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September 30, 2008

On rescues and bailouts

I’ve been thinking a lot about this topic lately, and though it seems there are a good many folk who approach the issue with great certainty, I do not share their confidence. I have, however, found it helpful to think through the following (not entirely original) scenario:

I am sitting on my back deck one fine afternoon and notice smoke coming from the kitchen window of my neighbor Joe. The color and volume of the smoke—and the fact that I know that Joe is not home—leave no doubt that the kitchen is on fire.

I begin to calculate my possible responses. I think Joe has a sprinkler system installed, so it is possible that safeguards already in place will soon put the fire out. Of course, I’m not entirely sure the system is up to the task—or even if it exists—so I consider a limited intervention in the form of running inside my own house and calling the fire department. They are a pretty efficient unit, but in the best of circumstances it will take them some time to arrive. So I also contemplate the most extreme measure available to me: grabbing my garden house, breaking down Joe’s back door, and addressing the fire directly.

It’s a hard choice, so I begin to think about the costs and benefits of each option. If I rely on the uncertain quality (or existence!) of the sprinkler system, or wait for the fire department to arrive, the fire could spread rapidly and possibly threaten my property. On the other hand, if I rush in with my hose, I could get hurt—the direct intervention could be costly, too. What’s more, my intervention might not do the trick—the fire could be too big, my garden hose too inadequate a firefighting tool.

I decide to throw caution to the wind, grab the hose, and burst into Joe’s house. I am able to successfully quell the flames, escaping with only a few minor burns and watery eyes. I feel pretty good about the whole business, but the truth is I discovered that the sprinkler system was indeed operating and may have put out the fire on its own (though it hadn’t yet). And just as the last flicker expires, I hear the fire engines in the distance. They may have arrived in time to spare my house (though it is clear that the fire was spreading quickly). So, I wonder. Did I do the right thing?

Actually, my dilemma deepens. When the fire marshal arrives, he discovers that the cause of the fire was a cigarette, foolishly left to burn near a stack of old papers. I knew all along that old Joe was the reckless sort, and now I fear that by stepping in and containing the damage that Joe had brought upon himself I may just be encouraging more such carelessness in the future.

Then again, the kitchen is a total loss, and the smoke has permeated Joe’s house and ruined more than a few pieces of furniture. Though it is obvious that Joe has been spared total ruin, will he really feel that his actions have gone without consequence? Will he feel that the fates have bailed him out?

I wonder.

UPDATE: I'm getting some ribbing over the similarity between my scenario and the analogy offered today by a certain well-known candidate for high political office. Though I did note that my story is not entirely original, I assure you that the present coincidence is, well, entirely coincidental.

September 30, 2008 in Banking, Financial System, Money Markets | Permalink


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Tracked on Sep 30, 2008 8:52:26 PM


Well what Joe learns is partially up to him.

But Joe IS your neighbor. His property values affect your property values. And the fire threatened the house of your cousin, who lives next door to him.

Let's imagine that the cause was not merely a careless act of a misplaced cigarette, but was rather induced by Joe's son Charley, a Gothic type, who had been experimenting with homemade explosives in the basement.

Charley was in over his head and thought that past experience with harmful chemicals proved that they could never combust spontaneously in his absence.

Furthermore, some of the chemicals in Charley's possession required the consent of an adult to purchase, a "technicality" Charley had never complied with. Should Charley's father be punished?

However, the whole analogy of a neighbor's house on fire is completely unacceptable because it does not convey the possible consequences of the offending conduct.

This catastrophe in the interbank market that is beginning to amplify through the "real" economy is not merely a "house fire".

There is a small but quantifiable chance it could cause millions of premature deaths worldwide over the next ten years.

A far more apt analogy would be if the glorious Government researchers at Fort Detrick Maryland had been searching for a "defensive" response to an al Qaeda biological attack and had inadvertently released a highly virulent strain of smallpox into the population that threatened to kill 30% of the people worldwide.

But they never intended to do such a harmful thing.

Should the Secretary of Defense lose his job over such an occurrence?

Matt Dubuque

Posted by: Matt Dubuque | September 30, 2008 at 03:43 PM

Sorry, I don't feel *at all* like Joe's neighbor. I feel much more like the unwilling neighbor of a problem gambler.

Also on the face of it, it appears that Joe has a wealthy aunt (let's call her Sen. Auntie Em) he has ingratiated himself with. This is an aunt that he can intermittently tap for funds when he can't make his boat payment or those infrequent (but readily predictable) times when he burns his house down.

Makes the case for helping Joe a little less compelling, yes?

Posted by: IdahoSpud | September 30, 2008 at 03:43 PM

I suppose the question of whether Joe is careless again depends on whether he will be ever again be offered tens of millions of dollars in bonus to do so.

The real problem is that the incentives are skewed even without intervention.

Posted by: Anurag | September 30, 2008 at 03:54 PM

On the other hand, your other neighbors suffered no loss and will feel free to behave recklessly in the future, confident that you will save them.

Posted by: Erik | September 30, 2008 at 03:58 PM

The comparison isn't adequate. The risk/reward ratio in the case above should'nt motivate you to rescue joe's house at the risk of losing your own life.

To be brutal: that's why banks can't recapitalize at the moment unless at the cost of massive shareholders dilution.

To come back to your story: the owner would have called joe and asked 'if I go in now, do I get half the ownership of your house??'

Posted by: Marc | September 30, 2008 at 04:44 PM

The primary problem with this analogy is that it assumes an unlimited supply of water. But this type of fire, the more water you use, the less effective it becomes. Indeed, it won't be long before the water is actually fueling the fire.

The secondary problem is that it assumes Joe has morals. Forget it! He never had any and never will. The idea that the Joes of the world are affected by morality is something dreamed up by the government.

Posted by: Anonymous | September 30, 2008 at 06:10 PM

But Joe has only been occupying this house which actually is owned and guaranteed by his wealthy uncle and if it burns, it doesn't matter - he has partied there for a long time, all the while profiting considerably from the saved rent. Further, since as a neighbor he has been so ostentatious and selfish, and because we have a buffer zone in between our houses, I am willing to bet that my damages will be relatively minor in the hope that this pest of a neighbor will be effectively smothered by his benefactor.

Posted by: BR | September 30, 2008 at 08:16 PM

Just a mark of your obvious thoughtfulness Dave ... Don't disown the post!!

Posted by: Guhan | September 30, 2008 at 09:03 PM

Matt Dubuque

The interbank lending market remains in a coma threatening us all, irrespective of what the Dow Jones Industrial Average may be doing on a short-term basis.

As Senior Economist Gordon Sellon of the Kansas City Federal Reserve discussed in his seminal paper "Monetary Policy and the Zero Bound: Policy Options When Short-Term Rates Reach Zero" published in the Fourth Quarter 2003 edition of the Kansas City Federal Reserve's "Economic Review", the Federal Reserve should now consider under taking "twist" operations in the open market.

That paper is available here at the bottom of the link:

A "twist" operation by the Federal Reserve in the current context would consist of the Fed SELLING 3-month Treasury Bills while simultaneously PURCHASING 5-year Treasury Notes. Such operations, applied judiciously, would affect the term structure of various markets in a positive way.

Such "twist" operations are not without precedent. It was performed during the Kennedy Administration:

I urge people to STUDY Sellon's critical paper at the link provided above to grasp some of the subtleties involved here before engaging in uninformed knee-jerk criticism.

This is not a cure-all, but it is clear that it should be on the short list of our policy options.

Matt Dubuque

Posted by: Matt Dubuque | October 01, 2008 at 09:30 AM

I like your metaphor - the only thing I think you missed is that the water hose used to put out the fire may bankrupt me and my children due to future taxes to pay for it. Makes me think more about taking some fire damage vs bankruptcy

Posted by: GR | October 01, 2008 at 09:53 AM

The best way to approach the liquidity & then part of the insolvency in the non-banks is to get the commercial banks out of the savings business (REG Q in reverse but excluding the non-banks).

What would this do? The CBs would be more profitable, there would be an immediate increase in the supply of loan-funds (non-inflationary liquidity), both long-term & short-term interest rates would be considerably lower, and the economy would crawl out of this depression.

Posted by: flow5 | October 01, 2008 at 05:57 PM

Just like“Banks have long contended that the costs of reserve requirements (i.e., forgone earnings) put them at a competitive disadvantage relative to non-bank competitors that are not subject to reserve requirements – Testimony of Treasury

“These measures should help the banking sector attract liquid funds in competition with non-bank institutions and direct market investments by businesses” Testimony of Treasury

A commercial bank becomse a financial intermediary only when there is a 100% reserve ratio applied to its deposits.

Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, by data networks, checks, or similar types of negotiable credit instruments, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.

From a systems viewpoint, commercial banks as contrasted to financial intermediaries: , never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time deposits (TDs) or the owner’s equity or any liability item.

When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, state, and other governmental jurisdictions) and every person, except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (TRs).

The lending capacity of the member CBs of the Federal Reserve System is limited by the volume of free gratis legal reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities (transaction accounts), as fixed by the Board of Governors of the Federal Reserve System.

Since 1942, money creation is a system process. No bank, or minority group of banks (from an asset standpoint), can expand credit (create money), significantly faster than the majority banks expand. If the member banks hold 80 percent of all bank assets, an expansion of credit by the nonmember banks and no expansion by member banks will result, on the average, of a loss in clearing balances equal to 80 percent of the amount being checked out of the nonmember banks.

From the standpoint of the individual commercial banker, his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, and probably its free/gratis legal reserves, not a tax [sic] – and thereby it’s lending capacity. But all such inflows involve a decrease in the lending capacity of other commercial banks (outflow of cash and due from bank items), unless the inflow results from a return flow of currency held by the non-bank public, or is a consequence of an expansion of Reserve Bank credit. Hence, all CB liabilities are derivative.

That is, CB time/savings deposits, unlike savings accounts in the “thrifts”, bear a direct, one-to-one, unvarying relationship, to transactions accounts. As TDs grow, TRs shrink pari passu, and vice versa. The fact that currency may supply an intermediary step (i.e., TRs to currency to TDs, and vice versa) does not invalidate the above statement.

