The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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September 17, 2009

An agnostic gets a little religion

Yesterday's consumer price index (CPI) report showed further disinflation in August, at least on a year-over-year basis. Headline inflation was down 1.4 percent from last year, the largest 12-month decline since January 1950, save for the 2.1 percent decline the month before. Core inflation crept down to 1.5 percent in August, and private forecasters see slow price growth continuing through at least next year. The Blue Chip Economic Indicators, a monthly poll of around 50 business economists in the United States, showed consensus expectations for year-over-year growth in core CPI at 1.5 percent in 2010, a relatively low number compared with recent history, and a shade under the panel's forecast for 1.6 percent in 2009.

I'm a bit of an agnostic when it comes to the predictive capacity of the Phillips curve—the inverse relationship between unemployment and inflation. There is considerable evidence that looking at the gap between unemployment and the nonaccelerating inflation rate of unemployment (NAIRU, sometimes termed the natural rate of unemployment) isn't necessarily useful for estimating future inflation; Atkeson and Ohanian found that inflation predictions from Phillips curve–based models were no more accurate than a naïve forecast where future inflation is defined by its recent past, ignoring the current state of the economy. A more recent working paper by Stock and Watson supports Atkeson and Ohanian's evidence that the predictive abilities of Phillips curve forecasts are not very robust. But Stock and Watson also point out that when the gap is big, there is more information that can be gleaned.

"When the unemployment rate is near the NAIRU … Phillips curve models do worse than the UC-SV model [a modified version of the Atkeson-Ohanian naïve forecast]. But when the unemployment gap exceeds 1.5 in absolute value, the Phillips curve forecasts improve substantially upon the UC-SV model. Because the gap is largest in absolute value around turning points, this finding can be restated that the Phillips curve models provide improvements over the UC-SV model around turning points, but not during normal times."


Stock and Watson argue that large positive (or negative) unemployment gaps (like those usually found around turning points in the business cycle) do improve the inflation forecast. So when the unemployment gap swells—as it did following the 1990 and 2001 recessions—we should anticipate more downward pressure on inflation than the naïve models would have forecast. The chart above, which shows core CPI and the unemployment rate gap as estimated by the Congressional Budget Office (CBO), seems to bear out this point. High rates of unemployment following the 1990 and 2001 recessions were also associated with turning points in the core inflation trend.

If Stock and Watson have it right, then the huge rise in the unemployment rate we've seen over the past year isn't something that inflation forecasters will want to ignore, and the downward drift in core inflation associated with this recession could be with us for a while. That potential scenario follows their reasoning, but like I said, I'm an agnostic when it comes to Phillips curves.

By Laurel Graefe, senior economic research analyst at the Atlanta Fed

September 17, 2009 in Inflation | Permalink


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It is interesting that (CPI and GDP deflator) inflation has very low correlation with contemporary and past values of unemployment in the USA, but its correlation with unemployment 2.5 years in the future is more than 80% (see, for example, The Anti-Phillips curve http://mpra.ub.uni-muenchen.de/13641/). In other words, inflation can be treated as the driving force of unemployment, i.e. just opposite to that presumed by the conventional Phillips curve.)
Even in the current crisis the (month-on-month) inflation leads the unemployment by several months. So, the conventional Phillips curve has never been a right one for the USA and hardly become useful.

Posted by: Ivan Kitov | September 20, 2009 at 09:53 AM

Isn't the point of the Philips curve that there is a mechanized tradeoff function between unemployment and inflation? If so, bounding the application of the tradeoff to certain extreme values really negates the Philips curve concept entirely (at least in my estimation)

Posted by: fischer | September 20, 2009 at 11:52 AM

The Phillips curve is the least of my concerns.

No civilization can maintain a reserve currency while constantly funding its expenses by borrowing from rising powers indefinitely. It's never happened that way in world history. You guys believe in empircal study of history right?

By "reserve currency" I mean basically the currency that governments save in. Many governments have no savings as they are in debt, but some do. China and Russia have savings, they aren't issuing massive amounts of debt onto the world bond market(like we do)...they have over time taken in more money than they have spent...when they have savings they have a choice(save it in dollars/euros/silver/oil/nuclear missiles/corn etc)...when they hold it in dollars they are fine if the dollar is rising or stable in value.

read this:

This came out in March but people have been talking about China(and Japan) building up massive amounts of treasuries of years. Russia also has a lot. These three countries along with the oil producing mid-east countries(Saudi Arabia,Kuait,UAE) have played a big role in keeping the dollar up at relatively lofty levels...they continually buy the treasury bonds that the US government auctions off regularly throughout the year. traditionally when countries have deficits(as a percent of GDP) as high as we do, the curency starts to weaken. When you here that the US government has a budget deficit of 400 billion a year and now 1.8 trillion a year...that means someone is buying that many bonds during that year. Until now...this year the Fed started buying a good number of these bonds as well. Whend the fed buys the bonds from the US governemnt, they are just creating the dolalrs out of thin air. The countries that have dollar reserves are naturally worried by this, because if this trend were to keep going then it would eventually seriously devalue the dollar.


The argument you will hear from mainstream democrats and republicans(and there is some truth to it) is that china doesn't want to do this because if the dollar crash then americans would not be able to buy as much stuff from china factories(prices would be too high) and this would cause too much unemployment and political instability in China. HOWEVER, I think(and many others) that it is silly to think that China has not been well aware of this and that they do see it as a critical weaknes and they are trying to make themselves gradually less vulnerable AND if they feel they are really pushed into a corner by America that they would be willing to basically kill the dollar and suffer from the negative externalities...but that they would also have prepared their portfolio and position in a attempt to minimize the negative effect it would have on their economy.

They would do this by building up reserves of commodities, ownership of mines and natural resources through partnerships with african mnations(which they have done)...building massive stockpiles of copper,platinum, uranium, silver, nickel, gold, oil etc. and doing all this without gradually without causing too much panic int he market so they can get these positions built up as high as possible without causing everyone else to panic and force all these prices up before they can get their positions built up.

