News Headlines and the CBO Report on the Minimum Wage

Two weeks ago the CBO released their report analyzing the effects of raising the federal minimum wage to either $9.00 per hour or $10.10 per hour (you can read the report here). In short the results were mixed. Looking specifically at the increase to $10.10 per hour they found job losses to be approximately 500,000 (or about 0.3% of our total level of employment) with a 2/3 probability job loss will lie between slight decrease to a decrease of one million. On the flip side they found incomes for families below the poverty threshold would increase by $5 billion. Incomes would increase by $12 billion for family with income from one to three times the poverty threshold and another $2 billion for families with income four to six times the poverty threshold. Incomes will decline by $17 billion for families with income greater than six times the poverty threshold (you can see the poverty threshold here).  On the net real income in the economy would increase by $2 billion (or 0.022% of total wage income).  In regards to the increase to $9 per hour the net effects would be 100,000 jobs lost and a net increase of $1 billion in real income.

So the conclusion is not much of a conclusion. Increasing the minimum wage involves a tradeoff (a small one at that) do we sacrifice 500,000 jobs for a net increase of $2 billion in real income? Is it better to have more jobs or fewer, better paying jobs? Either way this provides further evidence that an increase in the minimum wage is not the answer to combat the rising levels of income inequality. The benefits of a higher minimum wages are far lower than those touted by liberals. But the costs are also significantly lower than those proclaimed by conservatives. Of course, neither party wants to admit that they are exaggerating the truth.

I did a google search on the phrase: CBO report on higher minimum wages, and was interested to see the message espoused by news organization. Here are screen shots of the headlines in order of conservative, liberal, and neutral:

Conservative commentary (I focused on articles that emphasized the negatives, i.e. job losses)

Liberal Commentary (I focused mainly on articles that emphasized the positives, i.e. income growth)

Neutral Commentary 

Most mainstream new organizations reported relatively neutral headlines. I did not read each and every article and cannot comment on the content within each article. For the most part Fox News (perhaps most surprising), NY Times, CNN, WSJ, Washington Post, PBS, and Al Jazeera used neutral headlines. Whereas CNBC, FoxBusiness, Christian Science Monitor, News Max, NY Daily, Washington Times, The Hill, and Barrons lead with more conservative leaning headlines. Those with more liberal headlines were Huffington Post, Fiscal Times, NPR, and Politico.

Did Reinhart and Rogoff Get it Wrong?

Mike Konczal at the Next New Deal provides a thorough review of the work by Thomas Herndon, Michael Ash, and Robert Pollen, "Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff."

For a thorough review of the arguments you can turn to Mark Thoma or Tyler Cowen. If the RR paper were the only paper that showed a substantial slowdown in growth resulting from excessive levels of government debt, then yes, this a very concerning result. We should never place a large emphasis on one result. Fortunately, we didn't. The RR paper motivated a large literature and their results were found to be largely true by a number of other authors. Here are two key papers:

"The Real Effects of Debt" by Cecchetti, Mohanty, and Zampolli:

At moderate levels, debt improves welfare and enhances growth. But high levels can be damaging. When does debt go from good to bad? We address this question using a new dataset that includes the level of government, non-financial corporate and household debt in 18 OECD countries from 1980 to 2010. Our results support the view that, beyond a certain level, debt is a drag on growth. For government debt, the threshold is around 85% of GDP. The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems. The longer-term lesson is that, to build the fiscal buffer required to address extraordinary events, governments should keep debt well below the estimated thresholds. Our examination of other types of debt yields similar conclusions. When corporate debt goes beyond 90% of GDP, it becomes a drag on growth. And for household debt, we report a threshold around 85% of GDP, although the impact is very imprecisely estimated. 

"The Impact of High and Growing Government Debt on Economic Growth. An Empirical Investigation for the Euro Area" by Checherita and Rother
(Here is a similar published version)

This paper investigates the average impact of government debt on per-capita GDP growth in twelve euro area countries over a period of about 40 years starting in 1970. It finds a non-linear impact of debt on growth with a turning point—beyond which the government debt-to-GDP ratio has a deleterious impact on long-term growth—at about 90-100% of GDP. Confidence intervals for the debt turning point suggest that the negative growth effect of high debt may start already from levels of around 70-80% of GDP, which calls for even more prudent indebtedness policies. At the same time, there is evidence that the annual change of the public debt ratio and the budget deficit-to-GDP ratio are negatively and linearly associated with per-capita GDP growth. The channels through which government debt (level or change) is found to have an impact on the economic growth rate are: (i) private saving; (ii) public investment; (iii) total factor productivity (TFP) and (iv) sovereign long-term nominal and real interest rates. From a policy perspective, the results provide additional arguments for debt reduction to support longer-term economic growth prospects.

These are two papers that come to mind that show supporting evidence in favor of the RR results.  There are also papers that don't necessary support the RR hypothesis. Here is one that comes to mind are:

"Public Debt and Economic Growth. Is There a Casual Effect." by Panizza and Presbitero

This paper uses an instrumental variable approach to study whether public debt has a causal effect on economic growth in a sample of OECD countries. The results are consistent with the existing literature that has found a negative correlation between debt and growth. However, the link between debt and growth disappears once we instrument debt with a variable that captures valuation effects brought about by the interaction between foreign currency debt and exchange rate volatility. We conduct a battery of robustness tests and show that our results are not affected by weak instrument problems and are robust to relaxing our exclusion restriction. 

