Real GDP and Its Components: 2008QIV versus 2007QIII

BEA released its advanced estimate for the last quarter of 2008 and the news was awful:

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- decreased at an annual rate of 3.8 percent in the fourth quarter of 2008, (that is, from the third quarter to the fourth quarter), according to advance estimates released by the Bureau of Economic Analysis. In the third quarter, real GDP decreased 0.5 percent.

While real GDP rose somewhat during the first two quarters of 2008, real GDP fell a bit during the last quarter of 2007. Real GDP was running at an annualized clip of $11,625.7 billion as of 2007QIII but real GDP for 2008QIV was reported to be only $11,599.4 billion.

I guess the silver lining was that both government purchases and net exports continued to improve. The improvement in real exports was tiny but imports fell – likely as a result of a weaker economy. Consumption demand fell by more than $90 billion – while investment demand fell by more than $190 billion. Maybe this will wake up a few Republicans in the Senate that we have indeed entered into a deep recession.

About Hedge Funds

· ‘Survivorship bias’
Hedge funds that die are not included in the index, and since the mortality rate among hedge funds is higher than among mutual funds, it produces a greater gap between the returns reported in the indices versus those earned by a typical investor. There are about 9000 funds. Half of them have a life span of three years. About one out of ten goes bust.


· Distortion of returns reported to hedge funds versus the typical investor
– associated with the higher mortality rate of hedge funds. Also the reporting for hedge funds is voluntary and they tend not to report bad results.

· Lack of auditing.
They represent a relatively small share of total financial assets but their relative share has increased significantly.

· Substantial leverage
Hedge funds have the ability to take on substantial leverage.

· Large potential impact on financial market conditions
The substantial leverage of hedge funds magnifies the potential impact on financial market conditions.

· Hedge funds play a large (inappropriate) role as an insurer for regulated institutions
"Hedge funds have become an important source of protection to regulated institutions by being large sellers of credit insurance in the rapidly growing market for credit default swaps . But highly-leveraged and unregulated hedge funds are not the ideal type of insurer!"

· Hedge funds are receiving money from Australian superannuation funds.
Because of the current great doubt experienced by the two major political parties about the virtues of the fiduciary habits of ordinary workers, they feel compelled to take their savings away. The money is placed in pension funds for their old age. Workers are not allowed to withdraw this money and especially they are not permitted any control over the way in which these dollars are invested. (Meanwhile we'll continue to tout the virtues of a 'free market' system).

..Superannuation fund trustees have traditionally not invested in hedge funds both because of the infancy of the hedge fund market in Australia and because of the legal obligations described above. Rather,superannuation trustees have tended to prefer to invest in fixed interest investments, cash, government bonds and property investment trusts.

Hedge funds have not been favoured areas of investment principally because of perceptions concerning:
• the volatility of returns;
• level of regulation;
• the perceived lack of transparency of hedge funds ;
• levels of management fees; and
• additional risks associated with the use of derivatives by hedge fund managers.

In order to make such investments, superannuation trustees need to give careful consideration to the legal restrictions imposed in the form of general trustee duties and the investment parameters imposed by their trust deed, investment plan and the SIS Act.

However, despite this traditional reluctance to invest in hedge funds, superannuation trustees in Australia are now starting to use hedge funds to diversify their investments. Hedge fund investment is providing superannuation trustees with a way of counter-balancing the decline in returns on investments in traditional products. Those trustees are also attracted by the relative low correlation between the performance of some hedge funds and that of the equity markets more generally. There is also a considerable degree of liquidity with hedge funds, something that real estate or other structured assets may not offer. Finally, the introduction of hedge funds for retail investors has made the product apparently more mainstream and therefore, for trustees, possibly less likely to result in fund member concern..."
Australia: Some Legal Issues relating to Superannuation Trustees as Hedge Fund Investors
By Tessa Hoser and Katherine Henzell, Blake Dawson Waldron
1 December 2002.