Monetary savings are never transferred to the intermediaries; rather monetary savings are always transferred through the intermediaries. Indeed, as evidenced by the existence of “float”, reserve credits tend, on the average, to precede reserve debits. Therefore, it is a delusion to assume that savings can be “attracted” from the intermediaries, for the funds never leave the commercial banking system.

Consequently, the effect of allowing CBs to “compete” with financial intermediaries (non-banks) has been, and will be, to reduce the size of the intermediaries (as deregulation did in the 80’s) – reduce the supply of loan-funds (available savings), increase the proportion, and the total costs of CB TDs.

Contrary to the DIDMCA underpinnings, member commercial bank disintermediation is not, and has not been, predicted on interest rate ceilings. Disintermediation for the CBs can only exist in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction, as a consequence of currency withdrawals. The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933, the Federal Reserve has had the capacity to take unified action, through its "open market power", to prevent any outflow of currency from the banking system.

However, disintermediation for financial intermediaries- (non-banks), is predicated on their loan inventory (and thus can be induced by the rates paid by the commercial banks); earning assets with historically lower fixed rate and longer term structures.

In other words, competition among commercial banks for TDs has: 1) increased the costs and diminished the profits of commercial banks; 2) induced disintermediation among the "thrifts" with devastating effects on housing and other areas of the economy; and 3) forced individual bankers to pay higher and higher rates to acquire, or hold, funds.

Savers (contrary to the premise underlying the DIDMCA in which CBs are assumed to be intermediaries and in competition with thrifts) never transfer their savings out of the banking system (unless they are hoarding currency). This applies to all investments made directly or indirectly through intermediaries. Shifts from TDs to TRs within the CBs and the transfer of the ownership of these TRs to the thrifts involves a shift in the form of bank liabilities (from TD to TR) and a shift in the ownership of (existing) TRs (from savers to thrifts, et al). The utilization of these TRs by the thrifts has no effect on the volume of TRs held by the CBs or the volume of their earnings assets.

In the context of their lending operations it is only possible to reduce bank assets and TRs by retiring bank-held loans, e.g., the only way to reduce the volume of demand deposits is for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a bank service, or for the purchase from their banks of any type of commercial bank security obligation, e.g., banks stocks, debentures, etc.

The financial intermediaries can lend no more (and in practice they lend less) than the volume of savings placed at their disposal; whereas the commercial banks, as a system, can make loans (if monetary policy permits and the opportunity is present) which amount to server times the initial excess reserves held.

Financial intermediaries (non-banks) lend existing money which has been saved, and all of these savings originate outside the intermediaries; whereas the CBs lend no existing deposits or savings; they always, as noted, create new money in the lending process. Saved TRs that are transferred to the S&Ls, etc., are not transferred out of the CBs; only their ownership is transferred. The reverse process, which is called “disintermediation”, has the opposite effect: the intermediaries shrink in size, but the size of the CBs remains the same.

Professional economists have no excuse for misinterpreting the savings investment process. They are paid to understand and interpret what is happening in the whole economy at any one time. For the commercial banking system, this requires constructing a balance sheet for the System, an income and expense statement for the System, and a simultaneous analysis of the flow of funds in the entire economy.

From a System standpoint, time deposits represent savings have a velocity of zero. As long as savings are held in the commercial banking system, they are lost to investment. The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.

From a system standpoint, TDs constitute an alteration of bank liabilities, their growth does not per se add to the “footings” of the consolidated balance sheet for the system. They obviously therefore are not a source of loan-funds for the banking system as a whole, and indeed their growth has no effect on the size or gross earnings of the banking system, except as their growth affects are transmitted through monetary policy.

Lending by intermediaries is not accompanied by an increase in the volume, but is associated with an increase in the velocity or turnover of existing money. Here investment equals savings (and velocity is evidence of the investment process), whereas in the case of the CB credit, investment does not equal savings but is associated with an enlargement and turnover of new money (money supply).

The difference is the volume of savings held in the commercial banking system is idle, and lost to investment as long as it is held within the commercial banking system. Such a cessation of the circuit income and transactions velocity of funds, funds which constitute a prior cost of production, cannot but have recessionary effects in our highly interdependent pecuniary economy. Thus, the growth of time deposits shrinks aggregate demand and therefore produces adverse effects on GDP and the level of employment.

It began with the General Theory, John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution serving to join the saver with the borrower when he states that it is an “optical illusion” to assume that “a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”

In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term financial intermediary in order to make the statement correct. Perhaps this is the source of the pervasive error that characterizes the Keynesian economics, the Gurley-Shaw thesis, Reg Q, the DIDMCA of March 31st, 1980, the Garn-St. Germain Depository Institutions Act of 1982, etc.

How does the FED follow a "tight" money policy and still advance economic growth.? What should be done? The commercial banks should get out of the savings business (REG Q in reverse-but leave the non-banks unrestricted-compensated for transition). What would this do? The commercial banks would be more profitable - if that is desirable. Why? Because the source of all time deposits within the commercial banking system, is demand/transaction deposits - directly or indirectly through currency or their undivided profits accounts. Money flowing "to" the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know. The growth of the intermediaries/non-banks cannot be at the expense of the com. banks. And why should the banks pay for something they already have? I.e., interest on time deposits.

Dr. Leland James Pritchard (MS, statistics - Syracuse, Ph.D, Economics - Chicago, 1933) described stagflation 1958 Money & Banking Houghton Mifflin,

“The Economics of the Commercial Bank Savings-Investment Process in the United States” -- “Estratto dalla Rivista Internazionale di Scienze Econbomiche & Commerciali “ Anno XVI – 1969 – n. 7
“Profit or Loss from Time Deposit Banking” -- Banking and Monetary Studies, Comptroller of the Currency, United States Treasury Department, Irwin, 1963, pp. 369-386.

Posted by: flow5 | October 01, 2008 at 06:00 PM

I never liked this blog much, and now I like it even less.

Posted by: whaaa? | October 01, 2008 at 07:51 PM

Can I just say thank-you for publishing this blog. Could we make it mandatory reading for members of Congress?

Posted by: Mr. ToughMoneyLove | October 01, 2008 at 09:57 PM

Question: Will the water from your water hose corrupt the DNA on the cigarette remains and wipe any remaining finger prints from the paper ashes, door handle, etc? If so, the fundamental incentive for putting out the fire before the investigators arrive may become clear.

Posted by: Ken | October 01, 2008 at 10:01 PM

Yes, what a fine analogy.

The problem is the water table is running real low in the county.

For years Joe and his friends in the McMansion subdivisions have been watering their lawns knowing full well that the water table is low.

You have to decide if putting out the fire in Joe's house is the best idea.

Putting it out might be it. The water might run out for the whole county. If so everyone will have to move out and go somewhere else.

You also know that Joe has insurance and an insurance agency standing behind him. While losing his property because the lack of water will probably raise everyones insurance payments, at least no one would have to abandon the county and the county will be able to continue looking for a new source of water and live to fight another day.

So you really must choose between putting out the fire at the risk of loosing everything and perhaps even being unable to stop the fire from spreading if the well runs dry before it's out or creating a backfire that might help save everyone from facing the fire coming from Joes' house.

Posted by: Chris | October 02, 2008 at 11:57 AM

Whatever happened to 'individual responsibility and accountability?' I believe you've entered a highly contentious area of individual risk vs. the perceived common good.

When did you become big brother? When did you become his keeper? Where's your name on his deed/mortgage? When were you hired as security for his property? Are you his insurance company? Is he required to ask permission from you before he smokes his cigarettes, buys a newspaper, turns on the stove, yearly furnance checks, plugs in electrical appliances? Do you check his house for smoke and carbon monoxide detectors? Do you come over and replace the batteries yearly? Is he allowed to walk, talk, and chew gum at the same time....hahahahaha

And BTW, I'm your next door neighbor. I've noticed that you leave your lights on all nite. I'm concerned. What are you doing? Do you remember to turn off the stove after cooking and that woodburning fireplace is used way to often and is a fire hazard. When did you last get your electrical wiring replaced? Hmmmmmmm

Point; I will not demand that you comply to my standards. Therefore, as an adult I shall take precautions with my own home and wish my neighbor good luck as he does me.

"They that can give up essential liberty to obtain a little temporary safety deserve neither liberty nor safety." B. Franklin

Posted by: rps | October 02, 2008 at 01:44 PM

It's a good analogy. I have traded in the credit market for 20 years. This has been a market unlike I have seen. In 1987, we had a heart attack. But the market worked its way out of the mess. The Fed provided the correct action.

This has been with us for over a year, and has been brewing for longer than that. Kind of like a cancer.

I am against a bail out of gigantic proportions. However, it is mission critical that we get the credit interbank market operating again. It is the lifeblood of our economy. The government must do something targeted toward that.

What is the critical problem? Counter party risk. No one trusts the other's balance sheet. Do you blame them?

There is only one way I know of to alleviate counterparty risk. It's a clearing house, similar to the ones used by futures exchanges. If you go to, you can get a good description of how a clearing house works.

So going forward we don't necessarily need more regulation, but we do need a different market structure with a clearing house being an integral part of it.

Looking backward, it's really tough to figure out what to do. I am not in favor of suspending mark to market-because they didn't mark the stuff to market for years on their books. But we do need to get this stuff off their books. If this is through a RTC type vehicle so be it. As long as the government buys the stuff for pennies on the dollar, then we should be okay long term.

The other thing that concerns me is the politics around the issue. In the next administration, they really should not raise taxes-and they should do everything that they can to lower trade barriers. My worry is that they will do the opposite-replaying 1932.

Posted by: Jeff | October 02, 2008 at 11:20 PM

Aside from the fact that making up a ridiculous analogy proves nothing, the real situation involved giving $700 billion to an administration which has proven that not only *could* it f*ck up a two-car parade, but has repeatedly done so, while stealing vast sums.

And it's made by somebody who won't suffer when the administration does steal the money and laughs, handing the problem over to the Obama administration for Bailout II.

Posted by: Barry | October 03, 2008 at 01:03 PM

The analogy is stupid, as it leaves out several features of what is really going on, like the obscene paychecks on Wall Street, the fraudulent CDS sold by AIG to European banks to enable them to get around inconvenient capital requirements, and the big lie that the troubles of Wall Street are having such a terrible effect on Main Street that we must give them hundreds of billions of dollars. It is truly disgusting.