As you can see from the article and if you search on this topic you'll find many other example, they ARE CONCERNED. The question is would they ever get frustrated enough that they didn't propose some kinda UN'y IMF'y world government soft currency9as they have so far), but instead come right out and say "US we are tired of your armies in JAPAN, South Korea and your Taiwan posturing...get out of the far east or we will actively dump treasuries onto the market and convert all of our existing dollar reserves into precious metals. then we will issue new reserve curency together with Japan, Russia, Japan, Brazil. This curency will be backed by gold/silver and a set unit that is 100% fully redeemable at any time. We will not borrow money on this currency and we will not print this currency beyond the reserves we have in storage backed by the ageed upon commodity basket.

This seems like a drastic move, but it is certainly not as drastic as the US threatening people with nuclear weapons and certainly (if done correctly) it is not as self destructive as using nuclear weapons.

Posted by: Gabe | September 24, 2009 at 12:04 PM

Posted by: Ivan Kitov | September 20, 2009 at 09:53 AM

Isn't the relationship your talking about driven mostly by the fact that over the last two decades the Fed has tended towards raising interest rates after seeing the CPI spike?

Isn't it the raising of interest rates that is a stronger leading indicator of unemployment? and of course that is during a long 27 year boom phase caused by the expansion of the money supply since we completely divorced from gold in 1971. Things could be much different if the dollar loses it's reserve curency status.

Posted by: Gabe | September 24, 2009 at 04:55 PM

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September 10, 2009

Economists got it wrong, but why?

Economists definitely received some bad publicity this past week, most prominently in the New York Times, where Paul Krugman asked "How Did Economists Get It So Wrong?," a nonrhetorical question he goes on to answer this way:

"As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth… the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

"Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets—especially financial markets—that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don't believe in regulation."

For at least one part of the Krugman critique, I have some sympathy. On the occasion of a 2005 conference honoring the 25th anniversary of Chris Sims's pathbreaking article "Macroeconomics and Reality"—an article that was itself a critique of empirical practices then dominant in central banks—I had this to say about the dangers of groupthink and questions we might be missing as a consequence:

"We are close to falling dangerously in love with the basic New Keynesian framework, the sticky price aspects of it in particular. Here is a simple observation: In the [statistical models] that are identified in the usual ways, inflation wants to drop like a rock in response to a basic technology shock. Models that engineer significant price inertia don’t want to let that happen…

One final point. In my time at the Fed, I have come to appreciate that most of the really important policy choices have nothing to do with Taylor rules or the like. They have to do with those episodes of financial crisis in which Taylor-like rules are woefully inadequate. Think here October 1987, the period from summer 1997 through the end of 1998, and the aftermath of September 11, 2001."

Though Professor Krugman spends a lot of time attacking acolytes of the so-called "Chicago" school, the fact is that the New Keynesian framework (described here by Greg Mankiw) is the workhorse theory within policymaking circles. If economists were unable to see their way to the macroeconomic consequences of the unfolding crisis, criticism needs to start with that framework.

I think such criticism is warranted, but the thrall of the New Keynesian world view has little to do with how "beautiful" the model is or that it is built on a lot of "impressive-looking mathematics." Quite the opposite. As I said in my 2005 comments, "the dynamics of the policy briefing game seem to favor forecasting performance over theoretical integrity." The models that we use for policy analysis are constructed on the basis of what connects with the facts we see (or think we see) in the data. If these models fail to contemplate things that might happen, it is precisely because there is a bias toward frameworks that explain history.

Robert Lucas zeroed in on this point in his "defence of the dismal science":

"The Economist’s briefing [criticizing the foresight of mainstream economists] also cited as an example of macroeconomic failure the 'reassuring' simulations that Frederic Mishkin, then a governor of the Federal Reserve, presented in the summer of 2007. The charge is that the Fed’s FRB/US forecasting model failed to predict the events of September 2008. Yet the simulations were not presented as assurance that no crisis would occur, but as a forecast of what could be expected conditional on a crisis not occurring. Until the Lehman failure the recession was pretty typical of the modest downturns of the post-war period. There was a recession under way, led by the decline in housing construction. Mr Mishkin's forecast was a reasonable estimate of what would have followed if the housing decline had continued to be the only or the main factor involved in the economic downturn."

Some attempts have been made to exploit the information contained in data from the Great Depression. (If you have patience for technical analysis you can find an example here.) And there have been many attempts to jerry-rig existing models to capture the financial shocks and their aftermath, especially once we had seen what that sort of reality looks like. But, by and large, the last year has been a data point we haven’t seen before, and it is not so surprising that models designed to capture the average quarter in the economy’s life would not do so well when very unaverage events arise.

It is certainly clear that the dominant pre-2007 strain of New Keynesian models was inadequate to the task that would confront us post-2007. That this was the case was not unknown. If I may quote myself again:

"I have in the past agreed that it is useful to think of the policy choices [following financial market events like the stock market crash of 1987] as policy shocks. I would still argue that today. But it sure would be helpful if at least some of these events would appear as something more than completely random disturbances. In other words, it would be very useful to have usable measures of what we loosely call 'financial market fragility,' and more useful still to have a coherent [sophisticated] quantitative model that captures them."

The problem with that prescription was that the relative infrequency of such events would likely have required us to step outside of our existing data-driven policy models and apply more theory, not less.

So does all this lead to the conclusion that we ought to ditch the presumptions of rationality and (largely) efficient markets, as Professor Krugman suggests? I have my doubts. Even some of the examples in the Krugman article seem to rely on the power of those ideas. In describing the problem of the lower bound of zero on nominal federal funds rates, he says this:

"During a normal recession, the Fed responds by buying Treasury bills—short-term government debt—from banks. This drives interest rates on government debt down; investors seeking a higher rate of return move into other assets, driving other interest rates down as well; and normally these lower interest rates eventually lead to an economic bounceback…

"But zero, it turned out, isn’t low enough to end this recession. And the Fed can't push rates below zero, since at near-zero rates investors simply hoard cash rather than lending it out. So by late 2008, with interest rates basically at what macroeconomists call the 'zero lower bound' even as the recession continued to deepen, conventional monetary policy had lost all traction."

That whole story relies on a conventional monetary transmission mechanism, one that fundamentally plays off of efficient markets thinking.

In another passage from the New York Times article, we have this:

"I like to explain the essence of Keynesian economics with a true story that also serves as a parable, a small-scale version of the messes that can afflict entire economies. Consider the travails of the Capitol Hill Baby-Sitting Co-op.