· One third of hedge fund capital comes from pension funds
One third of hedge fund capital comes from pension funds. “Pension funds reusing hedge fund investment to diversify their own risks, but a situation where almost one-third of the capital for institutions on the cutting edge of financial risks comes from institutions whose first priority is safe investments certainly bears watching”.
Rodrigo Rato, IMF Managing Director

· The insurance provided by hedge funds lacks integrity.

1. How can you collect on an insurance contract when no-one can agree on the amount of the losses??

2. Both the buyer and seller of CDS may trade their obligation in the OTC market. There is nothing to prevent the insurer from offloading his obligation to an unqualified or unreliable party, in the process irreparably damaging the value of the insurance originally purchased.

I would be interested to learn if anyone can shed light on a potential problem in financial markets larger by at least an order of magnitude greater than subprime + CDO s sold to the SIV s and other institutions that hold them. Dr. Roubini has put numbers on subprime and alt-A plus CDO s, of about 1.5 trillion, and we don't have good estimates yet for auto loan and credit card securitized debt. Dwarfing these numbers is the 30 to 40 trillion dollar (or more) value of credit default swaps (CDS) outstanding. These swaps are essentially insurance policies between 2 parties. The FIRST buyer, presumably, is one with an asset (bond or securitized debt) to hedge. The FIRST seller, presumably, is a party known to the buyer who is financially able to provide the contracted protection in the event being insured (default) in return for the fee collected. But if both sides of this equation may TRADE their obligation in the OTC market, what is to prevent the INSURER from offloading his obligation to an UNQUALIFIED party, damaging irreparably the value of insurance originally purchased. If the insured has no control over the assignment to a third party of the obligation, of what value is the insurance. You may recall that in the DELPHI automotive bankruptcy, with 2 billion in bonds outstanding, there were over 20 billion in CDS outstanding. If the presumed solvency of unregulated insurance providers has enabled careless debt instrument purchases, watch out.
Written by RHK on 2007-11-06 08:01:26

3. The Over the Counter (OTC) trade is opaque and allows for the creation of fictionalised capital.

· There’s been a dramatic acceleration in number and type of derivative instruments.
(But current accounting and regulatory practice – as of December 2007 - allow for the creation of huge amounts of imaginary capital that is opaque and not subject to appropriate credit ratings. With the possibility of firms upping their trade in derivatives to hide the day of reckoning that comes with insolvency. See the linked article on credit default swaps.)

Hedge funds (holding Russian corporate bonds with ‘put options’) are demanding either full payment of debt or much higher interest rates; up to 16% during 2008.

· The total number of hedge funds has grown dramatically.
In 2007 there existed about 9000 funds. Half of them have a life span of three years. About one out of ten goes bust.

· Hedge funds are ‘Program Trading outfits’. They make money by buying large baskets of stocks.
A hedge fund, like investment banks, are referred to as ‘Program Trading outfits’. They make money by buying large baskets of stocks and then will blow out of those positions when their computers are programmed to sell.

· The range of hedge fund returns is large and unprecedented.

· Hedge fund managers’ earnings are astronomical. are determined by the gains of their own capital in their funds and their share of their firm’s management and performance fees. Most funds charge a 5% management fee and a 44% performance fee)

Of the 200-plus funds that Permal invests in, the poorest performer in the year to date – from January through to November 15 – had reported a loss of 7 per cent, and the top performer had returned 70 per cent. [unsourced]

“…Combined, the top 50 hedge fund managers last year earned $29 billion. That figure represents the managers’ own pay and excludes the compensation of their employees. Five of the top 10, including Mr. Simons and Mr. Soros, were also at the top of the list for 2006….”
Wall Street Winners Get Billion-Dollar Paydays
By JENNY ANDERSON
Published: April 16, 2008
+