The Fed publishes a daily commercial paper report, as well as the weekly H.8 release that lists banking assets and liabilities. The CP report shows that nonfinancial companies are NOT having any trouble getting funded, while the H.8 shows that the expansion in bank credit continues unabated. Banks will not lend to each other because they know the balance sheets of other banks, like their own, are largely fictitious. But they are making loans to nonfinancial companies, and that's all that matters for the larger economy.

Posted by: NotTheSameJeff | October 04, 2008 at 03:33 PM

I think we need to add the part where Joe is standing in front of his house afraid to go in and put out the fire himself, but will be just happy enough to let his neighbors do it.

Posted by: Jim | October 04, 2008 at 11:12 PM

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September 25, 2008

Wall Street worries, Main Street woes

A fair amount of the discussion around what now seems to be an imminent rescue plan to settle unsettled financial markets has been focused on a debate as to whether Main Street should pay or Wall Street should pay for the plan. Pimco’s William Gross, however, is suggesting it is a false choice:

“If this were a textbook recession, policy prescriptions would recommend two aspirin and bed rest—a healthy dose of interest rate cuts and a fiscal package that mildly expanded the deficit.… But recent events have made it apparent that this downturn differs from recessions past.…

“And so, instead of mild medication and rest, it became apparent that quadruple bypass surgery is necessary. The extreme measures are extended government guarantees and the formation of an RTC-like holding company housed within the Treasury. Critics call this a bailout of Wall Street; in fact, it is anything but. I estimate the average price of distressed mortgages that pass from ‘troubled financial institutions’ to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury.…

“The Treasury proposal will not be a bailout of Wall Street but a rescue of Main Street, as lending capacity and confidence is restored to our banks and the delicate balance between production and finance is given a chance to work its magic.”

That assessment—that the goal is to get market-mechanisms working again—was expressed by Chairman Bernanke in his Tuesday testimony before the Senate Banking Committee:

“If you have an appropriate auction mechanism, together with other types of inputs, with flexibility to address different assets in different ways, I think what you will do is you will restart this market. And then you'll get a sense of what the more fundamental value is.”

It may be a good point to note that there is no guarantee that the magic worked by markets will be quick. Yesterday’s report on existing house sales and today’s news on new home sales—covered by the go-to guy Calculated Risk here and here—clearly indicate that the fundamental Main Street adjustments are not yet complete.

Unfortunately, it is difficult to make the case that the trip to stabilization of house prices will be a short one. Simple economics predicts this relationship: movements in house prices are the result, mainly, of movements in land prices (as shown in a good piece of analysis by Morris Davis and Jonathan Heathcote, respectively, from the University of Wisconsin-Madison and the Federal Reserve Board of Governors). The supply of land is fairly inelastic and as a result, changes in house prices should be determined primarily from demand factors. According to Gregory Mankiw and David Weil, this demand is related to the number of prime-aged, child-bearing households.

As the following chart illustrates, house-price growth (measured by the year-over-year growth rate of nominal house prices constructed by the Office of Federal Housing Enterprise Oversight, or OFHEO) and the growth rate of the civilian labor force (CLF)—a reasonable proxy for prime-aged, child-bearing households—were tightly linked for more than two decades.

Growth Rates: House Prices vs. Civilian Labor Force

That pattern broke down around the time of the 2001 recession. This deviation from presumed fundamentals is well known, and we can use the underlying economic theory to get a rough benchmark for how far from complete the adjustment process may be. Consider a hypothetical path for house prices such that the ratio of the growth rate of the OFHEO index to the growth rate of the civilian labor force is maintained at its pre-2001 historical value. That exercise suggests house-price appreciation of 3.3 percent, represented by the green dashed line in this chart:

House Price Growth Rates: An Alternative Series

An estimate of the “overvaluation” of housing is given roughly by the area below the red line (the actual growth in house prices) and above the hypothetical dashed line. With this alternative growth rate series, the OFHEO index would have been at a level of 301 in the second quarter of 2008, instead of the realized value of 381. If the ratio for the post-2000 period is to return to its historical value, house prices would drop 21 percent from second-quarter 2008 levels.

These numbers are, of course, just ballpark calculations. The future need not look exactly like the past, and even if it does there is no way to predict how close we have to get before economic conditions normalize. But to the extent that the past is in fact a reasonable guide, this simple exercise may provide a sense of how much work remains to be done.

By Pedro Silos, research economist and assistant policy adviser, and David Altig, research director, of the Federal Reserve Bank of Atlanta.

September 25, 2008 in Housing | Permalink


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Pimco is looking forward to managing the billions of dollars of assets.

Posted by: Trade Meme | September 26, 2008 at 06:05 AM

Bill Gross will be a direct and major beneficiary of the bailout. PIMCO has billions of dollars of bank debt in its funds. If and when the bailout occurs the value of that debt will soar. Anything he says on the subject of the bailout is tainted by his financial interest, and should be viewed with extreme scepticism.

Posted by: dlr | September 27, 2008 at 02:49 PM

Trade Meme, I agree that Bill Gross is an extremely unreliable prognosticator here. Not only is he deeply compromised by his own interests, he also has a mixed record as a long-term prognosticator. He has done a good job of predicting the government's near-term actions (probably through tip-offs from his corrupt insider buddies), but his returns would be quite a bit higher if he had anticipated the current magnitude of the real estate and credit crises. He CANNOT be sure that the government will make money on these securities.

Posted by: Disgusted | September 29, 2008 at 12:39 AM

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September 23, 2008

Time out

I am often amazed by the ability of folks to speak with absolute certainty on subjects that are defined by absolute uncertainty. Here is what we know, as of the moment on Tuesday afternoon when I am writing this, about U.S. Treasury Secretary Paulson’s proposal to obtain authority to purchase troubled assets: A request has been made for Congress to authorize up to $700 billion (with automatic adjustments to the national debt ceiling) for the purpose of purchasing distressed assets from US financial institutions. Here’s what we don’t know: Almost every other relevant detail.

Though a possible version of a possible House bill has been drafted, the final details remain a conjecture. Even more uncertain is the ultimate impact once the program is implemented. I think Tom Maguire nails it:

Suppose Merrill Lynch (to pick a name at random) has marked its sludge down to 50 percent of face value. Let's further suppose that with perfect foresight investors could see that this is the "right" price in the sense that over the life of the assets Merrill will receive that amount in present value, risk adjusted terms.

Does this mean that Merrill's financial statements are reliable and lenders will lend to them? Not in the current environment . . .

Lacking perfect foresight, investors have no idea whether 50 cents on the dollar is fair but even if they suspected it was they also have an excellent idea that lightning could strike and Merrill could go bust tomorrow, which means they won't lend to Merrill today. Or, if the idea of a lightning strike seems too abstract, investors might believe that, although 50 cents is the mean expected value of the assets in question there is a high enough probability that they will ultimately be worth 25 cents that a loan to Merrill is too risky.

However, if Merrill sells those assets at 50 cents, they have not received a subsidy but they have removed a major source of volatility from their financial statement - there is no possibility that Merrill will later mark those assets down to 25 cents because they have been sold. Of course, they will never mark them to 75 and book a profit, but lenders were hardly worried about that . . . So why doesn't Merrill and everyone else sell their troubled assets and move on? Well, sell them to whom? Merrill did sell some of this stuff but the collectively the financial firms simply have too much to move. Hence, there is a role for the government as a patient, well-capitalized investor of last resort—it is *possible* that the government can break even or make money on these assets if the purchase price is fair. Obviously, it is also possible that the government will get stuffed with the worst of the worst at inflated prices, or that the government will consider it its patriotic duty to pay inflated prices in order to quietly re-capitalize some of these firms. But this bail-out can be effective without assuming that to be the case.

In other words, the devil may be in the details, but might be a good idea to see some of those details before judging the final product.

The second line of discussion that I think deserves a time-out is the pronouncements of all sorts regarding the ultimate cost of the plan to U.S. taxpayers. Many others have focused on the analogy to the Resolution Trust Corporation — or lack thereof — but let’s revisit the facts one more time. This is from a 2000 analysis by FDIC economists Timothy Curry and Lynn Shibut:

In response to the deepening [savings and loan] crisis, Congress enacted FIRREA on August 9, 1989, beginning the taxpayers’ involvement in the resolution of the problem… FIRREA also created the RTC to resolve virtually all troubled thrifts placed into conservatorships or receiverships between January 1, 1989, and August 8, 1992. Because of the continuing thrift crisis, however, the RTC’s authorization to take over insolvent institutions was twice extended, the second time to June 30, 1995 . . .

FIRREA provided the RTC with $50 billion to resolve failed institutions… Because the $50 billion in initial funding was insufficient to deal with the scope of the problem, Congress enacted subsequent legislation three times, raising total authorized RTC funding for losses to $105 billion between 1989 and 1995.

Before, during, and even after the RTC’s lifetime, estimates of the costs of the crisis created widespread confusion. Federal agencies, politicians, thrift industry experts, and others put forth myriad estimates on what was called the size of the problem. These forecasts often diverged widely and changed frequently in response to surging industry losses . . . Reflecting the increased number of failures and costs per failure, the official Treasury and RTC projections of the cost of the RTC resolutions rose from $50 billion in August 1989 to a range of $100 billion to $160 billion at the height of the crisis peak in June 1991, a range two to three times as high as the original $50 billion.

As of December 31, 1999, the RTC losses for resolving the 747 failed thrifts taken over between January 1, 1989, and June 30, 1995, amounted to an estimated $82.7 billion, of which the public sector accounted for $75.6 billion…

You can either be concerned by the fact that the RTC workout cost more than originally projected, or take comfort in the fact that the costs did not even approach the worst-case scenarios. It is certainly true that in any case taxpayers are being asked, via their duly elective representatives, to take on large risks. But, as Secretary Paulson and Chairman Bernanke emphasized today, risk is not avoided by doing nothing.

September 23, 2008 in Federal Reserve and Monetary Policy | Permalink


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What I am concerned with is that people have continually been presented with the BEST case scenario by being repeatedly told that taxpayers MIGHT make a profit by purchasing this highly toxic radioactive waste that no capitalist in their right mind wants on their books.