"This co-op, whose problems were recounted in a 1977 article in The Journal of Money, Credit and Banking, was an association of about 150 young couples who agreed to help one another by baby-sitting for one another’s children when parents wanted a night out. To ensure that every couple did its fair share of baby-sitting, the co-op introduced a form of scrip: coupons made out of heavy pieces of paper, each entitling the bearer to one half-hour of sitting time…

"Unfortunately, it turned out that the co-op’s members, on average, wanted to hold a reserve of more than 20 coupons, perhaps, in case they should want to go out several times in a row. As a result, relatively few people wanted to spend their scrip and go out, while many wanted to baby-sit so they could add to their hoard. But since baby-sitting opportunities arise only when someone goes out for the night, this meant that baby-sitting jobs were hard to find, which made members of the co-op even more reluctant to go out, making baby-sitting jobs even scarcer…

"In short, the co-op fell into a recession."

That's a great example, but where is the irrationality? That tight monetary policy might cause a downturn in the economy may be absent from purely classical models, but it is dead center of the New Keynesian framework. The problem was that our mechanism for capturing monetary nonneutrality—essentially wage and price stickiness—was far too simplistic to capture the shocks that we were about to face (and that we arguably faced to lesser degrees during past financial market events).

In short, I accept the criticism that the dominant New Keynesian framework for forecasting and economic modeling needs some work (to say the least). I'm less convinced that we require a major paradigm shift. Despite suggestions to the contrary, I've yet to see the evidence that progress requires moving beyond the intellectual boundaries in which most economists already live.

By David Altig, senior vice president and research director at the Atlanta Fed

September 10, 2009 in Business Cycles, Forecasts | Permalink


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Economists got it wrong because there's not one who understands the difference between a positive and a negative feedback loop.

Posted by: diemos | September 10, 2009 at 03:24 PM

Economists got it wrong because they only know how to model liquid markets. The fact that most markets are somewhat illiquid (that is, the decisions of participants frequently affect prices to varying degrees) means that the profession needs a major paradigm shift. The faults of modern economic models (including the New Keynesian models) were all described by Keynes in chapter 12 of the General Theory.

Posted by: Anonymous | September 10, 2009 at 08:57 PM

I called a bad recession 3 years ago ...it was pretty simple.

The Case-Shiller housing index was obviously a bubble and indicated to me that we had just experienced the largest misallocation of resources in the history of the world.

There were plenty of other signs early on ...inverted yeild curve, part time employment fell off a cliff and so on.

That so many economists didn't use some basic common sense is shameless. What happened was the equivalent of 99.9% of meteorologists telling everyone not to worry when Hurricane Katrina was 10 miles from landfall.

Anyway, I have an Economics degree, but work in the software field. I read econ blogs as a hobby and I predicted far better than the "professionals."

The scariest part is that now everyone who predicted it wouldn't happen is now saying it's over. They have kicked the can down the street with the stimulus and the bailouts, but we still don't have a clue what any big bank is worth or what is on the Fed/Treasury balance sheets.

I think there is still alot more pain ahead ...hope I'm wrong this time.

Posted by: Jim Hancock | September 11, 2009 at 02:35 AM

Economists got it wrong because they think in Gold Standard. They do not understand the causality in the flow identity

S - I = G + NX - T

Economists think that this equation implies Government spending doesn't change S and I goes down. It is exactly the opposite. S goes up with no direct on I.

Roughly, the correct logic is Government spending increases deposits and bank reserves simultaneously. Taxes do the opposite. Bond sale just reduces bank reserves. Adding up, deficits increase private sector savings.

Because the right hand side of the equation written above was negative for a long time now, (the stock of) private sector savings kept going down.

Such a thing was already known to Wynne Godley - the absolute gold medalist for the prediction of the crisis. http://www.levy.org/pubs/sevenproc.pdf

Posted by: Rams | September 11, 2009 at 04:49 AM

Modern macroeconomic models in the DSGE mould are all offshoots of the Arrow-Debreu model. There is no need for money in an Arrow-Debreu world and so they will never ever be useful for understanding a monetary-based economy. So I disagree with David, a paradigm shift is required. Robert Clower has expressed these ideas far more eloquently and powerfully in his address to the Southern Econonomic Association in 1993.

Posted by: PE | September 11, 2009 at 08:26 AM

You are absolutely correct about the Taylor rule being the workhorse during normal times. Monetary policy is the tool of choice for micromanaging and making incremental adjustments to the economy.

The bigger problems and economic crises are NOT adequately addressed by monetary policy. Those who advocate ONLY the use of monetary policy are trying to fight the economic battles with most of the tools locked in the tool kit. Monetary policy loses traction as it approaches the zero bound. Monetary policy also loses traction as interest rates approach double digits. Monetary policy is too broad in its effects to target single sectors that are out of whack and cannot operate outside the normal bounds without creating unwanted distortions.

The largest risks of inflation are commodity inflation or shortages (oil shocks, housing bubbles, tech stock bubbles, etc.). Monetary policy is impotent for addressing these problems. Attempts to use monetary policy as a corrective cannot work because any policy will leave a negative impact on multiple sectors of the economy. Commodity inflation problems are narrow sector problems that are best addressed by regulations that can narrowly target the problem sector.

Oil shock- Carter fixed that with regulations requiring energy efficiency. Efficiency standards worked very well until efficiency standards were relaxed. Implementing new tougher standards and promoting alternatives going forward will prevent future oil shocks. Housing bubble: Ideological opposition to enforcing lending standards and sufficient collateral allowed the bubble to develop. Tech stocks, inadequate enforcement by SEC and inadequate transparency requirements. All of these problems could have and should have been addressed. However, we got the sorry excuse that nothing could be done. Something could have been done, but it meant admitting that Monetary-Policy-Only ideology is WRONG and that better use of targeted regulatory policy is necessary. The anti-regulation crowd is ignoring the fact that all economies operate under a set of rules and no set of rules is ever perfect. Rules need to be changed and ENFORCED to keep the "game" clean, promote transparency and fairness. Those who are trying to make excessive profits by gaming the system will always work to undermine fairness and transparency in the system because transparency and fairness are the enemies of gaming the system).