The mistakes made in the Reinhart-Rogoff paper are concerning, but that find does not dismiss the results found by many other authors.

Reinhart-Rogoff Effect

Carmen Reinhart has quickly become the top economist for understanding financial crises. Carmen is the most cited female economist. Lately she has focused her attention on the recovery following a financial crisis and economic growth in a period of debt (paper 1 and 2).

Today, she finds herself thrown into the political debate for her views on an economic recovery following a major financial disruption.

Rutgers University economic historian Michael Bordo and Cleveland Fed economist Joseph Haubrich studied just U.S. recessions going back to 1882 and found that U.S. recoveries following financial shocks tend to be rapid. Top economic advisers to Republican Mitt Romney have leaned on this research to argue that the culprit in the current slow recovery is Mr. Obama himself, not the financial crisis that preceded him. This line of research has taken issue with the Reinhart and Rogoff studies, arguing, among other things, that U.S. crises can’t be likened to financial crises that have happened elsewhere in the world — such as small developing markets – because their economic institutions are so different.

When Barack Obama first took office he promised a quick recovery. We had just went through the largest financial disruption in over eighty years. Quick was not going to happen. Reinhart and Rogoff said so. In December of 2008 they posted, "The Aftermath of Financial Crises," in which they showed for major financial crises unemployment will remain above 7% for nearly five years. Why did Obama think this time would be different. It wouldn't be. Have we not learned anything?

Now Reinhart and Rogoff are firing back. In a short paper they released this weekend, they fire back at the Bordo work. They see several flaws. One of their main arguments is that the Bordo work includes borderline financial shocks which weren’t full blown crises. Reinhart and Rogoff argue that if the paper focused on the four full blown U.S. crises of the past 150 years – in 1873, 1893, 1907 and the 1930s – they would get results similar to the broad swath of international crises the Harvard professors examined.

Four years ago, I was using Reinhart and Rogoff's view to criticize Obama's policy views. He made a mistake by telling the American people the recovery would be swift. Unfortunately, he was wrong. Should we be surprised? No, it did not matter what the president did in office or who we elected. After a financial crisis it takes a tremendous amount of time for capital markets to liquidate bad assets, home and stock prices to stabilize, and government debt to come under control.

Here we are, five years after the collapse of the housing market. What have we learned? Reinhart and Rogoff were correct once again.

Secondly, we assess how has the US has fared, so far, compared to other advanced economies countries that experienced systemic financial crises in 2007-2008 as well other advanced economies that experienced borderline episodes. Focusing on real per capita GDP, we show (i) the recent crises patterns confirm our earlier result that the countries that recently suffered systemic financial crises have generally fared quite poorly compared to countries where the financial problem was less severe, that is, borderline, and (ii) although tracking worse than the countries that did not have systemic financial crises, the United States output performance is, in fact, among the best of those that did.

For more information, Rogoff did an interview here.

Ezra Klein has a nice write up here.

Comparing Household Survey with Payroll Numbers

A quick addition to the last post. One of the concerns was the large difference between the payroll numbers (114,000) and household survey numbers (873,000) (for a detailed definition check here). I am simply going to point out that the difference is not that big comparing to previous periods. Here is a graph showing the difference in the month-to-month change in the employment data where I have taken the difference between the household survey data and the payroll data.

As expected, the graph still shows a lot of noise and in absolute terms 2012 does not appear to be an anomaly. 

Month	Difference in Housing Survey and Payroll
2000-01-01	1788.00000
1960-04-01	932.00000
1948-04-01	931.00000
1990-01-01	913.00000
2003-01-01	896.00000
2002-02-01	883.00000
2001-09-01	848.00000
2012-09-01	759.00000
1954-02-01	725.00000
1983-08-01	708.00000
1991-04-01	669.00000
1953-01-01	665.00000
1960-11-01	659.00000
1948-06-01	652.00000
2002-09-01	652.00000
1970-10-01	617.00000
1983-06-01	613.00000
1956-07-01	609.00000

BLS Numbers

All of the talk today has been over the recent unemployment numbers. The unemployment rate fell from 8.1% to 7.8% and employment increased by 873,000. With these numbers came the conspiracies (google Jack Welch). Without going into a lot of details about the conspiracies, I'm going to post two graphs that will hopefully end this debate. Here is the first graph that simply compares month-to-month change in employment reported by the household survey. 

First thing one is likely to notice is the considerable noise in the data. The next thing you will likely notice is the spike that occurred in January of 2000. During this month the economy added 2 million jobs. In fact you will likely notice that April of 1960 and January of 1990 also included large spikes in employment. In 2012 there were two employment spikes, the first in February (went largely unnoticed) and then in September. The economy added 847,000 and 873,000 jobs, respectively. These number also compared to those posted in 1983. In June of 1983 the economy added 991,000 jobs and the May of 1984 added another 857,000. Both 2012 and 1983-4 are very similar in that they follow large periods of declines in the employment numbers. 

