

Under Bush, oil and gas, drug companies and defense contractors, insurers and usurers, banks and big media control the government of the United States. John McCain..., as chair of the Senate commerce committee,... presided over Lobby Central; notoriously, his campaign is run by lobbyists ... and until last week his policy could be summed up in slogans: he was a "free market" man, a "deregulator." ... Bush and McCain are the predator state writ large...

On the morning that Lehman Bros. and Merrill Lynch fell,... the ... Dow Jones average fell 504 points... As stocks crashed, suddenly people remembered that modern markets cannot exist without a cop on the beat. Every important market out there, from fresh food and safe drugs to autos and air travel to housing and health care, depends on government to maintain trust, and without it, none of them would survive. Without regulation, predators take over, and when they do, trust eventually collapses. Every important market is in peril now, precisely because of the predators in power these past eight years. And none more immediately than finance.

The Bush-Paulson bailout exposed the predator state in detail. Deregulation and desupervision were the origin of this crisis: the 1999 Gramm-Leach-Bliley Act repealing Glass-Steagall, and the Gramm-authored loophole legitimating credit default swaps in 2000. Bush's financial regulators brought chainsaws to press conferences, a clear signal to sub-prime hustlers that "anything goes." "Liar's loans," "neutron loans" and "toxic waste" became financial terms of art. ...

It seems unlikely that John McCain, the regulation-wrecker, will become, overnight, the man who would turn vice to virtue on Wall Street. But even suppose he were serious. Who would trust him? No one with money on the line.

This is McCain's deeper problem. If he is elected, under his leadership, trust cannot be restored. ... Restoring trust requires a government of trustworthy people. Team McCain doesn't have any, and some, especially Gramm, inspire the opposite. It wouldn't matter what their policies were or pretended to be. Nothing they attempted would work.

The ... choice in this election is well-defined. One party believes that the government serves no public purpose. The other believes that it must. One party has turned the government over to lobbies, to cronies and to big donors. The other is beginning to realize that a real government must be rebuilt. One party would keep the same crowd in office; the other would have to begin by clearing them out. No one can say there is no difference between the parties this year, and the basic issue in this election is really just as simple as that.

I thought the best part of Sebastian Mallaby's article came when he provided this link: "There's a vigorousargument about whether Calomiris's number is too high." As to his main argument, "that deregulation is the wrong scapegoat," I don't think it was deregulation of any particular sector that caused the problems we are having in credit markets,I think it was lack of effective regulation of the shadow banking sector in general (i.e. the regulations that did exist in the shadow banking sector were not directed at the right issues, thus, it's possible to believe, as I do, that some of the deregulation was warranted while still believing that needed regulation was missing). The shadow banking sector should be under the same regulatory umbrella that traditional banks are subject to, and extended the same sorts or privileges within the Federal Reserve system in return (deposit insurance of some type, and lender of last resort functions in return for regulatory restrictions). There is no guarantee this would have stopped the credit crisis from developing, but I don't think the conclusion we should draw from the present experience is that these markets weren't free enough. Hopefully, we can use what we've learned as the crisis has unfolded and also use what we've learned from regulating the traditional banking sector to devise a regulatory structure that will improve the stability of credit markets.

Paul Krugman: Health Care Destruction.

The McCain health care plan has a reverse Robin Hood effect in that it takes health care insurance away from those who need it the most and gives it to those who are healthiest and most able to afford coverage:

Health Care Destruction, by Paul Krugman, Commentary, NY Times: ...Conservative Republicans still hate Medicare, and would kill it if they could... (that’s what the 1995 shutdown of the government was all about). But so far they haven’t been able to pull that off.

So John McCain wants to destroy the health insurance of non-elderly Americans instead.

Most Americans under 65 currently get health insurance through their employers. That’s largely because the tax code favors such insurance ... as long as the ... plan ...[is] available to all employees, regardless of ... the state of their health.