“Hedge fund managers, those masters of a secretive, sometimes volatile financial universe, are making money on a scale that once seemed unimaginable, even in Wall Street's rarefied realms. One manager, John Paulson, made $3.7 billion last year. He reaped that bounty, probably the richest in Wall Street history, by betting against certain mortgages and complex financial products that held them. Paulson, the founder of Paulson & Company, was not the only big winner. The hedge fund managers James Simons and George Soros each earned almost $3 billion last year, according to an annual ranking of top hedge fund earners by Institutional Investor's Alpha magazine, which comes out Wednesday. Hedge fund managers have redefined notions of wealth in recent years. And the richest among them are redefining those notions once again. Their unprecedented and growing affluence underscores the gaping inequality between the millions of Americans facing stagnating wages and rising home foreclosures and an agile financial elite that seems to thrive in good times and bad. Such profits may also prompt more calls for regulation of the industry…”
Hedge fund managers get billion-dollar paydays
By Jenny Anderson
Wednesday, April 16, 2008

· G8 finance ministers meet on the issues relating to hedge funds but fail to address the issues.

G8 finance ministers met on the issue of the lack of supervision of hedge funds but they failed to address the issue. (When?, Source?)

Wall Street Bonuses in 2008 – Disappointing or Shameful?

When I first heard that bonuses paid to Wall Street types dropped from around $33 billion in 2007 to only $18.4 billion, the Manhattan resident in me thought – “ouch, that’s going to hurt the already sagging aggregate demand around here”. Call me a Keynesian. The President had a different thought:

President Obama branded Wall Street bankers “shameful” on Thursday for giving themselves nearly $20 billion in bonuses as the economy was deteriorating and the government was spending billions to bail out some of the nation’s most prominent financial institutions. “There will be time for them to make profits, and there will be time for them to get bonuses”

OK – we don’t reward incompetence and we don’t give income assistance during hard times to the very wealthy. I’m with you Mr. President!

Update: Rudy Guiliani goes Keynesian on this story too:

Bonuses for Wall Street fat cats are easy political fodder in uncertain economic times, but former New York Mayor Rudy Giuliani said Friday cutting corporate bonuses means slashing jobs in the Big Apple. "If you somehow take that bonus out of the economy, it really will create unemployment," he said on CNN's "American Morning." "It means less spending in restaurants, less spending in department stores, so everything has an impact."

Memo to self – in the future, check out what Josh Marshall has to say before blogging on these types of issues:

As a resident of New York City, I think it's probably true that those dollars do do a decent amount for New York City economy, in the form of tax dollars and supporting local businesses -- though I would question its relative efficiency in stimulus terms. (And that's in large part because it's a lot of money in a fairly restricted geographic area.) But the government support that keeps these firms afloat doesn't just come from New York City, does it? This is the definition of trickle down -- give huge amounts of money to a small number of individuals, most of which will be socked away but a relatively small percentage of which will be spent on luxury goods. Amazing that this goof was once the GOP frontrunner for president.

Stimulus Pork

Senator Max Baucus got $26 billion for private equity companies -- the vultures that buy companies, load them up with debt, collect exorbitant fees, and then try to sell them to the unsuspecting public.

Senator Robert Byrd is getting $4.6 billion for clean coal. "Clean, carbon-neutral coal can be a 'green' energy," Byrd said.

What the hell other crap is out there?




http://www.commondreams.org/headline/2009/01/28-2

Drucker, Jesse and Peter Lattman. 2009. "Senate Provision Would Let Buyout Firms Defer Taxes on Canceled Debt." Wall Street Journal (28 January).
http://online.wsj.com/article/SB123310671578422199.html?mod=todays_us_page_one

"Senate Finance Committee Chairman Max Baucus included language in the tax portion of the proposed stimulus package that would allow companies to defer income taxes triggered when they repurchase their own troubled debt at a discount. That would benefit a wide array of companies and industries, but would be a particular windfall to private-equity firms, which acquire companies using piles of debt in hopes of producing large profits for their investors. Amid the economic downturn, many of these deals have run into trouble and the firms are seeking to refinance them."

"The Joint Committee on Taxation estimates the proposal would cost the government roughly $26 billion over the next three years."

"A study by Boston Consulting Group found that, of 328 private-equity portfolio companies, roughly 60% had debt trading at levels considered "distressed"."