Here is a table showing the months with the most change in employment levels:

Month	Change in Employment
2000-01-01	2036
1960-04-01	1286
1990-01-01	1251
1983-06-01	991
2003-01-01	991
1948-06-01	889
2012-09-01	873
1984-05-01	857
1950-04-01	855
2012-01-01	847
1959-12-01	811
1950-08-01	796
1973-02-01	751

In the second graph, we are simply looking at the percent change in the employment numbers relative to the previous month. Here we see that the two months in 2012 saw employment increase by a little more than 0.6%. Relative to history, there are 48 months in the last 65 years that had a faster growth in the employment numbers. Compared to 1983 these numbers are considerably lower. In 1983-4 the two months added employment at rates of 0.82% and 1%. Conspiracy? Doubtful.

                          

Month	% Change in Employment
1960-04-01	1.988465047
1948-06-01	1.536626681
2000-01-01	1.513495833
1950-04-01	1.481083703
1950-08-01	1.349129676
1949-11-01	1.292147584
1959-12-01	1.256779792
1951-03-01	1.240341261
1952-09-01	1.222612477
1955-07-01	1.184830288
1951-12-01	1.104686142
1948-04-01	1.075063724
1954-02-01	1.06457417
1990-01-01	1.061699058
1953-01-01	1.059815599
1955-01-01	1.059618072
1952-11-01	1.024412958
1983-06-01	0.994560527
1957-02-01	0.982210209
1959-03-01	0.915457572
1955-04-01	0.903812086
1973-02-01	0.903067544
1951-07-01	0.899027172
1964-04-01	0.862382386
1976-01-01	0.848093233
1961-06-01	0.831181531
1984-05-01	0.821384757
1959-04-01	0.779560272
1977-11-01	0.761939561
1962-08-01	0.729509799
1960-11-01	0.72677962
2003-01-01	0.726401126
1968-05-01	0.722594989
1954-09-01	0.716756052
1953-06-01	0.716170373
1968-02-01	0.708165997
1971-07-01	0.695811166
1950-06-01	0.687138741
1969-02-01	0.679643252
1983-11-01	0.676212037
1955-12-01	0.675024108
1978-04-01	0.674370746
1962-02-01	0.650450778
1973-03-01	0.643531319
1973-06-01	0.634391834
1975-07-01	0.631480288
1964-02-01	0.620545319
1986-01-01	0.620056184
2012-09-01	0.614351764
1965-07-01	0.612460401
1972-01-01	0.606429645
1969-06-01	0.604557433
1984-02-01	0.603676321
1967-04-01	0.603221721
2012-01-01	0.601605228

The Importance of Central Bank Credibility

As much as a tend to shy away from posts made by Krugman (he is too political for me), he hits the nail on the head here. Monetary policy works best when the public believes the Fed's credibility and they are committed to maintaining stable inflation. The Fed needs the public to trust them. Given the current state of politics in the Congress, we need monetary policy more than ever. The constant Fed bashing by the Republicans is not helping. There have been a number of examples where Mitt Romney has gone out of his way to bash the Fed. It is one thing to bash the Fed using credible numbers. It is another to bash the Fed with blatant lies. In the secret video that was released, there was a part where Romney discussed recent treasury purchases by the Fed.  Here is what Romney said:

 [A]s soon as the Fed stops buying all the debt that we’re issuing—which they’ve been doing, the Fed’s buying like three-quarters of the debt that America issues. He said, once that’s over, he said we’re going to have a failed Treasury auction, interest rates are going to have to go up. We’re living in this borrowed fantasy world, where the government keeps on borrowing money.

Without question, if the Fed were buying three-quarters of debt that America issues we would be in serious trouble. So good thing they are not. Here is graphing showing the amount of government debt held by the public, the amount of government debt held by the Fed, and the ratio of the two.

 

As we can see in the red line (ratio of debt held by the Fed to total public debt) the most the Fed has ever held is a little more than 60%. This happen at one point back in the middle of 2011 following the announcement of operation twist (it was entirely expected). When Romney gave his talk, the Fed was only purchasing 20% of the government issued debt. As of today we can see the Fed is currently no longer purchasing government debt. 

Again, the issue here is that there are a number of people who believe Romney when he states, "Fed’s buying like three-quarters of the debt that America issues," it is simply incorrect. He later predicts we would have a failed treasury auction once they stop by debt. Well, we are waiting.

Ben Bernanke's Jackson Hole speech could be a letdown - Aug. 22, 2012

The Fed can do a lot to help the economy, but they can only do so much. With the uncertainty in Washington the Fed is rather limited. More than anything we need Congress to pass policies that last more than 1-year. We have the Bush tax cuts and payroll tax cuts expiring at the end of the year.  There is further uncertainty over changes in the tax system. 

Investors and economists agree: No QE3 - Aug. 26, 2012

Will the Fed announce QE3. My guess, they will do it in November.

http://money.cnn.com/2012/08/26/news/economy/federal-reserve-qe3/index.html?source=cnn_bin

7 Majors That Can Put You in the Top 1% of Earners

http://www.usnewsuniversitydirectory.com/articles/7-majors-that-can-put-you-in-the-top-1-of-earners_12174.aspx

Paul Ryan’s imaginary expertise - Daily News

http://m.nydailynews.com/1.1137112

Political economics: The Fed on the ballot | The Economist

Interesting arguments for why QE3 will be launched this September. Regardless of the election cycle, I suspect QE3 will come in September following big fed meetings in Jackson Hole and the next FOMC meeting.


http://www.economist.com/blogs/freeexchange/2012/08/political-economics-0?fsrc=scn/fb/wl/bl/fedbontheballot

This Time is Different, Really?