The battles prior to 1980 included wage-price spirals. Because of globalization, the US labor market is no longer capable of creating wage-price spirals. The old models that focus narrowly on national labor are inadequate for a global labor market. Commodity inflation and bubbles have replaced wage-price spirals as the enemy of stability. This needs to be acknowledged and the system adjusted to deal with current threats. We need to replace the old school anti-regulation crowd with new blood that understands how to create and implement good regulations.

Posted by: bakho | September 11, 2009 at 08:40 AM

Let's face it - economists rarely get anything right so it's hardly surprising that they failed to predict the financial crisis.

The underlying problem is that economies are wayyyy too complex to model effectively and truly understand. They cannot be predicted over any significant period of time any more than stock prices or the weather. Of course you won't find an economist who will actually admit that because their living depends on maintaining the fallacy that they know what's going on.

And so we must resign ourselves to a continual series of excuses - "We failed because we didn't take *this* factor into account. If only our models had fully offset *that* factor with *this*...". Blah, blah, blah ad infinitum. Truly a dismal "science", but one that will always be there due to the human propensity to try and see patterns and order where they don't exist.

Posted by: John Smith | September 11, 2009 at 09:30 AM


Your archives only go back to December 2008. If you would be kind enough to post your pre-Fed writings, there would be much ground to explore on the question of how economists got it wrong.

Not to be over-critical, but you are quoting yourself favorably here. I think that misses the vast complacency that you exhibited in the year or two leading up to the crisis.

Posted by: David Pearson | September 11, 2009 at 09:30 AM

OK, we all need to step back and remember that, when asking why the perspective of mainstream economics failed to do something we want it to do, we need to examine our own perspective, as well.

I have admired the work our host does since well before his arrival at the Fed. However, in this case, we have him saying "Look, the concerns outlined in a paper I wrote before this all happened got it right." Yes, and what a strong pull such success could have on one's own thinking. Strong enough,perhaps, that one might miss points others are trying to make. I, who have no such successful paper to attract my thoughts, saw Krugman's essay as largely a critique of our regulatory failure, rather than our central banking failure. If I read Krugman rightly, then saying that the Fed depends heavily on the New Keynesian model does not address what Krugman said. If you look at the effort to kill off regulatory oversight over the past decades, much of it does seem to rely on the excuse that market discipline will take care of limiting risk. Greenspan, who dominated policy making (at least in an advisory capacity) for a very long time, certainly took the "markets get it right" view, even if he was a New Keynesian when making monetary policy, and even if he stopped being a New Keynesian and became an Ad Hocian whenever disaster struck.

It strikes me that both the fresh-water/salt-water issue and the failings of New Keynesian thinking to account for liquidity and solvency problems need to be addressed. Room for both, because there are consequential failings associated with both.

Not that Anonymous was addressing Krugman, but Krugman did point out the failure of classical models to account for liquidity, and pointed out that other economic thinkers have taken into account the impact of capital depletion on the behavior or arbitraguers.

We should also avoid thinking along the lines of "Economists got it wrong because..." Economics is not monolithic, which is more or less the point of the exchange here and of Krugman's article. I also think there is good evidence that the biggest financial failure and recession since the Great Depression was not due to any one thing - not failure to understand the flow represented in the savings and investment equation, not failure to regulate, not failure to understand that risk doesn't go away when we ship it off to somebody else.

We did many things wrong. Each of us is likely to focus on one or two things, and that is to the good, within limits. Division of intellectual labor is likely to help us understand the individual facets of the crisis. What we need to avoid is the claim that our particular part of the puzzle was THE cause. It was THEM causes, not THE.

Posted by: kharris | September 11, 2009 at 11:57 AM

Blaming NeoKeynesianism without mentioning what caused NKians to rise to the fore--the pretense that the GUT of Economics had to be a Macro that conforms to the delusional Neoclassical principles*--is being careful to tell only half of the story. We could be nice and presume that is because you don't want to prove Krugman correct, but I'll decline that.

The pretense that group behavior is exactly identical to summing individual behaviors by the "freshwater" schools gave us the crime of NeoKeynesianism.

*The traditional wisecrack that the use of Neo- before an established branch of economics should be taken to indicate that the philosophy is the opposite of the original is noted for the record.

Posted by: Ken Houghton | September 11, 2009 at 12:23 PM

Is it a coincidence our financial system imploaded within 10 years of Glass-Steagall's repeal. The only reasonable explanation for why so few Economists questioned the wisdom of financial deregulation without calling for a mega-overseer (just in case) is our Economists fell prey to the same short-sighted self-interest that afflicted so many others in our "free market" system.


Posted by: bailey | September 11, 2009 at 12:28 PM

Ha, maybe we should add a "Best when used by" date on our money. Coors turns blue now when cold- maybe we could turn Hamilton red when hot?

Posted by: FormerSSresident | September 11, 2009 at 12:45 PM

Remember all the banksters and Wall Streeters who have prospered despite the crisis and whether or not they were trained economists does not obviate the fact that they knowingly gamed the system to their benefit only.

Posted by: ECON | September 11, 2009 at 01:44 PM

appreciate your post Prof Altig, and also appreciate John Cochrane's defense of economics in his recent publication.

It is impossible to analyze the financial disaster from purely an economic point of view. To do so regardless of whatever school you subscribe to will give you a myopic vision.

Certainly there should be much to say about how our banking industry is structured, what roles it should play, and how it's regulated. My fear here is that the largest most politically well connected participants will get to decide the rules of the game.

There are many questions that should be asked like, "Should Investment banks be allowed to trade for their own prop account and act as a broker, and as a financier?" "Should investment banks that proprietary trade be able to use the public market to raise capital?" "Should internalization of order flow be allowed to happen, or is it better for all orders to go through a centralized transparent marketplace?"

How about the agencies that graded the debt? How about the distortions to the market place caused by externalities due to government intervention, or the creation of a willing and non-transparent OTC marketplace?

This is much larger than the jaded lens Krugman views the world through.

Posted by: Jeff | September 11, 2009 at 02:32 PM

David Altig's remarks here, particularly his conclusion, "I've yet to see the evidence that progress requires moving beyond the intellectual boundaries in which most economists already live." reminded me of a WSJ debate about job-market "slack" Max Sawicky and I had with David back in August 2005.