This system does a fairly effective job of protecting those it reaches, but it leaves many Americans out in the cold. Workers whose employers don’t offer coverage are forced to seek individual health insurance, often in vain. For one thing, insurance companies offering “nongroup” coverage generally refuse to cover anyone with a pre-existing medical condition. And individual insurance is very expensive, because insurers spend large sums weeding out “high-risk” applicants — that is, anyone ... likely to actually need the insurance.

So what should be done? Barack Obama offers incremental reform... His plan falls short of universal coverage, but it would sharply reduce the number of uninsured.

Mr. McCain, on the other hand, wants to blow up the current system, by eliminating the tax break for employer-provided insurance. And he doesn’t offer a workable alternative.

Without the tax break, many employers would drop their current health plans. Several recent nonpartisan studies estimate that ... around 20 million Americans ... would lose their health insurance.

As compensation, the McCain plan would give people a tax credit — $2,500 for an individual, $5,000 for a family — that could be used to buy health insurance... At the same time, Mr. McCain would deregulate insurance, leaving insurance companies free to deny coverage to those with health problems — and his proposal for a “high-risk pool” for hard cases would provide little help.

So what would happen?

The ... total number of uninsured Americans might decline marginally under the McCain plan — although many more Americans would be without insurance than under the Obama plan.

But the people gaining insurance would be those who need it least: relatively healthy Americans with high incomes. Why? Because insurance companies want to cover only healthy people, and ... only those able to pay a lot in addition to their tax credit would be able to afford coverage (remember, it’s a $5,000 credit, but the average family policy actually costs more than $12,000).

Meanwhile, the people losing insurance would be those who need it most: lower-income workers who wouldn’t be able to afford individual insurance even with the tax credit, and Americans with health problems whom insurance companies won’t cover.

And in the process of comforting the comfortable while afflicting the afflicted, the McCain plan would also lead to a huge, expensive increase in bureaucracy: insurers selling individual health plans spend 29 percent of the premiums they receive on administration, largely ... to screen applicants. This compares with costs of 12 percent for group plans and just 3 percent for Medicare.

In short, the McCain plan makes no sense at all, unless you have faith that the magic of the marketplace can solve all problems. And Mr. McCain does: a much-quoted article published under his name declares that “Opening up the health insurance market to more vigorous nationwide competition, as we have done over the last decade in banking, would provide more choices of innovative products less burdened by the worst excesses of state-based regulation.”

I agree: the McCain plan would do for health care what deregulation has done for banking. And I’m terrified.

Krugman: The International Finance Multiplier.

Paul Krugman develops an "international finance multiplier" that works through key leveraged intermediaries that connect countries together financially. His model shows that under capitalization, not liquidity is the main problem to be solved, and that "there are large cross-border externalities in financial rescues":

1. The International Finance Multiplier, Paul Krugman, October 2008: 1. IntroductionThe current financial crisis is remarkable in many ways, but one aspect is of special interest for international economists: even though the roots of the crisis lie in the U.S. housing market, the crisis is now very much a global affair. Figure 1 shows the decline in a number of stock market indices over the year ending October 4, 2008; essentially, all markets fell by the same amount.

The freeze on interbank lending and in the commercial paper market is affecting Europe to much the same degree that it’s affecting the United States, with the gap between Euribor and the repo rate similar to that between Libor and the Fed funds rate. Banks are failing, or needing urgent government rescue, on both sides of the Atlantic.

International economists have been interested in interdependence for a very long time – arguably too interested. Global interdependence is one of those topics people love to talk about because it sounds sophisticated – the Wall Street Journal once published a piece mocking Multilateral Man, who wants to cooperate to improve coordination and coordinate to improve cooperation. (This is as opposed to Euro Man, who wants cohesion to promote convergence …)

But the interdependence this time is real – and it seems to be operating through channels that are not yet part of standard international macro analysis. Much thinking about international linkages still relies on some version of the traditional foreign trade multiplier: country A’s GDP affects its level of imports, which are country B’s exports, so demand shocks get transmitted through international trade. As I’ll explain shortly, however, this won’t work for current events. Instead we seem to be dealing with a phenomenon I’ll call the international finance multiplier, in which changes in asset prices are transmitted internationally through their effects on the balance sheets of highly leveraged financial institutions. ...