Post Crisis Growth

Here is image from Reinhart and Rogoff. In terms of the US crisis, what should we expect in terms of growth?

Monetary policy: See no evil | The Economist

http://www.economist.com/blogs/freeexchange/2012/08/monetary-policy?fsrc=scn/fb/wl/bl/seenoevil

FOMC Policy Statement

The Federal Reserve's policy statement has been released. Here is the interesting stuff that carried over from June:

The Committee also decided to continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.

Read over this statement and compare it with the last statement. You will notice paragraphs two and three have remained unchanged.

From June: Information received since the Federal Open Market Committee met in April suggests that the economy has been expanding moderately this year.

From August: Information received since the Federal Open Market Committee met in June suggests that economic activity decelerated somewhat over the first half of this year.

Overall, not a whole lot was done. They left the door open for more policy down the road. It will be interesting to see if the Fed does anything prior to the election. They have a big conference in Jackson Hole, Wyoming in the end of August. Last year they announced operation twist in September following this meeting. Here is a list of what can be done.

Monetary Policy Today

I think this is a very good proposal. Here's why:

Right now interest rates on a 30-year mortgage are around 3.25%. Now, I purchased a home in April of 2009 and our interest rate was 4.625. Last October, we refinanced and took out a 20-year mortgage at 3.75%. We refinanced after the announcement of QE1 and operation twist. I follow the markets fairly closely and both times felt confident that interest rates would not, could not go lower. Fast forward less than a year and interest rates have dropped again. I could take out a 20-year (or 30-year) mortgage today at 3.25%. Again, I find myself asking, are rates going to be lower. Is it worth the hassle of doing another refinance. What if rates go down again?  What if my appraisal comes in much lower than previously?

Now if I know interest rates are going to stay at 2.5% for the next year the uncertainty is removed and further it will help spur home sales. I can take my time with my refinance, get my paper work together, and not worry about a low appraisal.

Now, does it make a difference?  Suppose you were looking at financing a home and needed to borrow $300,000 under a 30-year note here are your payments:

4.625% .....$1542.42
3.75%........$1389.25
3.25%........$1305.62
2.50%........$1185.36

As you can see, the payments drop significantly, anyone else think that would be a huge boost to the economy? One, side note. A number of people are unable to refinance because they are underwater or have lost a considerable amount of equity. If you do not have 20% equity you must pay mortgage insurance. That could add an additional $100-150 per month to your mortgage. The government needs to change this. If someone has been a good borrower and not missed a payment over a significant period (3+ years), they should not be required to have mortgage insurance. The government should accept this risk, its the least they can do to homeowners.

Audit the Fed

As always, Ron Paul wants to audit the Fed. Here is an overview of his bill. This article sums up my views nicely. Ron Paul wants the Federal Reserve to disclose all of their loans to banks through the discount window. Given our recent discussion on adverse selection what would happen if the Fed had to publicly announce who was borrowing from the Fed and selling securities through the open market operations?

Break Up the Big Banks

One of the men responsible for the creation of banks too big to fail, now wants to break them up.

To me, the issue is not about breaking up the larger banks. These banks are going to all be technologically advanced and very difficult to breakup, let alone regulate. The issue is about the 6,200 banks that cannot compete electronically and the subsection of these banks that are still facing issues of solvency.

Bernanke's Classic Paper

I have everyone read Ben Bernanke's paper: Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression.  It is a great paper explaining why the Great Depression lasted as long as it did.


Here are my slides that I typically go over in class. 

Too Big to Fail

The problem is that if a bank thinks it is too big to be allowed to fail, it has an incentive to take on a lot of risk, confident that the government will have its back if it gets into trouble.

I'm interested in hearing your thoughts on financial institutions are are deemed too big to fail. On my page there is a link to the Minneapolis Fed. They have taken the lead on analyzing too big to fail.

Does Dodd-Frank do enough to curb too big to fail.

Here are some readings/videos:
Economist - The Dodd Frank act: Too big not to fail
NY Times - Telling Strength from Weakness
St. Louis Fed president wants them broken up.
Sheila Bair on TBTF

Goldman's Shady Business Dealings

Why off balance sheet activities need to be on balance sheet activities. Goldman Sachs was selling CDO's to investors, while at the same time telling top clients and investors to purchase credit default swaps against the very same securities they were selling. That is wrong!

The wiki post does a nice job summarizing everything:

The complaint states that Paulson made a $1 billion profit from the short investments, while purchasers of the materials lost the same amount. The two main investors who lost money were ABN Amro and IKB Deutsche Industriebank. IKB lost $150,000,000 within months on the purchase. ABN Amro lost $840,909,090. Goldman stated the firm also lost $90 million and did not structure a portfolio that was designed to lose money. After the SEC announced the suit during the April 16, 2010 trading day, Goldman's Sachs's stock fell 13% to close at 160.70 from 184.27 on volume of over 102,000,000 shares (vs. a 52 week average of 13,000,000 shares). The firm's shares lost $10 billion in market value during the trading session. On April 30, 2010, shares tumbled further on news that the Manhattan office of the US Attorney General launched a criminal probe into Goldman Sachs, sending the stock down more than 15 points, or nearly ten percent to $145.

More on Capital Requirements

This is going to be a running post on articles talking about the need for bank capital.