Unemployment was 5% and David was inclined to view continued low labor force participation rates as more a result of demographic trends and informed choice than of policy failure. Speaking of demographic trends, I had a look just now at the time series of the employment to population ratio for 16-24 year olds and I think that picture tells a story it would be very, very foolish to overlook.

Since the comments here don't accept graphic files, I'll have to invite readers to my EconoSpeak post at:


It seems to me that the youth employment to population ratio has been signaling something or other for the last 20 to 25 years. If it isn't signaling policy failure or paradigm exhaustion, then I'd like to know what it is signaling.

Posted by: Sandwichman | September 11, 2009 at 07:07 PM

"Economists got it wrong because they think in Gold Standard. They do not understand the causality in the flow identity

S - I = G + NX - T

Economists think that this equation implies Government spending doesn't change S and I goes down. It is exactly the opposite. S goes up with no direct on I.

Roughly, the correct logic is Government spending increases deposits and bank reserves simultaneously. Taxes do the opposite. Bond sale just reduces bank reserves. Adding up, deficits increase private sector savings.

Because the right hand side of the equation written above was negative for a long time now, (the stock of) private sector savings kept going down.

Such a thing was already known to Wynne Godley - the absolute gold medalist for the prediction of the crisis. "

This is perhaps the most incoherent thing ever written. Try making sense.

Posted by: Jimmy Jabbadoo | September 12, 2009 at 12:41 AM

Guys ...it was easy ...we spent $4-5 trillion on houses we didn't need. Why do we need a complicated economic model to figure out this is bad??

If all your income is allocate to bills and you suddenly discover your spouse put 4 months of your annual salary on credit cards ...it is gonna get ugly!!

Why is this so hard for people to wrap their head around? The potential train wreck was obvious, but people ignored the signs because it is uncomfortable to go against the herd.

Posted by: Jim Hancock | September 12, 2009 at 02:27 AM

The New Keynesian framework is simply the New Classical/RBC framework with frictions thrown in so that the models can work better with existing data. The Classical foundations are there and obvious, and it is hard for anyone to claim that removing the frictions would make for models that would have worked better in crisis situations. Yes we need more theory, but we don't need more Classical theory. That stuff doesn't work in crisis situations, period.

It is also incredible to see Krugman's account of a liquidity trap situation get described as a "conventional money transmission mechanism" that fundamentally plays off "efficient markets" thinking.

Posted by: Jason | September 12, 2009 at 04:38 AM

Let's assume Dave A. is correct in summing: "I've yet to see the evidence that progress requires moving beyond the intellectual boundaries in which most economists already live."
What now? My question is: Why should John Q. Public take seriously any Economist who is not arguing for our need to correlate our economic indicators & measuring methodology to correlate to a population sampling (any size)?
For me it's simple, the FED has the clout. It alone sets the framework for Macroeconomic argument. For evidence listen to the jokes at FED analyst meetings. EVERYONE knows the extent & seriousness of the problem, yet NO ONE speak to it.
My advice to PK, BDL, DA & way too many of their peers is even simpler: Get out of the box & speak to the overarching problems of your chosen profession or sit back & enjoy the life it affords you.

Posted by: bailey | September 12, 2009 at 12:44 PM

Puuhlease, you mean the "media experts" got it wrong. Those media experts are being confused with actual economists (Michael Hudson, Paul Craig Roberts, James Galbraith, et al.) who predicted correctly.

The system was gamed and the countervailing powers (regulations from the New Deal) were gutted. Keynes warned (as did John Kenneth Galbraith) as to what would occur without the proper countervailing factors in place.

Regulation Q (anti-usury) needs to be resurrected. Glass-Steagall needs to be resurrected. Proper interviewing, vetting and background checks of those working at SEC needs to be resurrected (and please, no more Blackwater or Kroll (now Veritas Capital) nor USIS clownish background verifications).

Posted by: sgt_doom | September 12, 2009 at 01:33 PM

Jimmy (Jabbadoo),

I have made sense of it! Deficits increase private sector savings - rather than decreasing it. Its an accounting identity - $-for-$, ex-ante and ex-post.

Till the time Economists keep making this mistake of not accepting this identity, they will always get stuff wrong :)

Posted by: Rams | September 13, 2009 at 05:54 AM

Why should economists get in right? In both academia and media, there is much more benefit to being wrong with everybody else than in being right by yourself. Only the handful that are not dependent on other's opinions can afford to be right.

Posted by: Ed | September 13, 2009 at 03:20 PM

Comments do not allow a full-scale debate on this issue. I can not help referring to own piece presenting a complimentary agenda for economic profession. Briefly, we should scrutinize basic measurements, which are generally not compatible over time as all statistic agencies urge researchers. To begin with, we have to develop a consistent definition(s) to macroeconomic variables and re-estimate past readings. Just a simple example, the definition of unemployment has multiple revisions last 20 years ans still has many versions.

The paper is - Does economics need a scientific revolution? http://mpra.ub.uni-muenchen.de/14476/

This is a reaction to the paper "Economics need a scientific revolution" by J.-P. Bouchaud in Nature http://www.nature.com/nature/journal/v455/n7217/full/4551181a.html

Posted by: Ivan Kitov | September 14, 2009 at 03:04 AM

Economists got it wrong because it did not matter to them if they were wrong. Their jobs being tied to much different things then being right. Many non-economists called it very well.

Posted by: Simon | September 14, 2009 at 04:23 AM

In a sense, we are all customers of economic theory because it ifluences in one way or another decisions made by economic and financial authorities. As the customers we should ask the economic profession to formulate a new research plan. This plan has to define clear (for general public and experts in various fields) ideas and tools which are necessary to answer the question why the theory has failed to describe 2007-2010, and when it expects a new unpredictable change likely to happen.
Meanwhile, it would be helpful for economists to regain public trust. This current discussion on the difference between various (failed) approaches does not look like helpful. If they follow the route of the negation of the presence of educated audience waiting for reasonable answers, they will completely detach themselves from the scientific community and general public as well.

Posted by: Ivan Kitov | September 14, 2009 at 08:51 AM

Got it wrong? Sure did.
And what are they doing about it? They are saying it was the 'other' economists who got it wrong.

Do you know of any prominent economist who has changed anything in response to being wrong?????

Posted by: wally | September 14, 2009 at 09:03 AM

Everyone is stuck on stupid.