Let' stipulate to the fact that this is a crisis and that competent crisis management techniques are called for.

From an engineering perspective, let's imagine that this catastrophe has formal similarities to the potential for a nuclear meltdown.

Recall the crisis at 3-mile island. At the height of the crisis, we were informed that there was a rapidly expanding bubble inside the containment vessel NINE FEET in diameter, with deeply uncertain implications.

We were also informed that EVERY mathematical model by physicists (both PRO and CON re: nuclear power) had predicted ONLY a 1/4 inch diameter bubble was possible.

It is indeed ironic that some of that math used to model this by physicists was later employed in modeling derivatives today.

So at 3-Mile Island, we didn't have a mathematician in the world with a competent track record to predict a range of likely outcomes.

Yet the situation was dire.

What was done therefore was that a range of scenarios was put forth as to how things might proceed and an engineering solution was devised.

THE KEY POINT is that BEFORE the final engineering solution was selected, SEVERAL WORST CASE scenarios were vetted as to what could go wrong.

And it eventually worked out OK.

But the inferior math had gotten us into a serious jam.

In the instant case of the 700 billion dollar toxic asset relief plan that is before us, we are ONLY being provided with the BEST case scenarios.

Let's see some WORST case scenarios here, so that our crisis management approaches the level of competence required by the futures of our children.

IF we adopt the plan, what can go wrong?

Why is this simple, competent path of analysis so scrupulously ignored by Americans?

Is it because we have been so dumbed down as a nation?

Matthew Dubuque

Posted by: Matt Dubuque | September 23, 2008 at 09:48 PM

Can we claw back the 50 billion that goldman paid out in bonuses over the last two years as some down payment assistance for our 700 billion mortgage? Hank knows some guys over there, right?

Just checkin'


Posted by: praetorian | September 24, 2008 at 12:19 AM

Can we get 9% or 14% like Buffet?

Posted by: me | September 24, 2008 at 12:43 PM

Good points - but two thoughts:

1. the RTC stepped in only AFTER the regulators made a determination that the financial institution had failed - so any cost comparisons to RTC are suspect. Under RTC, the Fed was able to sell the entire S&L, and was not limited to selling radioactive securities with an unknown half-life

2. While risk is not necessarily avoided by doing nothing, in many situations, including investing, doing nothing is often the best thing to do. When doing something is needed, for example when a swimmer is drowning, lifeguards in Red Cross training are taught that they need to be very careful not to be pulled down by the panicked swimmer, as both could drown.

Here, after months of telling us that everything's under control, Paulson (and Bernanke) appear to me to have panicked and are about to jump into the water to save Paulson's Wall Street buddies.

I think Paulson and Bernanke honestly believe this is the right thing to do - but I also am quite sure they're wrong, and the country will either be pulled under financially by this, or be exposed to a new wave of foolish risk-taking by executives that have not ever been held accountable for their mistakes.

If this goes through, it will only engender further distrust within the US and among those who, amazingly, still look to the US for world leadership.

Posted by: Eric Dewey | September 24, 2008 at 01:24 PM

The big difference (beyond the orders of magnitude in size) is that the RTC took receivership of the failed banks. In other words they got the assets because the thrifts went bankrupt. In this case we actually have to pay for assets from banks that have not yet failed.

Posted by: Ted | September 24, 2008 at 02:03 PM

I don't thik it's unreasonable to question BB regarding ANY resolution to the housing dilemma we're faced with. After all, in the Spring of 2006, AFTER the Real Estate Bubble peaked, he said our housing prices were driven by fundamentals.
He may still get to make decisions, but his actions and inactions make him fair game for every ridiculous question one can conjure up.

Posted by: bailey | September 25, 2008 at 10:04 AM

My concern is simple. I believe each FED Chair enters with a clean slate & should be evaluated by how he responds to the economic climate left by his predecessor AND the plans & programs he devises and implements to set his path for our future.
In my view there's ample evidence to suggest BB has done poorly in responding to the problems foist upon him.
Further, I can't believe no one has asked him how the goal of an ever-increasing GDP, regardless how that GDP is achieved, is in the best interests of our kids & grandkids. Maybe it's just to foolish a question.

Posted by: bailey | September 25, 2008 at 12:01 PM

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September 18, 2008

What’s a swap line?

This morning the Federal Open Market Committee (FOMC) authorized a $180 billion expansion of its temporary reciprocal currency arrangements (swap lines). According to the Fed’s press release, the changes allow for “increases in the existing swap lines with the ECB and the Swiss National Bank” and for “new swap facilities…with the Bank of Japan, the Bank of England, and the Bank of Canada.”

“These measures…are designed to improve the liquidity conditions in global financial markets,” the release continued.

What did the Fed do and how will this action address some of the strain in liquidity conditions that recently have emerged?

A good place to start is by looking at what, exactly, a currency swap line is. A currency swap is a transaction where two parties exchange an agreed amount of two currencies while at the same time agreeing to unwind the currency exchange at a future date.

Consider this example. Today the Fed initiated a $40 billion swap line with the Bank of England (BOE), meaning that the BOE will receive $40 billion U.S. dollars and the Fed will receive an implied £22 billion (using yesterday’s USD/GBP exchange rate of 1.8173).

Currency Swap:

Figure 1

An underlying aspect of a currency swap is that banks (and businesses) around the world have assets and liabilities not only in their home currency, but also in dollars. Thus, banks in England need funding in U.S. dollars as well as in pounds.

However, banks recently have been reluctant to lend to one another. Some observers believe this reluctance relates to uncertainty about the assets that other banks have on their balance sheets or because a bank might be uncertain about its own short-term cash needs. Whatever the cause, this reluctance in the interbank market has pushed up the premium for short-term U.S. dollar funding and has been evident in a sharp escalation in LIBOR rates.

The currency swap lines were designed to inject liquidity, which can help bring rates down. To take the British pound swap line example a step further, the BOE this morning planned to auction off $40 billion in overnight funds (cash banks can use on a very short-term basis) to private banks in England.

Figure 2

In effect, this morning’s BOE dollar auction will increase the supply of U.S. dollars in England, which would work to put downward pressure on rates banks charge each other.

Consistent with this move, the overnight LIBOR rate fell from about 5.03 percent yesterday to 3.84 percent today.

Figure 3

The bottom line is that the Fed, by exchanging dollars for foreign currency, has helped to provide liquidity to banks around the world. This effort can help to bring interbank rates back down at a time when restrictively high rates can choke off access to financing that banks and other businesses need to operate.

By Mike Hammill in the Atlanta Fed’s research department

September 18, 2008 in Capital Markets | Permalink


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What does the Fed do with 22 billion pounds?

Also, is this a good gauge of the magnitude of bad (illiquid) debt held by European banks?

Posted by: tinbox | September 18, 2008 at 08:59 PM

My question - is this swap between CBs and the notional amounts are certian or have the foreign banks pledged assets to secure the swap?

In short is the USG on the hook for items that any other central bank has exchanged cash (or Ts)?


Posted by: Barley | September 18, 2008 at 11:45 PM

Won't opening swap lines with worldwide central banks create an artificial supply of dollars and as a result cause a short term devaluation of the dollar w.r.t the pound. Also would the reduction of the LIBOR cause a subsequent reduction in the risk premium charged to financial institutions?

Posted by: Akhil | September 24, 2008 at 05:06 AM

Interesting. While not harming your story, it might be of interest that the LIBOR systematically understates the borrowing costs, since banks have chosen to report too low interest rates (the LIBOR is survey-driven). Apparently, banks want to hide the true amount of stress in the system, even though it costs them, since they collect LIBOR + premium from their debtors.

Posted by: Dirk | September 27, 2008 at 06:49 AM

When I saw this morning that the Fed was more than doubling it's foreign swap lines to a total of $620, I figured I really need to understand these. A few questions:

1) Have they agreed to unswap at some future date at a set price, such that other central banks are taking on the currency risk of holding dollars?

2) Does this directly increase the money supply, and is it inflationary and/or a debasing of the dollar?

3) How is this functionally different from the Fed running the printing press, using that "new money" to buy pounds in the open currency market, and letting the British banks borrow in pounds from the BOE?


Posted by: lilnev | September 29, 2008 at 04:11 PM

Is the currency swap a "derivative"...I think the answer is yes.

Does this "Derivative" show up on the Fed's Balance Sheet ?

Wouldn't the risk to the USA be a precipitous drop in the value of the USD. If under the SWAP agreements, we need to return EUROs and the dollar continues to drop versus the other currencies, then wouldn't the number of Euros that we need to return increase as well ? I would assume that this would be inflationary...but would be interested in your comments....

Posted by: Dave Spurr | September 29, 2008 at 07:01 PM

Hello Mike,

Like Lilnev, I would be grateful to hear more detail about how these swaps work. In particular:

How is the unwind of the swap priced?

What is the Fed doing with the foreign currency it is receiving?

I presume that any lending by the foreign central banks is offset against the FRBNY lending, right?

I would be happy to be referred to a public document if one is available with such information. Thanks.

Posted by: RebelEconomist | September 30, 2008 at 01:11 PM

yesterday I spoke by telephone with one of the central banks undertaking swaps with the Fed. I was referred to the media dept where no one understood the mechanism of the swaps but I did have my call later returned by someone in the dealingroom who explained a little.

The USD side appears as a credit on the foreign CBs account with the Fed in NY while a corresponding foreign currency credit appears on the Fed's ledger. As the end of the agreed term the two credits are simultaneously extinguished. There is no foreign exchange rate movement risk nor interest paid by either party.

Therefore this doesn't sound like a derivative as none of the values derive from the price of anything else.

With the USD received by the foreign CB, these are used to repo local currency securities to provide the foreign market with USD liquidity largely for trade, letters of credit etc. The dealer advised there was a shortage of USD in his local marketplace because of the credit freeze.

It was only after the call I realized I'd forgotten the obvious question - that which appears at the very top of the comments - what does the Fed do with the foreign currency credit?

anyone know????

Posted by: blindedbytheslosh | September 30, 2008 at 07:22 PM

I have a professor that works for the Fed. I will ask him what the Fed does with the foreign currency tomorrow. This assumes he will answer me because he tends to avoid some questions because it is not in the interest of the Fed.