I will also be posting articles under the arguments for and against a strict bank capital requirement. Like any policy we need to understand the costs and benefits of added bank capital. The costs are reduced lending, the benefits are a reduced likelihood of a financial crisis. Here are the results from the Basel panel.

Here is recent article from the WSJ talking about recent moves toward more bank capital. Of course Citi Bank does not like the requirements.

Here is the first article from The Economist. This article talks about increased bank capital during the onset of the financial crisis.  How much capital is enough?

The Basel Accord has been an attempt to standardize bank capital requirements across countries. Here is an article talking about Basel III.

A panel discusses the effects of bank capital requirements on economic growth. The pros are simple, more capital reduces the likelihood of a bank become insolvent due to large loan write downs. The costs are simple, the more capital reduces the return on equity for bank owners.

I'm in favor of strict capital requirements for all bank-like institutions. I believe the financial system in a large way acts as a public good. Because of the problems posed by banks failing to fully account for the costs of risky behavior (yes, largely created by the types of regulations we currently have) large banks do not recognize the costs to society. I view capital requirements as an easy but highly effectively way of minimizing regulations while allowing banks to serve society (i.e. channeling funds from borrowers to savers). I like these requirements mainly because banks still have a choice for the types of assets they want to hold. If banks want to undertake in subprime lending they can, but it needs to be supported by added capital. Will this slow down growth, probably in the short run, but in the long run it will lead to fewer financial crises. Given the recent number of crisis that could have been avoid if banks were holding adequately capital, I view the long run benefits as a necessary.

Capital Requirements

I am a big proponent of increasing capital requirements (especially on banks that are deemed too big to fail). The World Bank produced a nice report summarizing capital requirements and leverage during the mid-2000s.  Here is a discussion in the Economist about capital requirements.

My preference for capital requirements would that they are increasing with the overall size of the balance sheet, riskiness of the assets held, and the greater the level of interest rate risk.

Here is a good article from the Economist supporting capital requirements:

Two numbers stand out. First, the short-term cost of tougher rules is fairly low: assuming a three-percentage-point increase in capital ratios and a four-year implementation period, absolute GDP would be just 0.6% lower than it would otherwise have been. Second, and offsetting the first effect, once the new rules are in place the benefits from having fewer crises are big. In a base case and assuming a three-percentage-point capital-ratio increase, the absolute level of GDP rises by some 1.7%.

Over the last three years there has been tremendous attention into financial reform. A major theme in our class will be discussing the role financial markets play in the economy and how to go about regulating these markets. Recently the US passed the Dodd-Frank bill which attempts to prevent future financial crises. Unfortunately, one area the bill fails to address is the need for bank capital requirements. Before getting into the gory details it may help to provide a brief side note on the role of bank capital.

Like any firm banks have assets and liabilities. Asset include loans made to households and business and government bonds. Liabilities include demand deposits (checking accounts) IRAs, and CDs, basically our accounts with banks. Bank capital is the difference between assets and liabilities. It shows up on the liabilities side of the balance sheet.

Banks prefer to not hold excess capital, they would prefer to pass the capital onto the owners in the form of equity or use the funds to create more loans. Nonetheless capital helps banks insurance against large loan losses. Remember loans (notably housing and commercial loans) appear on the asset side of the balance sheet, when banks experience large loan losses the asset side of the balance sheet decreases. If loan losses are large enough bank assets could become less than liabilities making the bank insolvent (i.e. the bank fails). Now because bank capital is a liability it helps offset loan losses.

Suppose you have two banks (A and B). Bank A has $100 million in capital and Bank B has $25 million. Each bank experiences large loan losses and writes down their assets by $50 million. Bank A will be left with $50 million in capital but Bank B will be insolvent with a net worth of -$25 million. If we go back 2 years, banks that failed lacked sufficient capital to insure against large loan losses.

Jump ahead to today and we still have not solved the bank capital requirements. Wall Street has argued against capital requirements, forcing banks into holding added capital will sufficiently hamper lending. I firmly believe we need to institution capital requirements based on three components:
1) The size of a bank's balance sheet. If mega banks pose added risk to the economy we need to force them into holding more capital.
2) The composition of a bank's assets. If banks want to hold riskier assets (i.e. subprime mortgages) we need to require greater capital requirements.
3) The composition of a bank's liabilities. If a bank has liquid liabilities (i.e. dependent on short-term financing) they are more prone to experience a bank run and a loss of funding, holding greater levels of capital will temper this threat.

The basis for my argument comes from the last 20 years of banking crises. We have seen large financial crises occur in Asian, Latin America, Scandinavia, and now the United States. In nearly every case banks did not hold sufficient amounts of capital. The solution to our financial crisis was to inject major banks with added capital (remember TARP). If banks were holding sufficient capital we could have prevented needing to bailout nearly every large bank.

Of course there was a fear of a large slowdown in global growth. Well, it turns out the costs of financial crises trumps the reduction in growth from a slowdown in banking lending. Banks would be forced into more due diligence when issuing loans and likely choose safer investments.

Is the EMH hypotheis to blame?

You decide. Here are some readings on the topic:

Ray Ball at University of Chicago
Siegel at University of Pennsylvania
Krugman

So who's right?

Bernie Madoff

On of the new chapters in the 6th edition of Kindleberger discusses Bernie Madoff. Fully admitting I still need to read this chapter (as I have the 5th edition), I am posting a Frontline video that discusses Bernie Madoff.

Watch The Madoff Affair on PBS. See more from FRONTLINE.