For those who need a reminder, the equation of exchange is an algebraic way of stating a truism; that the product of the unit prices, and quantities of goods and services exchanged, is equal (for the same time period), to the product of the volume, and velocity of money. Velocity is the rate of speed at which money is being spent.

It is self-evident from the equation that an increase in the volume, and or velocity of money, will cause a rise in unit prices, if the volume of transactions increases less, and vice versa. This is merely algebra, but it has an important economic application.

The economic question arises from differing opinions as to whether the monetary authorities (The Board of Governors of the Federal Reserve System and the Federal Open Market Committee) can control both the volume and velocity of money, and the effects of changes to the volume and velocity of money, in production and employment, as well as on prices.

Historically, it is mathematically impossible to miss any swing in economic activity. Why? Because all demand drafts drawn on all money creating depository institutions cleared through demand deposits – except those drawn on MSBs, interbank, and the U.S. government.

The Sept. 1981 top in AAA bond yields, was calculated at 1/1000 of a basis point off of the 1977 "base period". Of course, the near perfect correlation was somewhat lucky.

Posted by: flow5 | September 15, 2009 at 12:46 PM

Thanks for the lively commentary. A few reactions to the reactions:

diemos kicks things off with this: "Economists got it wrong because there's not one who understands the difference between a positive and a negative feedback loop."

I may not quite understand the reference, but it seems to me that at least one prominent economist -- Chairman Bernanke -- understands the distinction pretty well (http://www.federalreserve.gov/newsevents/speech/bernanke20080822a.htm).

"The Federal Reserve's response to this crisis has consisted of three key elements. First, we eased monetary policy substantially, particularly after indications of economic weakness proliferated around the turn of the year. In easing rapidly and proactively, we sought to offset, at least in part, the tightening of credit conditions associated with the crisis and thus to mitigate the effects on the broader economy. By cushioning the first-round economic impact of the financial stress, we hoped also to minimize the risks of a so-called adverse feedback loop in which economic weakness exacerbates financial stress, which, in turn, further damages economic prospects."

Anonymous offers: "Economists got it wrong because they only know how to model liquid markets. The fact that most markets are somewhat illiquid (that is, the decisions of participants frequently affect prices to varying degrees) means that the profession needs a major paradigm shift."

This is in the end, I think, a variation on the Krugman criticism of the efficient markets hypothesis. And it is, actually, a criticism with which I have some sympathy. My understanding of the Federal Reserve's shift to "non-traditional" policies -- described here: http://macroblog.typepad.com/macroblog/2009/04/snapping-ropes-and-breaking-bricks.html -- is fundamentally about the arrival of a crisis-induced segmentation of markets. I'd argue that such segmentation -- or absence of arbitrage, if you will -- is not a property that ought be invoked indiscriminantly, but segmented markets, trading frictions, and the like are model features than can be constructed well enough with a prettty standard economist's toolkit.

Which brings me to this comment from PE: "Modern macroeconomic models in the DSGE mould are all offshoots of the Arrow-Debreu model. There is no need for money in an Arrow-Debreu world and so they will never ever be useful for understanding a monetary-based economy. So I disagree with David, a paradigm shift is required."

No argument there -- almost. Most modern macroeconomic models are indeed offshoots of the Arrow-Debreu model. In simple terms, this means that a perfectly competitive, frictionless economy serves as a benchmark. But the New Keynesian model is not frictionless. As I noted in my earlier post, "sticky" wages and prices are central to the framework. As I also said, I think we have learned that these price rigidities are not up to the task of capturing the financial frictions that seem so important now that we have so clearly seen them. But the problem is not an unthinking devotion to the Arrow-Debreu ideal. (I also concede that the existence of money is not well motivated in a perfectly frictionless world, and very little attention is given in New Keynesian models as to the precise forms of the market imperfections that would give rise to a monetary economy. Here again, though, there are some quite prominent mainstream economists who are all over the issue: http://www.artsci.wustl.edu/~swilliam/papers/newmonetarism.pdf)

Some of the other comments I hope to address -- at least implicitly -- in the next post. Thanks again for the input.

Posted by: David Altig | September 15, 2009 at 02:17 PM

One more thing. One final point. David Pearson calls me out for some selective memory: "Your archives only go back to December 2008. If you would be kind enough to post your pre-Fed writings, there would be much ground to explore on the question of how economists got it wrong.

Not to be over-critical, but you are quoting yourself favorably here. I think that misses the vast complacency that you exhibited in the year or two leading up to the crisis."

Let me be clear. I used my comments from the 2005 conference because I still hold those sentiments, not because I claim anything close to prescience. Around the time I made the referenced comments referenced in the previous post, I said this, in print, in an exchange with Nouriel Roubini (http://online.wsj.com/public/article/0,,SB111202112287190860,00.html):

"You are right, of course, to point out the risks, and the longer we ignore those risks the bumpier the ride will be. But I see turbulence, at worst, not a flaming crash."

Not my best call, but I will also point out that the debate at the time was about whether large fiscal and current account deficits would cause a run on the dollar. The prediction of a hard landing due to those dynamics wasn't really any closer to way things played out.

Posted by: David Altig | September 15, 2009 at 03:26 PM

To add a rather less erudite note to the discussion, that takes us back to Greenspan’s rule at the Fed.

David was invited to a conference in October of 2007 which I attended. He gave a rather general talk about the status of the housing market then. I got up and asked an impertinent question: “where have the regulators been during this ‘irrational exuberance’ in the housing market?” David’s comment is seared in my memory. He said, “oh, the Fed doesn’t go around looking for bubbles to pop”. And I thought to myself: “why the heck not?”.

The rest is history. Now David of course was just following Greenspan’s dicta, but the social cost of such ideology is just monumental.

Posted by: Haynes Goddard | September 15, 2009 at 09:38 PM

OK -- One more thing:

Several of the comments strike a somewhat skeptical, even nihilistic, tone with respect to the prospect for economic models (as the profession understands the concept) to be of much value at all (at best). To that skepticism, I’d like to push back.

I often tell students that every statement about economic phenomena contains some assumptions about preferences (what people want), technologies and endowments (the resources people have to get the things they want), and how economic activity is coordinated. Economic models are just devices to lay those assumptions bare, and to follow them to their logical conclusions. Economic theory, expressed through an explicit model, is a way to hold the storyteller responsible for the coherence of the story.