"To stave off default, private-equity executives have made reduction of their companies' debt a top priority. The companies are asking investors to swap their bonds for ones with lower values and longer maturities and also seeking to settle debt with cash. However, reducing debt levels can result in a big tax bill. For example, if a company issues $1 billion in debt, but later runs into trouble and exchanges it for new debt worth $600 million -- or buys it back for $600 million -- the remaining $400 million in cash is taxable income."

Stimulus Debate: Flakey Economics

Jeff Flake had a novel argument against increasing at least one form of additional government spending as Josh Marshall notes and rebuts:

Now he's explaining how capital spending on AMTRAK is also not stimulus because AMTRAK doesn't run a profit. Again, total non-sequitur. I think rail is something we should be spending a lot more on. But you can certainly disagree with that on policy terms. But you can't claim that that capital spending on rail stock and rail upgrades doesn't provide jobs. Of course it provides jobs. And whether Amtrak is profitable or not is completely beside the point.

Net income for both Ford and GM has recently been negative so does Congressman Flake think that if the American automobile manufacturers are somehow encouraged to hire more workers that this fails to constitute stimulus? In fact, a lot of companies currently have negative net income. According to Flake’s “logic”, the prospect for a recovery is really dismal!

Do House Republicans Understand Tax Policy and Consumption Demand?

I submit that Congressman Jeff Flake does not:

Rep. Flake (R) was just on CSPAN moments ago talking about tax cuts in the Stimulus Bill. And he just made the argument that a lot of tax cuts in the bill go to 'people who don't pay income taxes', i.e., they're tax rebates … There's a decent case that one-off tax rebates aren't as potent as spending in terms of pumping money back into the economy. The one from last year didn't seem to have much of a punch. But whether the money goes into the hands of people who do or do not pay income taxes is a completely irrelevant point in itself. It's only relevant to whether you can focus tax breaks on wealthier people -- a political point. What's more, since people who 'don't pay income taxes' are overwhelmingly people with low incomes, those people by definition spend more than those with higher incomes, if only because they have no choice. It's just a straight-up nonsensical statement.

While I have been noting that Ricardian Equivalence would argue for the proposition that tax cuts do not increase aggregate demand while increases in government purchases would stimulate aggregate demand, we should recognize the role of borrowing constraints:

If “strapped consumers” means those facing borrowing constraints, it is precisely these households that are more likely to consume rather than save a tax cut.

Flake seems to be arguing that households that do not face borrowing constraints would be more likely to consume a tax “cut” than those that do face borrowing constraints. This proposition is precisely the opposite of what economic theory would tell us. Then again – economic theory tells us that increases in tax cuts (especially tax cuts for rich households) have less bang for the buck than increases in government purchases. Are these House Republicans hoping for the lowest bang for the buck or are they really this stupid?

World Growth Collapses

Econbrowser provides a link to a just-released IMF survey that reports that in November, 2008, world industrial production went from growing at a positive amount to an annual rate of -15%, and world merchandise trade went from growing at a positive rate to nearly a -45% rate, a total collapse probably more dramatic than even during the Great Depression. The IMF has lowered its projection for aggregate world economic growth in 2009 from 2.4% to 0.5%, which if it comes to pass would be the lowest rate of world GDP growth since WW II. We are indeed in a massive world economic crisis of the first order.

More Less

Pass the stimulus - then help shorten the work week

New York Daily News

By Dean Baker

Wednesday, January 28th 2009, 4:00 AM

As job losses hemorrhage, the American economy is in desperate need of a stimulus. It is becoming increasingly clear that Congress must work rapidly to approve some version of President Obama's plan.

Then, Obama and the Congress should very quickly turn to taking a second, temporary step to create more jobs: creating incentives for companies to reduce the workweek and work year for many Americans.

The idea is not as radical as it sounds - and could prove very productive indeed for the American worker....

Do We Really Import Microsoft Software from Ireland?