Posted by: bryan dennie | September 30, 2008 at 11:53 PM

My question is very similar to lilnev - is the Fed now running a printing press and if so - how is this sustainable within a serious dollar depreciation?

Thanks, Carmen

Posted by: macro carmen | October 01, 2008 at 07:39 PM

We are paying interest.

From the Bank of Japan:

Interest rates shall be determined by one of the following methods.

(a) Interest rates on the loans shall be determined by multiple-rate competitive auctions. The rate shall not fall below the rate set by the Federal Reserve Bank of New York (FRBNY) as a prevailing USD Overnight Indexed Swap market rate that corresponds to the duration of the loan.

(b) Interest rates on the loans shall be set by the Federal Reserve Bank of New York taking account of a prevailing USD Overnight Indexed Swap market rate that corresponds to the duration of the loan.

(2) Collection of Interest

The interest on a loan shall be calculated based on the rate determined by the method described in (1) for the number of days from the first day after the disbursement of the loan up to the maturity date, and the interest shall be collected after the loan reaches maturity.

Posted by: check your facts | October 16, 2008 at 02:27 PM

One more question, mainly dealing with Balance of Payments methodology.
If the Fed engages in a foreign currency swap with the BoE and has now received pounds, these should be part of the foreign currency assets of the Federal Reserve System. If these are liquid enough, they should be reflected in the international reserves of the USA. I do not think they are reflected there. Why not?

Posted by: Justin | October 27, 2008 at 08:50 PM

Lot's of good questions but not many convincing answers. How come organisations like the Fed cannot provide clear statements and outlines of the tools they so confidently exercise control over?

Please take a look at this link that seems to contradict what has been said here. According to this source, swap lines are in fact meant to be repaid and are severely affected by changes in currency valuations.

I am very suspicious of the comment made in this forum that swap lines can somehow simultaneously extinguish - sounds like utter nonsense to me. How can any good come of something that can just evaporate? And who would base an investment decision on something that they already know will not last and does not really exist.

Wake up - they exist - they have significant risk - and perhaps that is the real intention in the long run. Perhaps some parties at the Fed would like a private pool of foreign currency in case the USD tanks and again the US tax payer would be left worrying about the fall-out of not repaying the reciprocal party on the other end of the swap line .....

Just conjecture :)

Posted by: Toshiba | October 28, 2008 at 08:58 PM

What about swap lines with the countries that have only partially convertible currencies? Some of these countries have choked dollar inflows fearing money supply expansion in their home territory. I would assume that swap lines in most of these countries would impact money supply, particularly reserve money? Could someone answer this one ?

Posted by: c.shivkumar | October 31, 2008 at 04:29 AM

Wow, too complicated for me :)

Posted by: Roy Ewing | April 28, 2009 at 04:31 AM

>How much is to the treasury this swap?

Posted by: marco | January 01, 2010 at 08:38 PM

What is the Fed doing with the foreign currency it is receiving?

Posted by: Currency Rates | April 24, 2010 at 06:14 AM

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September 16, 2008

The left and right of it all

What a wild day it was on Monday in U.S. and global financial markets. We heard it quipped that the problem with financial institution balance sheets is that “on the left hand side nothing is right and on the right hand side nothing is left.” This is clearly an exaggeration, but it does raise the question: What do people look at when gauging the rightness or leftness of balance sheets?

A lot of the discussion about asset quality has focused on mortgage backed securities (MBS). The size of the MBS market has experienced phenomenal growth over the last decade or so—MBS issuance grew from around $500 billion in 1997 to over $2 trillion in 2007. As the name suggests, an MBS is a bond that is backed by the collateral of mortgages—either by mortgages guaranteed by Freddie Mac or similar institutions or other pools of mortgages. The MBS, or pieces of it, are then sold to investors, with the principal and interest payments on the individual mortgages used to pay investors.

Underlying the performance of MBS is the performance of mortgages themselves. Mortgage delinquency has been rising for some time, and especially for subprime mortgages.

Figure 2

At the same time, the value of the mortgages, as indicated by home prices have been falling.

Figure 2

One of the features of the U.S. financial system is that the debt of financial institutions tends to be weighted toward long-term obligations while the financing has been predominately from short-term borrowing. As the performance of the assets has deteriorated the need for liquidity has risen sharply.

The demand for cash was especially acute on Monday, as can be seen in the large intra-day variability in the federal funds market. Federal funds are the reserve balances of depository institutions held at the Federal Reserve. At times on Monday the federal funds rate traded well above the target of 2 percent before the New York desk intervened with an additional $50 billion injection of reserves. This Bloomberg news story describes Monday’s large movements in the federal funds market.

Figure 2

The demand for liquidity at 1 and 3 month horizons also surged, as indicated by the dollar LIBOR spread over OIS at 1 and 3 month horizons. LIBOR (the London Inter-Bank Offered Rate) is the interest rate at which banks in London are prepared to lend unsecured funds to first-class banks. As such it is a guide world-wide for the rate banks use to lend to each other. In the U.S., it is usually not far off from the fed funds rate. But after the emergence of the financial turmoil last fall the LIBOR has risen relative to the fed funds rate. The OIS (Overnight Index Swap) rate is a measure of the expected overnight fed funds rate for a specified term (1 or 3 months, for example). The LIBOR/OIS spread can be used as measure of the amount of liquidity or stress in short-term unsecured cash markets.

Figure 2

LIBOR spreads edged higher last week amid uncertainty about financial firms, and both spreads jumped higher on Monday and Tuesday, with both at or close to new highs.

Tuesday is another day, but some things will remain the same, including the focus of attention on the left and right of financial institution balance sheets, and the debate about the appropriate role of government in all this.

By John Robertson and Mike Hammill in the Atlanta Fed’s research department

September 16, 2008 in Capital Markets, Interest Rates | Permalink


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I think Geithner is doing a great job under impossible circumstances.

The only failure of the Federal Reserve here is in public relations.

The financial press (save the Financial Times) and the blogosphere are absolutely clueless as to why the Federal Reserve is proceeding as it is.

The level of ignorance in the American public about what the Fed does is terrifying. The "conspiracy theorists" are absolutely out of control and dominating the discussion.

This web site is a good beginning. I would like to see ALL Federal Reserve branches have such a blog and this would help. Kansas City should definitely be next in line; Sellon, Hakkio and Hoenig are true stars, as was the great Wayne Angell.

Matt Dubuque

Posted by: Matt Dubuque | September 16, 2008 at 08:42 PM

Matt - I wholeheartedly agree and third your motion. In fact so much so that I've been posting on my own blog numerous times trying to throw some starfish back in the sea. Apparently good conspiracy theories are too much fun no matter what the facts are; e.g. the willful distortion of CPI, the whole GDP deflator tempest, etc. If you've any interest there's a whole archive of my views on Fed policy and another on the credit contagions, for what the views of an amateur are worth.

Posted by: dblwyo | September 17, 2008 at 10:37 AM

Nice post guys. Glad to see some discussion on the underlying problems facing financials and the economy. There are bad assets hiding on banks' books. And now banks are hoarding cash.

Will be interesting to see how things shake out over the next couple weeks. Please keep putting up these kinds of posts. Very helpful and much appreciated.

Posted by: The Street | September 17, 2008 at 08:05 PM

I liked the content on this site. Would like to visit again.

Posted by: Shirin Jindal | September 18, 2008 at 02:59 AM

What Matt Dubuque Said, but...

"Mortgage delinquency has been rising for some time, and especially for subprime mortgages."

Uh, NO, on that "especially." The Fed knows better, and so do you. The "especially" at this point is the PRIME mortgages.

Posted by: Ken Houghton | September 23, 2008 at 07:15 PM

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September 11, 2008

Will automatic enrollment boost 401(k) savings?

In August the Congressional Budget Office updated its annual long-term projection for Social Security and noted that “future Social Security beneficiaries will receive larger benefits in retirement—and will have paid higher payroll taxes—than current beneficiaries do, even after adjustments have been made for inflation and even if the scheduled payments are reduced because the trust funds are exhausted. However, CBO estimates that “under both scenarios, those benefits will represent a smaller percentage of beneficiaries’ preretirement earnings than is the case now.”

Looking ahead, it seems certain future retirees will increasingly rely upon defined contribution 401(k)-type plans upon retirement. That means that millions of workers, with a wide range of preparation and financial literacy, are expected to make sophisticated investment decisions that will shape their future financial well-being. Policymakers are focusing greater attention on ways to increase worker participation in 401(k) type plans. The 2006 Pension Protection Act (PPA) included measures to increase contributions by creating safe harbor provisions that permit employers to offer automatic enrollment in 401k plans. For employers to qualify, contribution rates for those enrolled automatically must be at least 3 percent of salary the first year of participation, rising one percentage point per year to at least 6 percent in the fourth year.

These measures incorporate insights from behavioral economics that 401k default options have a tremendous impact on how much workers will ultimately save for retirement. In the new edited volume Lessons from Pension Reform in the Americas, Beshears, Choi, Laibson and Madrian examined the impact on worker savings when workers are automatically enrolled by their employers compared to when they must actively opt in to a retirement savings plan. They found that when automatic enrollment in retirement plans is the default option, participation rates are much higher than when workers have to opt-in. Furthermore, many workers view the employer default savings option as an implicit endorsement of both the contribution rate and the distribution of funds. They find that default choices are not neutral; they play an important role in every stage of the lifetime savings cycle, including savings plan participation, contributions, asset allocation, rollovers, and decumulation. Default options become even more crucial as defined contribution plans in the United States and the rest of the world introduce more investment options for workers.

Since the Pension Protection Act was just passed in 2006, it is still too soon to know what long-range impact it will have on retirement savings. However, a new paper by VanDerhei and Copeland models the results of automatic enrollment under PPA rules and finds that it will have a significant impact, especially for low-income workers. For the lowest-income quartile, total 401(k) balances would be only 0.1 times final earnings at age 65, compared to 2.5 to 4.5 final earnings (depending on the assumptions used) under automatic enrollment. For the top 25 percent of earners, the jump would be from 1.8 times final earnings to between 6.5 to 10.4 times final earnings.

