Calling the Bottom of the Market

Benign Deflation in a New Keynesian Model

As readers of this blog know, I am a advocate of monetary policy adopting a more nuanced view of deflation. Currently, most observers view any deflationary pressures as something to be avoided at all costs. This conventional wisdom assumes all downward price level pressures are economically harmful and, thus, fails to distinguish between between aggregate demand-induced deflationary pressures and aggregate supply-induced deflationary pressures. As a result, central bankers are likely to add monetary stimulus during periods of rapid economic growth--for example, when a positive productivity shock increases aggregate supply--in the mistaken belief that the deflationary pressures indicate economic weakness. Such actions, in turn, can generate a boom-bust cycle in economic activity. As I have argued elsewhere (here, here, here), the Fed's easy money in 2003-2005 in one such example.

Given these views of mine, I was pleased to come across Niloufar Entekhabi's new article, "Technical Change, Wage and Price Dispersion, and the Optimal Rate of Inflation." In it, Entekhabi uses a standard New Keynesian model to find the optimal rate of inflation and it turns out to be negative. One innovation of the paper is that it incorporate non-zero long-run growth in the model. From his conclusion:

This paper shows that adding real growth to the New Keynesian models is a very important feature, missing from the studies of these models. Real growth brings the arguments of price deflation rate as an optimal policy back to the policy discussion. In this research, real growth is added to a simple New Keynesian model with both price and wage rigidities. In such an environment, the economy faces four types of distortions, due to the imperfect nature of markets and the staggered contracts. Then, the Pareto optimal level of output is no longer attainable. The optimal policy is considered as the optimal rate of inflation which the central bank should target to minimize the distortions in the economy. In our experiment and under a wide range of parameter values and calibrations, this rate reveals to be slightly negative and therefore, deflation is the optimal policy... The results favor the old view in the monetary policy literature that a slight level of deflation is optimal. These results are very useful for policy analysis and show the path for the future research.

I had been meaning to do something like this paper after the reading the other New Keynesian-type analysis that also finds benign deflation might be optimal. This other paper, though, finds benign deflation to be optimal in the terms of minimizing asset boom-bust cycles. In case you missed it, here is part of my post on that research:

Lawrence Christiano, Roberto Motto, and Massimo Rostagno have a new NBER working paper titled "Two Reasons Why Money and Credit May be Useful in Monetary Policy." I find this article interesting because one of the reasons the authors cite for taking money and credit seriously in monetary policy--as opposed to standard New Keynesian analysis that sees little role for money--is that focusing "narrowly on inflation [alone] may inadvertently contribute to welfare-reducing boom-bust cycles in real and financial variables." The authors show that if (1) there are positive productivity innovations and (2) monetary policy follows a standard Taylor rule that responds to deviations of inflation from its target then boom bust cycles in asset prices can be generated.

The authors explain that in "the equilibrium with the Taylor rule, the real wage falls, while efficiency dictates that it rise [following a productivity shock]. In effect, in the Taylor rule equilibrium the markets receive a signal that the cost of labor is low, and this is part of the reason that the economy expands so strongly. The ‘correct’ signal would be sent by a high real wage, and this could be accomplished by allowing the price level to fall. However, in the monetary policy regime governed by our Taylor rule this fall in the price level is not permitted to occur: any threatened fall in the price level is met by a proactive expansion in monetary policy."

In other words, these authors are arguing that by not allowing for benign deflation--deflation generated by productivity innovations--monetary authorities are generating too much liquidity and, in turn, fueling asset price boom-bust cycles.

I hope to see many more papers like these ones on the macroeconomic implications of benign deflation. I have a few related projects in the pipeline and I believe Josh Hendrickson does as well. Maybe George Selgin and the folks at the BIS--see William White's classic "Is Price Stability Enough?"--can also push some more papers out on this topic.

Forecasting Olympic Medals

In the spirit of the Olympic games, here are some links to articles about economists and their econometric models that are used to forecast a country's medal counts.