John Ensign - Republican Policy Committee Chairman – claims we do:

You know, we have the second highest corporate tax rate in the industrialized world. Microsoft, which is a great American company, has zero exports from the United States. They have a lot of exports from Ireland, because, guess what, Ireland has a 12.5 percent corporate tax rate; we have a 35 percent corporate tax rate.

Microsoft does not manufacture products in Ireland to sell to the U.S. It designs all sorts of software that we can place on our personal computers. While you might argue that Microsoft has to manufacture things like the Xbox – such manufacturing is contracted to third parties. During fiscal year ended December 31, 2008, Microsoft incurred $8.2 billion in R&D expenditures according to its 10-K filing. This R&D is in part performed in Ireland but it also occurs in the U.S., Canada, China, Denmark, India, Israel and the UK.

Microsoft has used the provision of the U.S. transfer pricing regulation under section 1.482 to have whatever is developed by their R&D personal around the world to be jointly owned by the U.S. parent and its Irish subsidiary – even if most of the R&D occurs in the U.S. They do so under a series of contract R&D and Cost Sharing arrangements where the Irish subsidiary had to at one point compensate the U.S. parent for any pre-existing intangible assets. In the usual game, the multinational corporation hires some transfer pricing “expert” to write a “valuation” that supports a really low compensation. The IRS then has the right to challenge this valuation as to whether the compensation is truly arm’s length or fair market value. Often, it is below fair market value which would give the appearance that much of the value is being created by the Irish entity even if much of the value is truly being created within the U.S. To use the actual accounting when intercompany prices are not consistent with arm’s length prices to make the kind of inferences made by John Ensign is really silly.

Ricardian Equivalence Does Not Imply That Obama’s Fiscal Stimulus Will Be Ineffective

Kevin Quinn noted that the Wikipedia discussion of Ricardian Equivalence had the following error:

Ricardian equivalence states that a deficit-financed increase in government spending will not lead to an increase in aggregate demand. If consumers are 'Ricardian' they will save more now to compensate for the higher taxes they expect to face in the future, as the government has to pay back its debts. The increased government spending is exactly offset by decreased consumption on the part of the public, so aggregate demand does not change.

As noted here, John Cochrane made the same error. I would hope the Myron S. Scholes Professor of Finance at the University of Chicago Booth School of Business does not rely upon Wikipedia for his economic research. Alas, in an otherwise excellent post on fiscal policy, Menzie Chinn sort of falls into this trap as well:

Case 5 (government debts will have to be paid off in its entirety the future): When budget constraints hold with certainty intertemporally, and there is no way to default even partially on government debt (say via unexpected inflation), then increases in government debt due to tax cuts (for instance) induce no change in current consumption because households fully internalize the present value of the future tax liability

Menzie is right about transitional changes in tax policy not being able to change consumption in this Barro-Ricardo model, which is why GOP calls for using tax cuts to stimulate demand are likely not going to be the most effective policy tool. But what about transitional changes in government purchases? It is interesting that Wikipedia noted Ricardo’s 1820 Essay on the Funding System:

Ricardo studied whether it makes a difference to finance a war with the £20 million in current taxes or to issue government bonds with infinite maturity and annual interest payment of £1 million in all following years financed by future taxes. At the assumed interest rate of 5%, Ricardo concluded that "In point of economy there is no real difference in either of the modes, for 20 millions in one payment, 1 million per annum for ever ... are precisely of the same value".

Let’s modernize this example. Suppose we decide to have an additional $100 billion in public investment in 2009. In Ricardo’s example, permanent taxes will increase by $5 billion per year which would have a very modest offsetting reduction in consumption. So if government purchases rise by $100 billion and consumption falls by $5 billion, then isn’t the direct impact on aggregate demand closer to $95 billion for the year rather than zero?