Before we get there, however, let’s review the traditional analysis of interdependence.

2. Modeling interdependence

The granddaddy of all interdependence analyses is Romney Robinson’s 1952 paper, "A graphical analysis of the foreign trade multiplier." Robinson envisioned a two-country world with fixed exchange rates, fixed prices, and fixed interest rates, so that simple multiplier analysis applied. Home country GDP affected Foreign GDP through its effect on imports: higher Y led to higher Home imports, hence higher Foreign exports, hence higher Y*.

And Y* affected Y in the same way. So one had the picture of interdependence shown in Figure 2, in which HH shows Home GDP as a function of Foreign GDP and FF shows Foreign GDP as a function of Home GDP. A negative demand shock in Home would shift HH to the left, inducing a series of reactions that would reduce both Home and Foreign GDP.[2]

With floating exchange rates, the picture becomes more complicated, because shocks affect trade flows through the exchange rate as well as the effect of GDP on import demand. But trade flows remain the channel of influence.

The question is, how important is that channel? The fact is that in spite of globalization, trade flows don’t seem large enough to produce all that much interdependence. Figure 3 shows U.S. imports of goods and services as a percentage of rest-of-world GDP since 1980.

This share has roughly doubled, but it’s still fairly small. One way to think about this is to ask what it would take for a U.S. recession to impose a one percent of GDP negative demand shock on the rest of the world. For this to happen, U.S. imports would have to decline from 6 to 5 – a 17% decline. Given that the typical estimate of the income demand for imports is around 2, this would require a decline of more than 8% in U.S. GDP. So it would take an extremely severe recession in the United States to produce even a moderate-sized negative demand shock abroad.

But we’ve known for some time that trade flows aren’t the only source of international interdependence. The Asian financial crisis of 1997-1998 was notoriously marked by "contagion," the spread of crisis to economies with seemingly weak links to the original victims. In particular, the most severely affected nations were small economies that were not each others’ major trading partners, yet they experienced a dramatically coordinated slump. Figure 4 shows real GDP growth in the four "front line" economies; I think the figure speaks for itself.

And as the crisis spread, the linkages became positively baroque: Russia’s default seemed to cause a speculative attack on Brazil, and triggered a brief, scary liquidity crisis in the United States (at least it seemed scary at the time; by current standards it was a non-event.)

What was the explanation of global contagion? Some observers suggested that there were informational linkages – such as herding behavior by investors with incomplete information. Others, myself included, suggested that contagion was a sort of "sunspot" phenomenon: the afflicted economies were financially fragile, with the possibility of falling into a bad equilibrium always there, and the crisis atmosphere caused the descent.

The proposed channel that seems most relevant, however, seems to have been originally proposed by Calvo (1998): contagion through the balance sheets of financial intermediaries. Loosely, when hedge funds lost a lot of money in Russia, they were forced to contract their balance sheets – and that meant cutting off credit to Brazil.

An important paper by Kaminsky, Reinhart, and Vegh (2003) provided support for this view: it compared a number of episodes of international contagion, and found that all of the cases involved a "leveraged common creditor."

The argument of this short note is that an expanded version of the Calvo hypothesis is the best way to think about the global crisis now underway: essentially, all economies now share leveraged common creditors, so that balance sheet contagion has become pervasive. Today, we are all Brazilians.

Before we get there, however, it’s necessary to lay out a stylized account of the crisis.[3]

3. A minimal model of the crisis: single-country version

 

...[mathematical and graphical model]...

5. Implications

 

The story laid out here seems to have two main implications for policy in the crisis.

First, it suggests that the core problem is capital, not liquidity – or at least that you can explain much of what’s going on without appealing to a breakdown of buying and selling per se. To the extent that this is true, rescue plans centered on making troubled assets liquid, like the Paulson plan passed last week, won’t do the trick. Instead, what’s needed is an injection of capital, which can’t reverse the original shock, but can undo the financial multiplier effect of that shock.