These automatic enrollees will of course need to decide how to invest their 401(k) savings. Target-maturity date lifecycle funds, where participants select a fund based on a projected retirement date and fund managers rebalance the portfolio over time, offer one solution to problems arising from financial illiteracy, naïve portfolio diversification, and inertia. In a new working paper, Mitchell, Mottola, Utkus, and Yamaguchi find that lifecycle plans will have a more substantial impact if they are designed as the default option, with adoption rates being higher still if employers actively shift participants from existing portfolios to age-based lifecycle funds.

Automatic 401(k) enrollment and lifecycle funds can potentially boost retirement savings. The extent to which employers and workers will embrace these options from the 2006 Pension Protection Act is an open question, but the early signals are positive. At a May 2008 Employee Benefit Research Institute forum on the 2006 PPA, participants noted that an increasing number or employers, especially large ones, are adopting automatic enrollment.

By Stephen Kay, coordinator of Latin American analysis at the Atlanta Fed

Note: Macroblog will not feature postings on monetary policy issues during the Federal Open Market Committee meeting blackout period, which runs from the week before the FOMC meeting until the Friday after it. Also, David Altig, senior vice president and research director of the Atlanta Fed, will not post during this timeframe.

September 11, 2008 in Labor Markets, Saving, Capital, and Investment | Permalink


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I would hope that there would be widespread consensus for this approach. But in a nation increasingly dominated by those with lower educational standards, one can never be sure.

I would hope that all responsible parties would agree that we need to save more as a nation. This proposal would assist in that national security goal.

I am persuaded that you are aware that this "libertarian paternalism" approach has been widely popularized by the delightful book "Nudge", authored by University of Chicago professors Thaler and Sunstein:

Matt Dubuque

Posted by: Matt Dubuque | September 11, 2008 at 03:01 PM

> adoption rates being higher still if employers actively shift participants from existing portfolios to age-based lifecycle funds

That doesn't sound "voluntarily" to me anymore - I want to keep the freedom to save differently than the herd.

Posted by: Peter T | September 11, 2008 at 06:00 PM


I would support the "default" option for 401(k) enrollment, but I would oppose "default" options for such life cycle allocations afterwards.

I don't trust the government to decide whether it's appropriate to invest in various portfolios with massive derivative exposure such as some of the "safer" bond funds that jack up returns with highly questionable and illiquid derivative strategies.

You might enjoy the book I cite. Quite popular among University of Chicago school adherents.

All freedoms are still present; you can opt out at any time for any reason without penalty. Hence the "libertarian" portion of its description as "libertarian paternalism".

Matt Dubuque

Posted by: Matt Dubuque | September 12, 2008 at 09:35 AM

Default options sponsored by governments are generally the most transparent and therefore the most vetted of default options.

And there is understandable laziness in making a non-default decision.

Hence the behaviour.

Posted by: anon | September 12, 2008 at 10:16 AM

After food, fuel and rent there is nothing left for savings.

Posted by: David | September 21, 2008 at 11:25 AM

You can pay fuel?

Is anyone ever going to point out that 401(k)s as primary retirement vehicles are the second-dumbest idea ever invented, behind IRAs?

Bad enough to put money you can't afford to lose in the stock market--as several people are finding out, again as, for the second time in a decade, a "once-a-century" event occurs--but then not to be able to take a tax credit on those losses...

Posted by: Ken Houghton | September 23, 2008 at 07:19 PM

Auto enrollment plans are showing positive results in terms of increasing savings. I think they are particularly helpful with getting younger employees started on the right track towards retirement savings.

Posted by: Snap401k | November 17, 2009 at 01:25 PM

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September 09, 2008

Hurricanes put energy on center stage

Hurricane season is in full swing here in the Southeastern United  States. The Atlanta Fed pays particular attention to hurricanes for two reasons: (1) they have significant impacts on the local economies they strike, and (2) they can potentially have big impacts on the national economy.

For example, in 2005, even though the Katrina and Rita storm-damaged area of Louisiana represented only a small fraction of the nation’s gross domestic product (GDP), it cast an outsized shadow because of its very large role in oil and gas production and processing. Katrina and Rita’s disruptions of this production and processing spilled over into the national economy, destroying 113 offshore oil and gas platforms and damaging 457 oil and gas pipelines. This damage generated uncertainty about the availability and price of energy products, causing prices to immediately jump.

After relatively quiet hurricane seasons in 2006 and 2007, 2008’s hurricane season thus far has been quite active, with potentially significant national implications. That’s because the Gulf of Mexico remains a substantial source of oil and natural gas production—just as it was three years ago. In addition, coastal Louisiana is the home to upwards of 50 chemical plants, which produce 25 percent of the nation's chemicals that are used in a wide variety of products such as medicines, fertilizers, and plastics. Compounding the Gulf Coast’s concentration of oil, gas and chemicals is the fact the U.S. economy is in a weaker state today and, as a result, more vulnerable to economic shocks than in 2005, a point made in a recent CNNMoney article about Hurricane Gustav.

One of the questions we are often asked is, “what is the effect of a hurricane on the economy?” Not surprisingly, the answer depends on what “the economy” refers to. From a national accounting perspective, GDP is a measure of the nation’s current production of goods and services; thus GDP is not directly affected by the loss of property (structures and equipment) produced in previous periods.

However, there are usually second-round GDP effects that arise because of disruptions to production, income and consumption flows. The Bureau of Economic Analysis provides a good description. For example, in the short run after a hurricane, incomes in many industries are likely to decline because of cuts in production, while some industries involved in the cleanup and repair may see activity increase. Similarly, incomes and spending could increase in areas that are the recipients of evacuees. The net effect of these flow disruptions on GDP over time is often not large because lost output from destruction and displacement is offset by a big increase in reconstruction and public spending later.

But even if the effects are neutral on a national scale a storm’s impact can be long-lasting in an affected locale. For instance, the flooding associated with Katrina left the economy of New Orleans devastated, and in many dimensions it has not fully recovered three years after the storm. Air traffic through New Orleans International Airport increased 13 percent in June 2008 compared to a year earlier but still remained well below pre-Katrina levels. Hurricane Gustav resulted in another evacuation of the city and the cancellation of numerous tourist and other events. Clearly storms like this have the potential to wreak havoc on the prosperity of the Crescent City.

The Atlanta Fed regularly reports on regional economic conditions on its public Web site. As part of its efforts to monitor storm effects—both local and national—the Atlanta Fed is also providing information on post-storm conditions in the affected areas. So far, these reports have focused on Hurricane Gustav’s impact on key energy and transportation infrastructure. The Bank will provide similar updates on other storms, including Hurricane Ike, which had entered the Gulf of Mexico at the time of this posting.

By John Robertson and Mike Chriszt in the Atlanta Fed’s research department

Note: Macroblog will not feature postings on monetary policy issues during the Federal Open Market Committee meeting blackout period, which runs from the week before the FOMC meeting until the Friday after it. Also, David Altig, senior vice president and research director of the Atlanta Fed, will not post during this time frame.

September 9, 2008 in Energy, Katrina | Permalink


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Interesting that you should bring up hurricanes.

Those who claim that the Fed must only conduct monetary policy using linear/quadratic models (apparently Buiter among them?) would confine the Fed to models that assert that shocks hitting the economy are distributed in a Gaussian manner.

Mainstream Fed thought seems to understand that this is demonstrably false. I view it as asinine.

I wonder if those people who shout so loud that the Fed needs to use models that assume a normal distribution of shocks throughout the economy as a guide for open market operations similarly claim that shocks from a HURRICANE are normally distributed along its path......

Indeed, the similarities between economic shocks and hurricanes may not be a trivial one mathematically. Picking up momentum over water, etc.

And the damage that a hurricane causes is obviously skewed in various ways, depending on so many factors.

An interesting mathematical metaphor.

Matt Dubuque

Posted by: Matt Dubuque | September 09, 2008 at 09:12 PM

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September 04, 2008

Employment watch

I pity the folks on the National Bureau of Economic Research (NBER) Business Cycle Dating Committee, burdened as they are with the task of determining if and when the U.S. economy finds itself in an officially designated “recession.” While skepticism about the preliminary report on second quarter U.S. growth is not entirely unjustified, it isn’t so easy to square the presumption of an economy in recession with the gross domestic product (GDP) data we have in hand.

On the other hand, there is the employment picture, which I would rank high among equals on the list of things that the NBER committee says it monitors in making the recession call. A few weeks back, Menzie Chinn noted.

“Over the past few months, I've heard that, while job creation is insufficient to keep unemployment rates constant, job losses have not been consistent with recession…

“What is clear is that while the employment series might not be evidencing a severe dropoff, the hours series is [Update: this point has been made previously by Spencer at Angry Bear]. This is relevant because growth in hours is at levels consistent with at least the last two recessions.”

Actually in the referenced post from Angry Bear, Spencer notes that even the employment series looks awfully recession-like:

For this reason the monthly Bureau of Labor Statistics (BLS) employment report looms large, at least in my own thinking about the state of the economy. And today, of course, brings a sneak preview in the form of the ADP National Employment Report. The news didn’t suggest any break from the recent pattern:

According to Joel Prakken, chairman of Macroeconomic Advisers, LLC, "Nonfarm private employment decreased 33,000 from July to August 2008 on a seasonally adjusted basis, according to the ADP National Employment Report. The estimated change in employment from June to July was revised down from an increase of 9,000 to an increase of 1,000.

"The decline in August continues the recent trend in employment that is consistent with an economy that is growing slowly but has not fallen into recession."

If you follow these things, you know that today’s ADP news is not all that likely to be confirmed by tomorrow’s official BLS report. It’s useful to bear in mind, however, what is one of the main selling points of the ADP statistic:

“There is a very powerful statistical tendency for estimates of growth of establishment employment, as reported by the BLS after annual benchmarking, to be revised in the direction of estimates previously published in the ADP National Employment Report.”

Here’s what they are talking about.

In words, when the ADP stat on employment growth has exceeded the initial BLS number, there has been a tendency for ultimate revisions to the official BLS job growth number that are in the upward direction.

Today, of course, may not be like the past, but it’s something to bear in mind as you process tomorrow’s report.