These narratives have consequences, of course, as they do partially drive decisions—that is their purpose. To put it another way, an explicit economic framework helps put the “informed” in “informed judgment.” When the moral of the story leads to missteps, economists ought to (and do) think long and hard about what went wrong and why. And the public is right to ask, and even demand, that the profession does so.

My current thinking, which I was trying to emphasize in the previous post, derives from an uneasy feeling that the New Keynesian model we thought was working so well was heretofore built on a not-sophisticated-enough model of financial intermediation, which leads to a not-sophisticated-enough monetary transmission mechanism, which leads to a not-sophisticated-enough notion of what a sound monetary policy rule looks like. Questions like "might the Taylor rule amplify financial market volatility" in a model where financial elements are taken seriously are, to my mind, first order.

It is also the type of question that, I contend, can be addressed by adding to the cumulative product of macroeconomic theory as it exists today. These amendments might well include changes in the way we model information and expectations formation – as emphasized by Professor Krugman and discussed in this interview with New York University professor Tom Sargent: http://www.cesifo-group.de/pls/guestci/download/CESifo%20Working%20Papers%202005/CESifo%20Working%20Papers%20March%202005/cesifo1_wp1434.pdf. I admit that I am personally a bit hesitant about straying too far from the assumption of rationality --- strong assumptions about individual rationality were themselves added to mainstream macroeconomic models because their absence appeared to have led economists astray in the past. (See the 1970s.) But hey, let a thousand flowers bloom.

Posted by: David Altig | September 16, 2009 at 03:51 PM

hcg -- I don't really remember the conference, but I am prepared to fully own the comment, as I think the response you relate is still the one I would give. Trying to answer questions like "Where are the bubbles" and "What can we do to pop them" presumes an awful lot of information. If really smart people with big loads of money on the line don't get it right I'm not sure why it would be presumed that policymakers will. I think our efforts are better spent trying to find -- and then avoid -- policy choices that contribute to instability, and creating an infrastructure that is robust to the inevitable imbalances and mistakes when thet arise.

Posted by: David Altig | September 16, 2009 at 04:19 PM

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September 03, 2009

Words of wisdom from the South and East (way South and East)

I've had an interesting few weeks, starting with attending the Federal Reserve Bank of Kansas City's annual economic symposium at Jackson Hole to finalizing a cooperative research initiative between the Atlanta Fed's Americas Center and the Institute for Applied Economic Research (note that IPEA's site is in Portuguese) in Brasilia to a speech delivered at the BM&F Bovespa fourth International Financial and Capital Markets Conference in Campos do Jordao, Brazil, to sitting in on the Central Bank of Argentina's annual Money and Banking Conference. I tell you this not because I expect you to care about my schedule but because I plan to spend the next couple of blog entries trying to spill out of my brain some impressions and thoughts gleaned from some intensive listening to a wide variety of policymakers, businesspeople, and scholars explaining their impressions and thoughts.

On several points there appears to be a fair amount of unanimity: (1) the global economy has moved a substantial distance from the financial abyss and is now in the first phase of recovery from recession; (2) the financial crisis of the past two years originated, ironically, in the economies with the deepest and most advanced financial markets—the United States representing the epicenter—and is likely to have the longest-lasting negative impact in those economies; and (3) the time has come to begin building a market and regulatory infrastructure that can avoid or withstand the events associated with the recent turmoil.

There is a lot to be said on these topics, but a great starting point for conversation was provided at the Central Bank of Argentina's conference by Dr. Kiyohiko Nishimura, deputy governor of the Bank of Japan. Commenting on policy lessons learned, Governor Nishimura first offered two criteria that ought to govern the application of “unconventional” policy tools in times of stress, defined as those policies that entail microeconomic interventions and explicit risk taking by the monetary authority:

First criterion: Unconventional policies, as defined, inevitably distort resource allocation. The potential benefits of any such intervention must therefore be measured against these costs.

Second criterion: Because unconventional approaches entail taking more than the usual amount of risk onto a central bank's balance sheet, measures should be taken to guarantee adequate capital buffers in the event that substantial losses are incurred.

Assuming these criteria are met, what principles should guide the implementation of unconventional policies? Governor Nishimura offered four:

  1. Select what sorts of interventions are most important, and concentrate efforts in those areas.
  2. In any intervention, be careful to think through the broad implications and avoid creating further dysfunction. The example given was the decision, made by most central banks, to set the effective floor on short-run policy rates near but above zero in order to avoid eliminating all returns to participating in the market and hence driving all private players out of the market.
  3. Provide extensive safety nets to short-circuit panics.
  4. Design measures to be “self-fading” as conditions improve. For example, set lending rates and terms at levels above those that private providers will set once the acute phase of a crisis passes.

And finally the governor articulated a list of don'ts gleaned from the crisis experience:

  1. Don't assume the size of the balance sheet is, by itself, an adequate measure of monetary ease or support.
  2. Don't concentrate only on those markets where specific interventions are taken. Improvement in those markets cannot be assumed successful unless they improve the big picture.
  3. Don't underestimate the value of safety nets.
  4. Don't ignore the differences across countries or regions. One-size-fits-all strategies may fit no one.
  5. Don't assume things are going to return to the old status quo.

These thoughts strike me as a very nice departure point for debate and deliberation. If I were to add anything, I would start with one more item on the list of criteria: Unconventional policies should commence from a broad consensus on what level of risk is acceptable for a central bank to take in the “normal” course of business. In other words, the definition of unconventional policy assumes that there is a definition of conventional policy, and there should be collective agreement on how that is defined.

In the good old precrisis days, conventional policy was pretty straightforward: a buy-only-Treasury-securities policy for conducting open market operations and direct lending restricted to a narrow set of financial institutions (commercial banks) and largely on an overnight basis. There are good enough reasons to think that this is the way it should it be—Marvin Goodfriend, among others, has made this argument. But, in my view, I believe it is warranted to take to heart point number five on Governor Nishimora's list of don'ts and not yet assume the new conventional policy will look like the old one.