Second, the international implications: to the extent that we regard falling asset prices and their consequences as a bad thing, which we obviously do right now, this analysis suggests that there are large cross-border externalities in financial rescues. Macroeconomic policy coordination never got much traction, largely because economists never could make the case that it was terribly important. Financial policy coordination, however, looks on the face of it much more important. Capital injections by U.S. fiscal authorities would help alleviate the European financial crisis, capital injections by European fiscal authorities help alleviate the U.S. financial crisis. Multilateral Man, come home – we need you![6] ...

Climate Change and Gas Prices.

Is it good news or bad news that a carbon tax sufficient to reduce emissions by 10% won't have much impact on gas prices or miles driven?:

Climate change and gas prices: Less impact than you might think, CBO: CBO released a brief today on climate-change policy and CO2 emissions from passenger vehicles (for thePDF, click here).

Discussions about addressing climate change (e.g., through a cap-and-trade program or a carbon tax) often focus on the transportation sector. The brief argues, however, that most of the reduction in CO2 emissions would occur in other sectors (e.g., the electricity sector) and that the effects on vehicle emissions would be modest, especially in the shorter run.

To be sure, a cap-and-trade system or a carbon tax would raise the price of gasoline, encouraging consumers to drive less and to buy more fuel-efficient cars– but the magnitude of these effects would be relatively small. For example, CBO has estimated that a price of $28 per metric ton of CO2 in 2012 would lead to a reduction of about 10 percent in total U.S. emissions compared with a no-action scenario. Vehicle emissions, though, would remain relatively constant in the short run, and even over time they would decline only by around 2.5 percent — much less than the 10 percent reduction in overall emissions.

Several factors account for the relatively small influence that a price on CO2 emissions would have on passenger vehicles and driving behavior. First, a CO2 price of $28 per metric ton would raise gas prices by about 25 cents per gallon, far less of an increase than consumers have recently born with little behavioral result. (Between 2003 and 2007, gas prices increased from $1.50 to more than $3.00 per gallon. Vehicle miles driven, driving speeds, and the purchase of larger vehicles have all responded only modestly despite the dramatic increase in prices.) An increase in gas prices of 25 cents or so per gallon is unlikely to generate massive changes in driving behavior.

In addition, recent changes to corporate average fuel economy (CAFE) standards will require substantial gains in fuel economy over the next dozen years. Especially over the longer term, gas price increases are not likely to have a large effect beyond what CAFE standards will require.

Finally, cultural, historic, and geographic considerations drive the extent to which Americans have become dependent on automobile travel, and their choices tend towards larger and more powerful (and less fuel efficient) automobiles. While dramatic increases in gasoline prices (or shifts in cultural norms) might eventually influence these considerations, the magnitude of gas price increases under most legislation under consideration would likely have little effect.

"A Chance to Crack Down on Africa's Loot-Seeking Elites".

Paul Collier says the financial crisis presents a chance to stop looting in Africa:

A chance to crack down on Africa's loot-seeking elites, by Paul Collier, Comment is Free: ...A criminal can safely be put in charge of a fish-and-chip shop but not of a bank. The former has virtually no assets: if the criminal runs off with the day's fish he cannot retire to Bermuda. But a criminal banker can make a fortune if only he can loot the money that the bank has borrowed: the returns from criminality dwarf running the bank well.

In an ideal world the criminals would run fish-and-chip shops, where they could do no harm, and the honest would run the banks. But the market will allocate people in precisely the opposite way: the criminals will move heaven and earth to get into the banks... That is why vigilant public scrutiny is essential to prevent looting.

Vigilant public scrutiny is, of course, precisely what we have not had. In its absence the business model of our financial sector, while not literally criminal, has been to tap our wealth in its custody by shifting it into opaque assets for high fees. Manifestly, wealth-owners did not adequately understand what was going on. We had been lulled into misplaced trust by decades of regulation-enforced decent behaviour.