September 4, 2008 in Data Releases, Labor Markets | Permalink


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Dave says: "...there has been a tendency for ultimate revisions to the official BLS job growth number that are in the upward direction." Well, yes... and no. According to BLS data Actual vs. Revised US Nonfarm Payroll Total MoM Net Change SA, if we focus on the past year, we find that revisions have been on average -12K from actual. Put another way, over the past year, the BLS has reported 144K more nonfarm payroll jobs than were actually created when the numbers were ultimately revised. If however, we focus on let's say the past 2-years, the average revision has been +3.8K. So while over longer history Dave is correct, over the past year the BLS has been on average overstating, rather then understating nonfarm payrolls in their monthly report. Something else to keep in mind as we process tomorrow's report.

Posted by: Ken | September 04, 2008 at 06:43 PM

Dave, if you look at the "output gap" (where trend is measured as a straight line through log real GDP starting at 1973), our output gap is now -2%, which is lower than it was in the 01 recession and about the same place it was in the 91 recession.

Hope you are liking Atlanta!

Posted by: Morris Davis | September 08, 2008 at 06:03 PM

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Posted by: Employment Genius | April 12, 2011 at 12:38 PM

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September 02, 2008

Does the GDP deflator lie?

Though last week’s report on U.S. gross domestic product (GDP) growth in the second quarter is second-hand news by now, I’ve taken note that Barry Ritholtz’s views on the news has, in particular, continued to rumble through the blogosphere. Barry is not happy with the GDP deflator, and samples approvingly from a Barron’s article by Aaron Abelson:

“GDP, in common parlance, stands for gross domestic product, or the aggregate value of all the goods and services produced on these blessed shores... These days, alas, those initials more typically signify “gross deceptive pap”...

“Comes now the so-called preliminary estimate that claims second-quarter GDP grew by a much more robust 3.3%.

“The key here is the GDP deflator, which purports to adjust GDP for the impact of inflation; it’s a curious calculation in that, contrary to its moniker, it seems designed to do the exact opposite of deflating GDP.

“Thus, according to this accommodating measure (accommodating, that is, if you’re determined to put a good face on a dreary report), inflation grew at an improbably restrained 1.33% in April-June. And maybe it did—but not in the good old U.S. of A. However, obviously more important than accuracy to those doing the calculating is this simple equation: The lower the deflator, the greater the growth of GDP…

“Of course, even by the government’s not entirely extravagant figuring, the consumer price index was up a hefty 8% in the latest quarter. Perhaps the computer that tallies the CPI doesn’t talk to the computer that measures the deflator.”

Strong words, but if you ask me, misguided. Barry actually makes the case against the case in this picture, about which he notes:

Consumer Price Index Year-Over-Year % Change

“It’s no coincidence that the current situation resembles past ones where oil prices had spiked. Since more than half of the U.S. Crude consumption is imported, the price and quantity go into all GDP calculations as a negative.”

Exactly. Let me provide an elaboration of the spot-on point made at The visible hand in economics blog. For the sake of argument assume that every drop of oil consumed in the United States is imported, and everything imported to the United States is oil. If we leave exports out of the picture for simplicity, we can think of U.S. consumption as consisting of GDP—everything produced in the United States—and imported oil.

Suppose, then, that the price of oil rises precipitously. If both incomes and oil consumption are relatively fixed in the short-run, what would we expect to happen? The answer is more expenditure on imported oil and less spending on everything else. As the demand for domestically produced goods and services falls, so would their prices. (Or more generally, they would rise at a slower than normal pace.) Since domestically produced goods and services by definition constitute GDP, GDP-deflator inflation will be low, while the consumer price index (which would include nonexported GDP plus imports) could well be quite high.

Voila! A simple Econ-101 explanation, with nary an insult hurled at the good folks from the Bureau of Economic Analysis.

That said, there are plenty of reasons to be cautious in interpreting last week’s report. Mark Thoma has a fine roundup of many fine points by many fine bloggers. To that list I’d add comments by Spencer at Angry Bear, William Polley, Lim at The Skeptical Speculator, Ben Leeson at Working Thoughts, Zubin Jelveh and Felix Salmon (both at, to name a few. But I would delete the suspicion that low GDP-deflator-based inflation suggests shenanigans are afoot.

September 2, 2008 in Data Releases, Inflation | Permalink


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» The GDP Deflator and the Inflation Rate from Economist's View
There is confusion between the GDP deflator and other measures of prices such as the CPI and the PCE deflator. Here's one way to think about it that might help to clear things up. The CPI (or the PCE) attempts [Read More]

Tracked on Sep 3, 2008 7:04:58 PM

» Taking a Closer look at Other 3 % GDPs from The Big Picture
Over the years, I have criticized a variety of official data points as misleading: Consumer Price Index (CPI) for woefully understating price increases, Non Farm Payrolls (NFP) due to the Birth/Death Adjustment, Core Inflation for omitting anything goi... [Read More]

Tracked on Sep 4, 2008 7:44:13 AM

» Borrowing future growth from
By Fester: Today's employment and unemployment numbers were ugly. The unemployment rate went to 6.1%, another 84,000 jobs were cut in the initial August estimates after the July estimate was increased to a job loss of 100,000 jobs, and wage [Read More]

Tracked on Sep 5, 2008 3:21:21 PM


What I like about this explanation is that it also explains what's going on with the puzzle of slow GDP growth in Canada. The story is the same, but with the signs reversed.

Posted by: Stephen Gordon | September 02, 2008 at 06:31 PM

>Voila! A simple Econ-101 explanation

Aha! that means that is has no relation to the real world, like most "simple Econ-101 explanations" ...

Posted by: Marcello | September 02, 2008 at 08:33 PM

OK, I follow your argument. But it still seems too low. It is much lower than the core inflation numbers being reported which strip out food and energy. Add food back in and I bet it is north of 3%. What's the explanation for this?

Posted by: pclema | September 02, 2008 at 08:35 PM

Having seen the discussion on Barry Ritholtz’s series of posts, I agree with your conclusion here. You’ve described a scenario in which import inflation results in downward pricing pressure on domestic output and the deflator. A variation on this scenario is one in which import inflation at the margin adds to the current account deficit, with no change in the pricing of domestic value added or in domestic income, and no net effect on the deflator. This would still explain a deflator level that was persistently lower than an inflation rate that incorporated import prices.

These scenarios are variations on the same relative pricing effect. In either case, one can compare the difference between the deflator and some broader measure of consumer prices, such as the CPI, the latter which would include the price effect of embedded and directly purchased imports. The difference between the two is the degree to which there is downward pricing pressure on the deflator itself. Either way, the spread between the deflator and the more import inclusive measure of inflation widens.

The GDP deflator calculates price changes for domestic production, while broader inflation measures such as CPI capture domestic consumption. Both are sensitive to the treatment of imports and exports. The most evident difficulty in interpreting the deflator versus alternative measures has to do with these international elements.

A common objection is that the GDP deflator, because of its currently depressed level, doesn’t impress the “man (or woman) on the street”, who is seeing and experiencing a much higher headline CPI number.

The further inference is that the number or “the model” must be wrong. Add to this protest the other issues that are perennial fodder for the inflation measurement debate, and the discussion becomes a bit of a mess. And finally, for additional density, add conspiracy notions to the mix.

The irony is that the GDP deflator shouldn’t be that interesting to the typical consumer, who won’t be so curious about the price of goods that the US is selling overseas. But that person, if she does pay attention to this number, should know it excludes changes in import prices as embedded in final purchases. At the same time, she would want to know if such import price changes are being passed on, absorbed, or accentuated by the final product pricing of domestic vendors.

The GDP deflator is a complicated measure, in that it includes foreign exposure to US generated inflation, while excluding direct US exposure to foreign generated inflation. The typical consumer (or blogger), should probably approach its interpretation carefully, with this in mind.

At the same time, it should help the average consumer to know that alternative measures of inflation are available that are more indicative of price behaviour within their immediate experience. And if they are interested in the GDP deflator, they should read up on it at professional economic sites such as this, knowing that the explanation will be measured and correct.

Posted by: JKH | September 02, 2008 at 10:34 PM

I just had a very similar post about GDP chain deflator in my blog last week. You can check if you want, link is in my name.

Posted by: Andy Bebut | September 02, 2008 at 11:53 PM

Lie is the wrong word -- my question is, does GDP present an accurate portrayal of economic reality?

The short answer last quarter was no.

My take is that 3.3% in Q2 is very misleading -- and the guilty culprit is the deflator, a misnomer last quarter, as it served to INFLATE GDP data.

Note that this is not a conspiracy theory, but rather a critique of a model that does a mediocre job in portraying the economy . . .

Posted by: Barry Ritholtz | September 03, 2008 at 06:53 AM

"...As the demand for domestically produced goods and services falls, so would their prices. (Or more generally, they would rise at a slower than normal pace.)..."


that´s the same old fed rhetoric that justified the wave of rate cuts.

over the last year demand DID fall and prices DID rise as companies pass higher costs to protect their margins.

so far the text book of economics didn´t work.

Posted by: GreenAB | September 03, 2008 at 07:33 AM

Is it not simple quantitative analysis? The import deflator of -4.56% overwhelmed the PCE, Investment, Export and Government deflators of 2.93%, 0.11%, 1.37% and 0.98%, respectively.

BEA Table 1.1.8

Posted by: marmico | September 03, 2008 at 08:40 AM

Better to look at the deflator for Final Sales to Domestic Purchasers. This measures what people (and businesses) BUY, not what they produce. For 2Q08 it ran 4.3%. Makes one wonder about 2% Fed Funds and Treasuries under 5%!

Posted by: Doug | September 03, 2008 at 10:03 AM

I love economics, and that's why I read posts like this. But aren't Econ 101 explanations (deliberately) grossly simplified? I think the real world flaw in this explanation is the assumption that oil is solely a consumer ready commodity. Doesn't the rise in the price of imported oil affect domestically produced goods because oil is an input? Shouldn't the deflator be higher to account for this fact? If we're using nominal prices for output, I don't understand how the rise in a critical input like oil shouldn't make the deflator pretty high right now. This is not a conspiracy theory but goes to Barry's point that the headline number is ridiculous in the context of the real world we all inhabit.