1. Using Economics to Predict Olympic Medal Standings

2. Want to Predict Olympic Champs?

3. Economists predict whether the host country will rule the Beijing Olympics

Two Paths for Housing Prices

Here are two studies that come to vastly different conclusions on future declines in home prices. First up is the study by Charles W. Calomiris, Stanley D. Longhofer and William Miles. Titled "Housing Turmoil", this study looks at the relationship between foreclosures and home prices. These authors find that,

[e]ven under an extreme worst-case scenario for foreclosures,... U.S. house prices just aren't going to fall by very much in the next two years. In our worst-case scenario, the average cumulative decline is about 5 percent, and only 12 states experience declines greater than 6 percent by the end of 2009.

They conclude that "declines in house prices are highly likely to remain small.... [A]s foreclosures continue to climb in many states, house prices will remain flat or decline in those states -- but will not collapse."

Next up is Vladimir Klyuev in his study "What Goes Up Must Come? House Price Dynamics in the United States." He finds the following:

In the last few years, home prices had risen to unsustainable levels and then started to decline. In this paper we use a variety of techniques to assess the current extent of overvaluation. We put the most stock in the estimate based on a cointegrating relationship between the price-rent ratio and the real interest rate, which is quite robust to the choice of the sample period. According to these estimates, home prices were undervalued in the 1990s, but overshot equilibrium in 2000 and remain overvalued despite recent declines. In our best judgment, single-family home prices as measured by the OFHEO purchase-only index were around 14 percent above equilibrium in the first quarter of 2008, with a plausible range of 8 to 20 percent.

In other words, home prices may still have some ways to go. So which study is right? I find the latter study more reasonable, but I may be--and hope I am--wrong. Today's NY Times story on bigger waves of upcoming mortgage defaults from Alt-A and Prime mortgage (i.e. the good and supposedly safer mortgages) only seems to confirm Klyuev's finding. Thankfully, Arnold Kling , helps puts this housing debacle into a long-run perspective that is not so dour.

More Bail Ins, Less Bail Outs

Here is part of the Barron's interview with Roubini mentioned in the previous post. In this excerpt Roubini discusses how the government bailout of Wall Street should have had more bailing in of the creditors and investors. This approach would prevent systematic failure of the financial system without socializing the losses of Wall Street.

...How do you think Federal Reserve Chairman Ben Bernanke has handled the crisis so far?

The Fed's performance has been poor. More than a year ago the Fed said the housing slump would end, but it hasn't. They kept repeating this was a subprime-debt problem only, whereas the problems of excessive credit involve subprime, near-prime, prime, commercial real estate, credit cards, auto loans, student loans, home-equity loans, leveraged loans, muni bonds, corporate loans -- you name it.

The Fed's other mistake was to believe the collapse of the housing market would have no effect on the rest of the economy, when housing accounted for a third of all job creation in the past few years. When the proverbial stuff started to hit the fan last summer, the Fed went into aggressive-easing mode. But it has always been kind of catching up.

What should Bernanke have done a year ago, or even prior to that?

The damage was done earlier, beginning when the Greenspan Fed lowered interest rates in 2001 after the bust of the technology bubble, and kept them too low for too long. They kept cutting the federal funds rate all the way to 1% through 2004, and then raised it gradually instead of quickly. This fed the credit and housing bubble.

Also, the Fed and other regulators took a reckless approach to regulating the financial sector. It was the laissez-faire approach of the Bush administration, and (tantamount to) self-regulation, which really means no regulation and a lack of market discipline. The banks' and brokers' risk-management models didn't make sense because no one listens to the risk managers in good times. As Chuck Prince (the deposed CEO of Citigroup) said, 'when the music plays you have to dance.'

Now the regulators are attempting to make up for lost time. What do you think of their efforts?

The paradox is they're going to the opposite pole. They are overregulating, bailing out troubled participants and intervening in every market. The Securities and Exchange Commission has accused others of trying to manipulate stocks, but the government itself is now the manipulator. The regulators should investigate themselves for bailing out Fannie Mae (FNM) and Freddie Mac (FRE), the creditors of Bear Stearns and the financial system with new lending facilities. They have swapped U.S. Treasury bonds for toxic securities. It is privatizing the gains and profits, and socializing the losses, as usual. This is socialism for Wall Street and the rich.