The regulation which had worked well enough was dismantled because of the recent mantra that finance is the engine of growth as long as it is given free rein. Hence Gordon Brown's emasculation of financial regulation in the UK and Alan Greenspan's era of neglect in the US. This mantra radically exaggerates the upside potential of finance. At best, the contribution of the financial sector to the growth of an economy is second order: it facilitates the creativity of other sectors. Only at its worst is finance first order: as we are now seeing, it can be catastrophic. ...

At last, we have a chance for change. Because the banks do well out of secrecy, to date they have successfully opposed proper scrutiny. ... But now that we have the banks on the run there is an opportunity to extend scrutiny, not only to help ourselves, but to help Africa.

The loot-seeking elites that control parts of Africa illicitly send capital out of the region to the tune of $20 to $28bn per year. ... Capital flight of this magnitude is roughly equivalent to the entire aid inflow to the region...

Money flows out of Africa into our banks, and into the offshore banks that depend for their existence upon being able to transact with our banks. US rules on banking transparency are even weaker than the European rules: vast sums looted from the public purse in Africa are being held in nominee accounts and moved around the world at greater speed than our cumbersome legal processes can track them down. ...

The silver lining in this grim cloud is that we have a ... chance to clean up the banks. Which takes me back to where I began. There is one thing that a dirty fish-and-chip shop and a dirty bank have in common: they both stink.

What Caused the Financial Crisis?.

More answers to this question:

• What caused the financial crisis? - Tyler Cowen
• How did it all happen? - Megan McArdle
• My Fantasy Testimony - Arnold Kling

[Others: Barry Ritholtz, Nick Rowe.]

"Fundamentalists versus Realists".

Paul Romer says some fundamentalists need to get real:

Fundamentalists versus Realists, by Paul Romer: Debate among economists about the $700 billion Paulson plan reveals a deep divide between realists and fundamentalists. ...

The formal, model-based approach of the fundamentalists has contributed much to progress in economic analysis. At key junctures, it has also made important contributions to policy. The challenge is to maintain an intellectual environment that leaves space for ... realists as well. In complicated policy contexts where models don't yet capture key forces, the realists have much to offer...

The key difference lies in the relative weight each side gives to formal models as opposed to judgment.

Fundamentalists have an unswerving faith in models. Policies should always be derived from the best available model. Data should be filtered through a model. If an observation does not fit within the context of a model, it should be excluded from consideration. Realists are more conscious of the limits of models and more comfortable with a division of labor between the researcher who improves the models and the clinician who makes policy decisions. They recognize that the power of models comes precisely from a commitment to abstraction that filters out potentially important complexity. They believe that useful evidence can accumulate with direct experience as well as through the research process of testing and refining models. They believe that researchers should consider the possibility that the fault lies with the model when its predictions diverge from clinical judgment and that policies should draw on both sources of evidence.

Many times, the confidence fundamentalists have had in abstract models turned out to be well founded and the objections raised by realists who were more focused on details were misplaced. The fundamentalists were right that an airline industry could still function even if airlines could set their own fares; that people could still talk to each other even if they purchased phone service from different companies. The realists pointed to all the complicated details that arise in such markets, details that simple models could not capture. Fundamentalists, correctly, ignored the detail and pushed prescriptions based on the textbook model of competition.

Other times, the models are missing something that is too important. In the study of macroeconomic fluctuations, real business cycle theorists and their descendants, the dynamic stochastic general equilibrium modelers, are the quintessential fundamentalists. Their models are a useful way to make research progress, but in macroeconomic policy making, the great depression, which these models cannot explain, is a decisive data point warning us that the models are incomplete and have to be supplemented by clinical judgment.

In the current crisis, the astonishing and unexpected consequences of the Lehman Brothers bankruptcy should serve as a similarly decisive data point. On the Thursday and Friday before Lehman filed for protection, I was at a conference on the financial crisis. Everyone there expected them to file on Monday. We repeated for each other all the fundamentalist arguments: "Everyone had been given time to prepare." "The courts handle bankruptcies all the time." None of us expected that putting Lehman through a court managed bankruptcy would be much different from arranging a forced sale of Bear Stearns. We were all wrong. Within days, AIG was insolvent. Runs were developing on Goldman Sachs, Morgan Stanley, and the entire money market fund industry. Banks had stopped lending to each other in the Fed Fund market. Rates on Treasuries approached zero.