Yield Curve Explained

Mark Thoma offers one of the best explanations for the recent movements in the yield curve.

Global Savings Glut

There has been many attempts to try and explain the financial crisis. In my eyes there were no less than a dozen factors that contributed to housing bubble, housing collapse, and financial meltdown. A bubble is a lot like a forest fire that gets out of control. You need fuel (usually not one or two trees but a forest filled with overgrowth), you need the spark to ignite the fire (lightening). Finally, you need an accelerant (high winds).

In the case of the housing bubble the fuel was provided by decades of poor regulation and deregulation (alone each case is fine). For example, during the 90's we had a campaign to make everyone a homeowner (great idea, bad when we used subprime loans to do this). Toward the end of the decade we had Gramm-Leach-Bliley (more on this in later chapters) that removed the separation between commercial and investment banks (fine if commercial banks were stocked full of subprime mortgages desperately need buyers, enter investment banks).

The spark was a large amount of money flowing out of the stock market into the housing market. Domestic investors needed a home for their money after the collapse of the dot.com bubble.

Finally, you need the accelerator. Domestic money was not sufficient to sustain the low interest rates homeowners craved. If there were only a way to attract foreign money (enter China, OPEC, Europe, Banking centers). Here we have the global savings glut.  The inflow of cheap foreign capital prevented long-term interest rates from rising giving us the accelerant needed to sustain and prop up our housing bubble.

Just an interesting article

This was on CNN today. Thought it was interesting given this is a money and banking class.

Why I'm making you read Kindleberger:

I have the 5th edition (copyright 2005). Here is the quote on the cover:

I have been having my students read this book since 2005. Unfortunately, it was not because I thought we were headed into a potential Great Depression like crisis, but because I have a passion for understanding financial crises. 

Minsky Moment

Early in Kindleberger he elabortates on Hyman Minsky's theory of financial instability. In what was does Minsky's theory fit with the current financial crisis. Here is a Fed speech by Janet Yellen that may help. Sadly, following the financial crisis, economists quickly realized the literature was rather dated and economic research for the last 30 years left us helpless in understanding the crisis. We turned to work by Minsky.

Monetary Policy, Money, and Inflation

One of the challenges teaching this course is finding ways to incorporate (and sort through) the wealth of articles that are being published related to money, banking, and financial markets. Here is a nice article by John Williams (President of the FRBSF) discussing the relationship between monetary policy, money, and inflation (see chapter 3). Pay particular attention to the discussion on paying interest on bank reserves and the incentives for banks to lend out excess reserves.

Where did the ethics go on Wall Street.

It is disturbing that 26% of bankers will admit to behaving unethically if it makes them better off. This is also the number that is willing to come forward, I am sure there are others that will behave in a way that could harm society, but are not willing to come forward. Any one still questioning why Wall Street needs to be regulated?

http://ca.finance.yahoo.com/news/many-wall-st-execs-says-050334304.html

Stock Market and the FOMC

Seems like FOMC meetings provide adde optimism to for investors.

bit.ly/O52ovG

What is the real interest rate telling us?

Here is a blog post by Martin Wolf of the Financial Times discussing the real interest rate (the post is a few months old, but still worth reading and discussing. 

On area that is starting to gain a lot of attention on main street is the erosion of retirement savings. In response to the financial crisis interest rates have fallen to record lows (short-term rates by the Fed, long-term rates due to global uncertainty and savings glut). A low nominal rate combined with modest inflation (1-2%) has left many retirees earning 0% (and in some cases negative). At the same time, many of those over 45 have benefited from low taxes, a dot com bubble, and a housing bubble.

Countrywide's VIP loans

Here is a recent article discussing how Countrywide used special loan packages for VIPS (government officials and many working for Fannie Mae) to gain preferential treatment for their subprime loans:

"Other than Countrywide, no other entity's employees received more VIP loans than Fannie Mae," Issa said in a release. "These relationships helped Mozilo increase his own company's profits while dumping the risk of bad loans on taxpayers."

 There are two main issues that need to be discussed. First, there is needs to be separation between financial firms and government officials. How can we expect elected officials to pass important regulations when they receive generous benefits from the institutions they are trying to regulate (read Paulson's secret Russian meeting).

The second issue is the role of Fannie Mae and Freddie Mac. Here are two private companies that operated as a government sponsored enterprise.  They were free to take on excess risk, knowing they had the full backing the US government should they fail. They were free to go after excessive profits (through buying Countrywide's subprime loans) without facing the risks. Fannie and Freddie play an important role in the financial system. Banks issue 30-year mortgages and then sell them to Fannie/Freddie. The mortgages then get bundled and sold to investors all over the world. Fannie and Freddie then use this income to purchase more home loans. This process allows banks to issue more home loans. The problem now becomes risk. Banks no long care about repayment since they are selling the loans to Fannie and Freddie. This provides the perfect environment for creating more subprime mortgages.

Is Gold Money

Ron Paul says yes.
Ben Bernanke says no.
What do you say?

Here are some articles to help you better understand the role of gold in the economy.
1. CNBC 
2. Mises Institute
3. MacroMania

Bernanke's speech following the following the financial crisis.

I would like everyone to read Bernanke's speech following the monetary policy response of the financial crisis. You can find the speech here.