So the government should have let Bear Stearns fail, not to mention Fannie and Freddie?

If you let Bear Stearns fail you can have a run on the entire banking system. But there are ways to manage Bear or Fannie and Freddie in a fairer way. If public money is to be put at stake, first all the shareholders of these companies have to be wiped out. Management has to be wiped out, and the creditors of Bear should have taken a hit. Why did the Fed buy $29 billion of the most toxic securities, and essentially bail out JPMorgan Chase (JPM), which bought Bear Stearns?

Because JPMorgan was a counter-party?

Exactly. The government bailed out everyone. Even the unsecured creditors of Fannie and Freddie should have taken a hit. Sometimes it is necessary to use public money to rescue institutions, but you do it in a way in which you're not bailing out those who made the mistakes. In each one of these episodes the government bailed out the shareholders, the bondholders and to some degree, management.

Nouriel Roubini: The Prophet Jeremiah or Joseph in Egypt?

A few weeks ago I wrote the following:

It is worth noting that Nouriel Roubini predicted Fannie and Freddie's collapse back in August 2006. If you are curious as to how the rest of this financial crisis will unfold, take a look at Nouriel's 12 steps to financial disaster. Let me add Nouriel to my list of certified economic prophets.

Now Robin Goldwyn Blumenthal at Barrons makes a similar comparison:

LIKE THE EXHORTATIONS OF JEREMIAH TO THE NATION OF Israel before the first temple's destruction, the warnings of economist Nouriel Roubini fell on deaf ears. For the past two years Roubini, a professor at New York University, has cautioned about a huge housing bubble whose bursting would lead to a 20% drop in home prices; a collapse in subprime mortgages; a severe banking crisis and credit crunch; the near-failure of Fannie Mae and Freddie Mac, and a U.S. recession of a magnitude not seen since the Great Depression. So far, this latter-day prophet of doom has been on the mark, though time will tell about the recession part.

I love the prophet Jeremiah analogy. I wonder, though, if the Biblical character Joseph would be a better comparison for Roubini. After all, both were taken from their home lands (Canaan, Turkey/Italy) , educated in at the finest centers of learning of their time (Egypt, Harvard), and warned that the good economic times would be followed economic bust (7 years of abundance-7 years of famine, 4 years of housing boom, 2 -3 years of housing bust and residual fallout). Joseph, of course, was better at calling the turning point and had a longer forecast horizon, but I think he still makes a better comparison than Jeremiah. What do you think?

The "Great Moderation" at the State Level

Michael Owyang, Jeremy Piger, and Howard Wall have a paper that takes a fresh look at the "Great Moderation", the reduction in aggregate macroeconomic volatility since the early 1980s. This Great Moderation has received a lot of attention--including from this blog(here and here)--with a lot of it directed to explaining why the volatility has declined . These authors make a novel contribution to this literature by looking at this issue from the state level. Their paper, titled "A State-Level Analysis of the Great Moderation", points to better monetary policy as a key factor behind the reduced macroeconomic volatility. Here are the authors in their own words:

This paper documented the Great Moderation at the state level and found significant heterogeneity in the timing and magnitude of states’ structural breaks. Specifically, we found that 38 states experienced a structural break and that 14 states had breaks that occurred at least three years before or after the aggregate break, which we place at September 1984. The states for which we found weak or little evidence of a break tended to be along the Atlantic coast.

Typically, when macroeconomists are looking for explanations for the Great Moderation, they have only the single aggregate occurrence with which to work. As a result, severalhypotheses have gained support on the basis of temporal coincidence between various events or trends and this single volatility reduction. Unfortunately for this approach, however, a surfeit of events occurred alongside the Great Moderation, so it is difficult to sort out the many theoretically plausible explanations. Our set of state-level great moderations might, therefore, be useful in sorting through the various hypotheses.

Of the five main hypotheses that have been put forth, our results suggest that four of them—the inventory, good-luck, banking deregulation, and demography hypotheses—are implausible because they are statistically inconsistent with the state-level pattern of structural breaks. On the other hand, we found that the monetary hypothesis remains a plausible explanation of the Great Moderation in that it is not inconsistent with the state-level experience.

You can read the rest of their paper here.