Posted by: anon | September 03, 2008 at 12:46 PM

I just posted on this. Wish I had seen this yesterday...

Posted by: David Merkel | September 03, 2008 at 02:24 PM

The other dimension to this is that the GDP deflator also includes the price of residential investment, which has been falling in line with the OFHEO house price index.

In fact, there's a good argument to be made that the GDP deflator overstated inflation in Q2 because the BEA insists on basing that residential investment deflator on the OFHEO index rather than the Case-Shiller index. The latter suggests house prices have been falling much more sharply. If the BEA used the Case-Shiller index instead, the GDP deflator might have turned out to be negative.

Posted by: Anon | September 03, 2008 at 04:21 PM

The average person doesn't and shouldn't care about the GDP, nor should the press or any organization push it as a measure of economic health. The GDP can rise by 10% and it wouldn't mean a darn thing to someone buying milk at $5.50 a gallon. Real world economics is a whole different ball game. You have to look at prices on the streets.

Posted by: John Brock | September 03, 2008 at 04:56 PM

it would be more proper to state that if the price of one good (like oil) increases sharply, due to for instance, a supply shortage, and the money supply stays stable at the same time, then prices for other goods elsewhere in the economy would have to fall to balance the price rise in oil out. unfortunately this simple model doesn't work in the real world either, because the money supply is anything but stable. what is commonly referred to as 'inflation' is better called 'rising prices' as it is really only the effect of inflation (inflation of money and credit), and this effect tends to arrive with a considerable lag, as newly printed money is obviously not received by all participants in the economy at the same time. it feels downright odd to have to point this out, but inflation is a monetary phenomenon. in the meantime, as regards GDP , it is a pretty useless number for a great many reasons. Sean Corrigan wrote (a by now somewhat dated, but still pertinent) article on the 'anatomy of growth' that looks at this in some detail. link:

Posted by: pater tenebrarum | September 03, 2008 at 10:37 PM

Is it fair to extrapolate from this argument that U.S. companies have virtually no pricing power for domestically produced goods and services? It seems to me that this is a recipe for razor thin domestic operating margins. Are U.S. companies generally applying the airline model, whereby companies are trying to make up for negative margins through volume growth? Uh oh.

Posted by: Adam Butler | September 04, 2008 at 08:28 AM

That was a technical explanation of how it is calculated. It doesn't change the fact that the number does not reflect how strong or weak the economy is. It is simply not credible to assert 3+% economic growth when employment and real wages are falling an corporate profits at the same time is plummeting.

Posted by: Stefan Karlsson | September 04, 2008 at 09:49 AM

Hmmm, Here's an interesting observation:
“The current crisis has revealed fundamental shortcomings in the prevailing credit arrangement,” exposing weaknesses that will “require significant institutional change in both the public and the private sectors,” said Terrence Checki, executive vice president of the New York Federal Reserve."

Posted by: bailey | September 04, 2008 at 10:03 AM

Federal Reserve Bank of San Francisco President Janet Yellen said in a speech today that the economy's acceleration to a 3.3 percent growth rate in Q2-08 "is likely to prove ephemeral". Indeed, years from now we will look back at this Q2-08 GDP datapoint as an outlier to what is commonly inferred by GDP. The reality of the revised report is that Net Export contributed 3.1% of the 3.3% Q2 GDP number. The real growth rate of export was revised to contribute 1.65% from 1.16%, and the real growth rate of import was revised downward so as to contribute 1.45% from 1.26%. As such, the large impact net export had on the final GDP number reveals substantial weakness in domestic demand and hence the comments provided by others responding to this topic. The question Dave, Janet and the others at the Fed have to be asking themselves is if this export effect on GDP is likely to continue. The answer lies in one's belief about the strength of the largest US export economies, coupled with one's belief about the current rally in the US dollar. If the dollar rally is a temporary aberration, and the economies of Canada, Europe and Mexico are believed to escape the world's current economic malaise, then Q2 GDP won't seem so odd. However, if the dollar rally is sustained and the G7 economies tip into recession, this Q2 GDP number will soon be forgotten. Ms. Yellen went on today to say, "My forecast is for sluggish growth in the second half of this year with substantial downside risks." At this point, that seems a rational bet.

Posted by: Ken | September 04, 2008 at 05:52 PM

Even more pronounced difference happened in Slovakia in 4q07, when deflator was negative, even though the consumer prices rose by more than 4%. The nominal GDP growth was thus at around 11%, and real at 14.3% :)

Posted by: Michal Lehuta | September 05, 2008 at 10:32 AM

Your mindframe is still based on closed systems. That doesn't apply any more and leads to the faulty logic you once again show here.
Prices do not magically fall or fail to rise, because internal demand is faltering. Maybe the price in the barbershop. But nearly everything else today is tradeable, including services of course.
Prices of tradeables are not determined by internal demand. This is why your explanation is just horrific economics.Actually it's a shame.

Posted by: jboss | September 05, 2008 at 10:46 AM

The contentious issue was whether Q2 real GDP growth could be explained rationally. The debate was between those who could explain it rationally, and those who believe its a failure in "the model", due to the low level of the GDP deflator. My view is that the rational explainers win the debate, as presented here.

An entirely separate issue is whether Q2 real growth is sustainable. This is addressed in the Yellin speech.

The first issue has nothing to do with second.

But I fully expect that those who have rejected the Q2 number on the basis of the first argument will come back in Q3 and claim victory using evidence on the second.

Posted by: anon | September 05, 2008 at 10:47 AM

With regard to Anon's comment: According to Wikipedia (not the final authority on such things, but certainly a reasonable source for general interpretation in this context), "GDP is widely used by economists to gauge the health of an economy". If the debate in this topic is over the rationality of the Q2 GDP explanation, and as Anon has done, we accept that explanation as rational, then we must also conclude the Q2 GDP value as being indicative of the health of the economy in Q2 (based on the Wikipedia definition). So which of the following statements is most true for you:

1. I accept the GDP model works perfectly providing me with an exceptional insight into the health of the economy in Q2, and therefore will base by business investment decisions going forward on the fact that the trend in economic growth turned the corner in Q2.


2. Q2 GDP is a number that I find to be an outlier one-time event, particularly in light of the weak GDI and it provides little insight into the overall health of the economy. As such, I don't necessarily find the GDP model to be broken, but I will likely not alter my business investment decisions based upon this single number.

Distilled: a meaningful debate should be over if the Q2 GDP number the model produced was valuable in providing us with a guage of the economy's health and will alter business investment as a trend altering event going forward; or if in retrospect we will soon come to view the Q2 GDP number the model produced as an outlier.

Posted by: Ken | September 05, 2008 at 05:05 PM

Re: Ken’s comment from September 05, 2008 at 05:05 PM

Proposing a “meaningful debate” is fair enough, but the main post addresses a false line of argument that rejects the validity of the GDP result. This false argument impedes a more meaningful economic analysis of GDP results. The contrast is noted in the final paragraph of the post.

With respect to the questions posed, business decisions shouldn’t be based on a retrospective view of the economy. One needs to look deeper than an ex post quarterly GDP measure to investigate the probable path for future readings. The post concludes by pointing to forward looking analyses beyond the Q2 result. Most acknowledge that most of the growth was due to net exports, and question the sustainability of that factor.

And the accuracy of a particular GDP reading shouldn’t be confused with a legitimate difference between trend and volatility. Conversely, volatility doesn’t prove measurement inaccuracy.

This brings us back to the blogging case made against the veracity of Q2 GDP growth. The most aggressive version goes something like this:

a) The high level of the Q2 import deflator has artificially depressed the GDP deflator
b) The low level of the GDP deflator is not representative of “reality”
c) The low level of the GDP deflator has artificially boosted Q2 real GDP
d) Q2 real GDP is not representative of “reality”

Each of these is wrong. The first contradicts the factual definitions that determine the various GDP equations. The second confuses the deflator with competing consumption oriented measures such as CPI. The third further ignores definitional relationships. And the fourth is a summary conclusion supported by the additional general evidence of “gut feel”.

These erroneous contentions fail to consider Q2 net exports, which provided the largest sector contribution to Q2 GDP growth. Net exports constitute the least observable GDP component from the perspective of those who focus on domestic consumption/inflation, while ignoring the definition of GDP and the GDP deflator.

The difference between GDP and GDI is a valid measurement issue.

None of this means that Q2 GDP won’t be revised lower. Nor does it mean that Q3 GDP can’t be lower, or that import inflation can’t be lower, or that the deflator can’t be higher. To suggest that Q2 real GDP is not indicative of a trend is entirely reasonable. But it is a fraudulent distortion to suggest it is not so because the low reading on the GDP deflator has somehow “inflated” real GDP.

(Janet Yellen’s recent speech, as excerpted by Ken above, includes the reasonable prognosis of weaker GDP following the Q2 result. But in no way does it contradict the Q2 measure per se.)

Posted by: anon | September 08, 2008 at 06:19 AM

Re: Anon's 9/8/2008 6:19 a.m. comment

We are debating two seperate issues. The first is the validity of the measurement. For this I have no disagreement with what Anon or Dave have argued. They are in my view, absolutely correct. The subject of this post I didn't believe was to limit the debate to simply the validity of the measurement, but rather more to the point was the issue of people being so dumbfounded by the value that they were willing to believe fraud was the source. To debate the measurement is one debate. To debate the extraordinary implication of the value is another. I was addressing the later rather than the former. For further reading on this part of the debate, Caroline Baum has a great article on Bloomberg this morning titled, "Output Without Income Is Like a 'Virgin Birth'. It addresses the lack of GDI in the face of roaring GDP. She sources a study by Fed economist Jeremy Nalewaik that suggests "real time GDI has done a substantially better job recognizing the start of the last several recessions than has real time GDP". While perhaps others are not so inclined, there are times when I believe GDP does not give us sound information about the health of the economy. Q2-08 was one of those times.

Posted by: Ken | September 08, 2008 at 12:09 PM

Re: Ken’s 9/8/2008 12:09 p.m. comment

I don’t disagree. The number may well be questionable for several reasons. The GDI disconnect is a legitimate source of concern. The sustainability of net export growth is another. Inventing erroneous algebraic inferences within the GDP equations is not.

Posted by: anon | September 09, 2008 at 07:06 AM

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