There will not be discussion questions for chapter 1. It is really an introduction chapter. I will have narrated notes posted for chapters 1 and 2 by Wednesday. I am still getting back on my feet after my flight back from Italy. For now, keep up on the blog posts and read over chapter 1.

Money and Banking - Day 1

Hi All,

I am currently traveling back from Italy on Monday and will be back in Spokane late in the afternoon. I have not entirely completed the course outline and lecture notes for the first week. I should have everything up and going Monday evening, Tuesday morning. For now I would like everyone to look through the first chapter in Wright (lecture notes are posted, not narrated) and work on the discussion questions I have posted.  In addition to the first chapter please watch the video, "The Warning".

Watch The Warning on PBS. See more from FRONTLINE.

When watching the video I want you to think about the role the financial system should play in society. The ultimate goal of the financial system is to channel from from savers to lenders. From society's point a view the financial system should be to promote growth and regulated in a way that improves societal welfare. At the same time, financial intermediaries have a difficult job and are private firms that are entitled to maximize their profits. At what extent should financial intermediaries be able to pursue maximum profits in terms of risky assets?

You can probably see where I am going with these questions, there are no right answers. The goals of financial firms and society are different, but at the same time we want financial firms to provide us with the greatest returns, which means taking on more risk. Of course, households don't think of this and the costs of a financial crisis. Well they didn't until the last few years. We will get into many more questions, for now I just want you thinking about the role of financial intermediaries in a market economy. 

Eurozone: If Greece goes ... - FT.com

Nice summary of the events in Greece:

http://www.ft.com/intl/cms/s/0/175fcc8c-9b7f-11e1-8b36-00144feabdc0.html#axzz1uqoPJp5x

The Once and Future Dollar - Barry Eichengreen - The American Interest Magazine

Let's start reading some interesting articles on foreign exchange.

http://www.the-american-interest.com/article.cfm?piece=1228

House Advantage - Product Design - Banks That Bundled Bad Debt Also Bet Against It - NYTimes.com

http://www.nytimes.com/2009/12/24/business/24trading.html?pagewanted=all

That exam was hard

My top 5 responses to a student that complains my exam was too hard:

1. You're in college it's suppose to be hard.

2. Clearly you have not taken calculus. Now that is hard.

3. I really do enjoy making your life miserable.

4. Wait until you take the final, you'll think this exam was easy.

5. Really? Did you study?

Whatever Happened to the Free Market

Oil prices are determined in the global market. The Economists does a nice job summarizing the recent spike in oil prices. Many supply and demand factors will help determine the price of a barrel of oil. The demand side largely is influenced by US drivers, the rise of Chinese and Indian economies, and oil speculators purchasing futures contracts in hopes of driving prices higher. On the supply side comes down to OPEC and right now the concerns over a war with Iran. The POTUS has no influence on oil prices, but somewhere along the lines Republicans believe gasoline should be $2.50 per gallon. If you believe in the free market, you will quickly realize gasoline will never be $2.50/gallon. Of course the Republicans did not blame George W. Bush when gasoline prices reached $5/gallon in the summer of 2008. So what can we take from this, Republicans believe in the free market, that is until it is inconvenient to do so.

In the Long Run...

This article is a perfect example why journalist should not inject their opinion on an economic debate. In the long run it is all macroeconomics, not micro. We care about the efficient allocation of resources to increase living standards, minimize unemployment, and alleviate poverty. If we didn't have macroeconomic goals then we wouldn't care about microeconomics.

http://www.forbes.com/sites/timworstall/2012/03/16/in-the-long-run-its-all-microeconomics/?feed=rss_home

The Villain

Bernanke has found himself in the crosshairs of a debate between the left and the right over whether he is doing too much or too little to stimulate the economy. All this, while the debt troubles in Europe have threatened to compound America's problems and snuff out the recovery before it takes hold.

http://m.theatlantic.com/magazine/archive/2012/04/the-villain/8901/?single_page=true

Why the IS/LM model is still useful

Still the go to model for understanding the usefulness of policy.

"But economists who knew basic macroeconomic theory – specifically, the IS-LM model, which was John Hicks's interpretation of John Maynard Keynes, and at least used to be in the toolkit of every practicing macroeconomist – had a very different take. By late 2008 the United States and other advanced nations were up against the zero lower bound; that is, central banks had cut rates as far as they could, yet their economies remained deeply depressed. And under those conditions it was straightforward to see that deficit spending would not, in fact, raise rates, as long as the spending wasn't enough to bring the economy back near full employment. It wasn't that economists had a lot of experience with such situations (although Japan had been in a similar position since the mid-1990s). It was, rather, that economists had special tools, in the form of models, that allowed them to make useful analyses and predictions even in conditions very far from normal experience.