In response, the Treasury, Fed, and market regulators took drastic steps that the fundamentalists would surely have opposed had there been time for debate. ... Looking back, it appears that they had enough sand bags to hold back the flood and stop the panic, but perhaps just barely enough. This is not a data point that can be dismissed as an outlier. It is the kind of observation that should make the fundamentalists just a bit less confident in their models and a bit more willing to listen to the realists who are willing to defer to the policy makers on the front lines. ...

Fed Watch: Where Is The Rate Cut?.

Tim Duy says the Fed may not cut the target interest rate at its next rate setting meeting:

Where Is The Rate Cut?, by Tim Duy: On the surface, the case for a rate cut seems obvious. But, despite an extraordinary and historic two weeks on Wall Street, Bernanke & Co. have failed to deliver. And perhaps the lack of action today, a day of panic in global equity markets, is telling us something about policy – don’t look for a rate cut, at least not yet. Maybe we should be listening.

If there is one thing the Fed has taught us in the last year, it is that they are inclined to meet periods of financial turbulence with a rate cut. Hence growing expectation for a rate cut, expectations that were only heightened by the string of data that confirmed for almost all remaining doubters that the US economy had slid into recession by at least the third quarter, if not much earlier. Last week’s employment and ISM reports for September appeared to seal the deal on that call.

Relatively dovish Fed-speak appeared to confirm these expectations. And if a rate cut was coming, why wait until the end of the month, especially when equity markets needed a boost of confidence? Yet no rate cut emerged. Instead, some Fed speakers have come out against a rate cut, such as St. Louis Fed PresidentJames Bullard and Richmond Fed PresidentJeffrey Lacker. To be sure, perhaps they are simply out of step with the Board. But perhaps the Fed has come to the conclusion that, at least for now, interest rates are not the problem, especially since, relative to the rate of decline in the real economy, the Fed is well ahead of where it would normally be at this point in the cycle.

It is arguable that rate cuts have done little to stem the tide of deleveraging that is ravaging the banking system. Indeed, despite a policy path that appears determined not to remake the Fed’s mistake during the 1930’s by taking rates down quickly and flooding the financial markets with liquidity, the crisis continues unabated, as if the more the Fed does, the more financial markets need done. To be sure, perhaps the situation would be worse if not for the Fed’s actions, but those actions failed to produce anything remotely near the quick fix I think was originally envisioned by Fed Chairman Ben Bernanke. Some even think the Fed is making the situationworse via their liquidity provisions, prolonging the lack of interbank lending by providing an escape valve. Why try to reduce counterparty risk when the Fed stands ready to be the riskless partner?

The lack of a rate cut at this juncture suggests the Fed is readying a new bag of tricks. They letus sneak a peek at that bag today, using the new powers granted by TARP to pay interest on deposits, thereby setting a lower bound on the Fed Funds rate that should nearly reduce the Fed’s need to sterilize their liquidity provisions via term auction facilities. At the same time, they extended the size of the TAF. These are clear efforts to fix broken credit channels, and this is likely the Fed’s focus, not interest rates.

But, as noted above, will an expansion of the existing liquidity provisions, or additional rate cuts, have any impact? Or are they simply more of already failed policies? The Fed is likely preparing for a significant new initiative,consistent with reports that the Fed, with the cooperation of Treasury, is preparing a program to purchase a broader class of assets than simply troubled mortgage backed securities.Outright purchases of commercial paper appears to be on the table – not surprising as the growing credit crunch in this market threatens working capital, the lifeblood of daily commerce.

Would outright purchases be inflationary? Here is where the Fed would believe that the ability to pay interest on deposits is important – short term interest rates cannot fall much below the Fed Funds rate, asany excess money would simply flow into reserves at the Fed. The ability to pay deposits should automatically sterilize any excess money creation. This might also explain why the Fed would be hesitant to cut rates at this point; policymakers would want to see if the new syst