By Dave Altig, senior vice president and research director at the Atlanta Fed

September 3, 2009 in Monetary Policy | Permalink


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Well, in SoCal people are still flipping homes. Can you believe it? I tell you, they're now going in to the 200k guy who lost his shirt, putting in 50k of upgrades, and poof on the market with a dozen offers for 400k.. I kid you not..

So somehow either we've not learned a darn thing.. or CA is on it's deathbed. One or the other I think.

Posted by: FormerSSresident | September 03, 2009 at 06:32 PM

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September 01, 2009

Us and them: Reviewing central bank actions in the financial crisis

With all the focus on the financial crisis in the United States, folks in this country might sometimes lose sight of the fact that this crisis has been global in nature. To provide some perspective on the global dimensions of the crisis, we are providing a few summary indicators of financial sector performance and central bank policy responses in the United States, the United Kingdom, the Euro Area, and Canada. Based on this general review, we surmise that some of the experiences have been remarkably similar, while others appear to be quite different. To pre-empt the question: Why these four regions? The reason is simply that the data were readily available. We encourage readers to use data from other areas, and let us know what you find.

The first chart compares relative changes in monthly stock market price indices for 2005 through the end of August. During the crisis, market participants significantly reduced their exposure to risky assets, which helped push equities lower. All indices peaked in 2007, except Canada, which technically peaked in May 2008. Canada outperformed relative to the others in early 2008 but suffered proportionally similar losses thereafter. The United Kingdom, Euro Area, and Canada bottomed in February 2009 while the United States bottomed in March 2009. The Euro Area to date has experienced the strongest rebound in equities, increasing by almost 40 percent since the trough in February. However, Europe also had the largest peak-to-trough decline, almost 60 percent. Canada and the United States have jumped by about 33 percent since their respective lows in February and March, while U.K. stock prices have risen by about 30 percent since February.


The second chart compares long-term government yields. As the crisis unfolded in late 2007, yields on 10-year U.S. Treasuries sank as global flight to quality helped push yields lower. Yields on U.S., U.K., and Canadian bonds have all moved lower than they were prior to the onset of the crisis. Interestingly, in the Euro Area, prior to the crisis, sovereign yields were at or below bond yields in the other countries but are now slightly above those. In fact, Euro Area yields haven't moved much since the beginning of the crisis in late 2007.


The third chart contrasts monetary policy rates in the four regions. The chart shows that all the central banks lowered rates aggressively, but there are some subtle differences in the timing. For the United Kingdom, Euro Area, and Canada, the bulk of policy rate cuts came after the financial market turmoil accelerated in the fall of 2008, whereas in the United States the majority of the cuts came earlier.

The Fed was the first to lower rates, cutting the fed funds rate by 50 basis points in September 2007 at the onset of the crisis. The Fed continued to lower rates pretty aggressively through April 2008, with a cumulative reduction of 325 basis points. Once the financial turmoil accelerated again in the fall of 2008 the Fed cut rates again by another 200 basis points.

The Bank of Canada's cuts followed a generally similar timing pattern to the Fed but with differences in the relative magnitude of the cuts. In particular, the Bank of Canada rate lowered rates by 150 basis points through April 2008 and then by another 275 basis points since September 2008.

Similarly, the Bank of England cut rates three times in late 2007/early 2008, totaling 75 basis points. But like the Bank of Canada, the bulk of their policy rate cuts didn't come until the increased financial turmoil in the fall of 2008. Between September 2008 and March 2009, the Bank of England cut the policy rate by 450 basis points.

Unlike the other central banks, the European Central Bank (ECB) did not initially adjust policy rates down as the crisis emerged in late 2007. In fact, after holding rates steady for several months it increased its rate from 4 percent to 4.25 percent in July 2008. It started cutting rates in October 2008, and from October 2008 to May 2009 the ECB reduced its refinancing rate by 325 basis points. Of the four regions, the ECB currently has the highest policy rate at 1 percent. For some speculation about the future of monetary policy rates for a broader set of countries, see this recent article from The Economist.


The final chart compares relative changes in the size of balance sheets across the four central banks. The balance sheet changes might be viewed as an indication of the relative aggressiveness of nonstandard policy actions by the central banks, noting that some of the increases can be attributed to quantitative easing monetary policy actions, some to central bank lender-of-last-resort functions, and some to targeted asset purchases.

The sharpest increases in the central bank balance sheets came in the wake of the most intense part of the financial crisis, in the fall of 2008. There had been relatively little balance sheet expansion until the fall 2008. Prior to that, the action was focused mostly on changing the composition of the asset side of the balance sheet rather than increasing its size. The size of both U.S. and U.K. balance sheets has more than doubled since before September 2008, although both are now below their peaks from late 2008. Note that in the case of the Bank of England, quantitative easing didn't begin until March 2009, and the subsequent run-up in the size of the balance sheet is much more significant than in the United States. Prior to that, the increase in the Bank of England balance sheet was associated with (sterilized) expansion of its lending facilities.

In contrast, the Bank of Canada and ECB increased their balance sheets by about 50 percent—much less than in the United Kingdom or United States. By this metric, nonstandard policy actions have been less aggressive in Canada and the Euro Area. Why these differences? This recent Reuters article provides a hypothesis that focuses on institutional differences between the Bank of England and the ECB. In a related piece, this IMF article compares the ECB and the Bank of England nonstandard policy actions.


Note: The Bank of England introduced reforms to its money market operations in May 2006, which changed the way it reports the bank's balance sheet data (see BOE note).

By John Robertson, vice president and senior economist, and Mike Hammill and Courtney Nosal, both economic policy analysts, at the Atlanta Fed

September 1, 2009 in Europe, Financial System, Interest Rates, Monetary Policy | Permalink


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Re : "Of the four regions, the ECB currently has the highest policy rate at 1 percent."

Please, this is the kind of "analysis" we all could do without. You are comparing apples and pears. If you want to compare the US policy rate, i.e. an interbank overnight rate target, to something relevant in the Eurozone, then pick a euro overnight rate. Eonia has been at around 0.35% since June, not 1%, which is currently used as the very long term tender rate. As to 1 month Euribor, it is currently 0.48% while 1 month USD Libor is 0.28%.

Posted by: Henri Tournyol du Clos | September 01, 2009 at 07:12 PM

Yeah, but this analysis is accurate with the situation and the subject "Bank Actions".

Posted by: Andrew | September 08, 2009 at 04:46 AM

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