"And those who knew IS-LM and used it – those who understood what a liquidity trap means – got it right, while those with lots of real-world experience were wrong. Morgan Stanley eventually apologized to its investors, as rates not only stayed low but dropped; so, later, did Gross. As I speak, deficits remain near historic highs – and interest rates remain near historic lows.

http://krugman.blogs.nytimes.com/2012/03/05/economics-in-the-crisis/?pagewanted=all

Looking for a 'super' low unemployment rate? - Economy

8% is the magic number. If the unemployment rate is below 8% by November Obama will be reelected. 

http://economy.money.cnn.com/2012/03/06/looking-for-a-super-low-unemployment-rate/

Federal Reserve under attack ... again - Economy

Ironic, I was just having the conversation today in regards to Ron Paul. I said if anything those against the Fed should focus on the dual mandate and eliminate the goal of output stability. The reality, inflation is under control, the Fed has announced a firm inflation target, is publishing their forecasts, and has opened to the media. I don't see a single mandate of inflation targeting changing the current position of the Fed.

http://economy.money.cnn.com/2012/03/06/federal-reserve-under-attack-again/

CBO | Comparing the Compensation of Federal and Private-Sector Employees

Why it pays to have a federal job, well as long as you don't have a PhD.

http://cbo.gov/publication/42921

American manufacturers importing workers

Why we need better skills training programs in high schools:

http://cnnmoney.mobi/primary/wk_article?articleId=urn:newsml:CNNMoney.com:20120305:manufacturing-workers:1&category=cnnm_jobs&pagesize=10

Monetary Policy and the Yield Curve

Here is a nice link that talks about the relationship between the yield curve and monetary policy.

What did the Fed learn?

A recent speech by Bernanke talks about the need to focus on financial stability.

Conflict of Interest - Global Settlements

Here are the details surrounding the separation of research and investment banking:

• To ensure that stock recommendations are not tainted by efforts to obtain investment banking fees, research analysts will be insulated from investment banking pressure. The firms will be required to sever the links between research and investment banking, including prohibiting analysts from receiving compensation for investment banking activities, and prohibiting analysts' involvement in investment banking "pitches" and "roadshows." Among the more important reforms:
   
  • The firms will physically separate their research and investment banking departments to prevent the flow of information between the two groups.
     
  • The firms' senior management will determine the research department's budget without input from investment banking and without regard to specific revenues derived from investment banking.
     
  • Research analysts' compensation may not be based, directly or indirectly, on investment banking revenues or input from investment banking personnel, and investment bankers will have no role in evaluating analysts' job performance.
     
  • Research management will make all company-specific decisions to terminate coverage, and investment bankers will have no role in company-specific coverage decisions.
     
  • Research analysts will be prohibited from participating in efforts to solicit investment banking business, including pitches and roadshows. During the offering period for an investment banking transaction, research analysts may not participate in roadshows or other efforts to market the transaction.
     
  • The firms will create and enforce firewalls restricting interaction between investment banking and research except in specifically designated circumstances.
     
• To ensure that individual investors get access to objective investment advice, the firms will be obligated to furnish independent research. For a five-year period, each of the firms will be required to contract with no fewer than three independent research firms that will make available independent research to the firm's customers. An independent consultant for each firm will have final authority to procure independent research.
   
• To enable investors to evaluate and compare the performance of analysts, research analysts' historical ratings will be disclosed. Each firm will make its analysts' historical ratings and price target forecasts publicly available.

Quantitative Easing

I'm putting a presentation together on monetary policy and am going to policy relevant articles here.

From the Economist following the announcement of QE2

Morgan Stanley

One of the last remaining investment banks (Bear Stearns, Lehman Brothers, Wachovia, and Merrill Lynch all gone). Is Morgan Stanley next?

Moral Hazard and the Crisis

I will be using this post as a running entry with articles relating moral hazard to the financial crisis.

Here is a post by Paul Volcker in the WSJ.

A great post in Seeking Alpha.

Here is a nice explanation of the role of moral hazard during the failure of LTCM and 9/11.

An article from The New Yorker.

Adverse selection and the financial crisis (think of this as credit rationing by banks). The Bank of Canada has a nice review.

The Use of Unconventional Policies

Here is a letter from the SF Federal Reserve

The Role of Bank Capital

This is going to be a running post on articles talking about the need for bank capital.

I will also be posting articles under the arguments for and against a strict bank capital requirement. Like any policy we need to understand the costs and benefits of added bank capital. The costs are reduced lending, the benefits are a reduced likelihood of a financial crisis. Here are the results from the Basel panel.

Here is recent article from the WSJ talking about recent moves toward more bank capital. Of course Citi Bank does not like the requirements.

Here is the first article from The Economist. This article talks about increased bank capital during the onset of the financial crisis.  How much capital is enough?

The Basel Accord has been an attempt to standardize bank capital requirements across countries. Here is an article talking about Basel III.

A panel discusses the effects of bank capital requirements on economic growth. The pros are simple, more capital reduces the likelihood of a bank become insolvent due to large loan write downs. The costs are simple, the more capital reduces the return on equity for bank owners.

I'm in favor of strict capital requirements for all bank-like institutions. I believe the financial system in a large way acts as a public good. Because of the problems posed by banks failing to fully account for the costs of risky behavior (yes, largely created by the types of regulations we currently have) large banks do not recognize the costs to society. I view capital requirements as an easy but highly effectively way of minimizing regulations while allowing banks to serve society (i.e. channeling funds from borrowers to savers). I like these requirements mainly because banks still have a choice for the types of assets they want to hold. If banks want to undertake in subprime lending they can, but it needs to be supported by added capital. Will this slow down growth, probably in the short run, but in the long run it will lead to fewer financial crises. Given the recent number of crisis that could have been avoid if banks were holding adequately capital, I view the long run benefits as a necessary.

EMH and the Financial Crisis

This is going to be a running post with articles relating the EMH to the financial crisis.

Jeremy Siegel on the EMH

NYT on EMH

Ray Ball on the EMH

The Times on the EMH (it's dead)

The Economist on the EMH