Update: Republicans will oppose more government spending as they prefer tax cuts:

Hours before a meeting with President Barack Obama, House Republican leaders sought to rally opposition Tuesday to a White House-backed economic stimulus measure with an $825 billion price tag. Several officials said that Reps. John Boehner of Ohio, the GOP leader, and Eric Cantor of Virginia, his second-in-command, delivered the appeal at a closed-door meeting of the Republican rank and file. Both men said the legislation contains too much wasteful spending that will not help the economy recover from its worst nosedive since the Great Depression, the officials added ... Senate Republican Leader Mitch McConnell, R-Ky., said in a televised interview that Obama was having problems with Democrats, whom he said favor spending over tax cuts as a remedy for the economic crisis.

If Ricardian Equivalence holds, the GOP is opposing fiscal stimulus that will impact aggregate demand preferring tax cuts that will not increase aggregate demand. Go figure!

When Less is More

Dean Baker in the Guardian today:

Shortening the workweek would create jobs and stimulate the US economy – and give workers the benefits other countries provide.

What amuses the Sandwichman is the predictable bullying froth from opponents of shorter working time. A study in social pathology.

Cochrane’s Fiscal Fallacies

Greg Mankiw has found another critic of fiscal stimulus with this one being even more silly than the predecessors. John Cochrane claims the proponents of fiscal stimulus rest their case on three fallacies. The first is that Fama crowding-out by identity canard:

First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This is just accounting, and does not need a complex argument about “crowding out.”

Calling Brad DeLong:

Now the NIPA savings-investment identity holds in all models--it is, after all, an identity, true by definition and construction. And every single model that has been built in which there is a possibility of high unemployment and idle resources is a model in which fiscal policy works because increases in government spending lead to unexpected declines in inventories and unexpected declines in inventories lead to firms to expand production, which leads to increases in income and saving. I would, therefore, say that Fama's claim is "wrong". Not only does it not hold in all models in the class, it does not hold in any models in the class.

His second “fallacy” is just strange:

Second, investment is “spending” every bit as much as consumption. Fiscal stimulus advocates want money spent on consumption, not saved. They evaluate past stimulus programs by whether people who got stimulus money spent it on consumption goods rather save it. But the economy overall does not care if you buy a car, or if you lend money to a company that buys a forklift.

Any reading of the General Theory by Lord Keynes would also say that advocates of fiscal stimulus would assign as high a multiplier to increasing investment demand as we assign to increasing consumption. Has Cochrane not noticed that the Obama fiscal policy wants to increase public investment rather than stimulate consumption?

He closes by showing he does not understand Ricardian Equivalence:

Third, people must ignore the fact that the government will raise future taxes to pay back the debt. If you know your taxes will go up in the future, the right thing to do with a stimulus check is to buy government bonds so you can pay those higher taxes. Now the net effect of fiscal stimulus is exactly zero, except to raise future tax distortions. The classic arguments for fiscal stimulus presume that the government can systematically fool people.

Oh good grief! If we were talking about temporary reductions in taxes – which would have to later be followed by tax surcharges – then Ricardian Equivalence predicts no increase in aggregate demand. But if we are talking about temporary increases in government purchases then rational households would realize that the increase in their lifetime tax bills would be quite modest, which would imply a small reduction in consumption demand relative to the large increase in government purchases.

I have to wonder John Cochrane could even pass the macroeconomic class offered at Greg Mankiw’s college! I also have to wonder why Greg Mankiw keeps posting without comment such incredibly silly arguments against fiscal stimulus.

Liquidity Traps, Credit Crunches, the Past Two Recessions, and Interest Rates on Long-Term BBB Debt

Jack Healy and Vikas Bajaj tell us that the cost of borrowing has zoomed up:

But with the credit markets still tight, corporations are being forced to pay much higher interest rates than they did a few years ago, putting more strain on balance sheets already hammered by falling profits and a grinding recession.

For those of you who have heard we are in a liquidity trap, remember that this refers to short-term interest rates on government debt whereas Healy and Bajaj are talking about long-term corporate debt. Interest rates on 20-year Federal bonds aren’t that high but credit spreads are:

Even companies with strong credit ratings are paying about 5 percentage points more than the federal government to borrow money, according to Standard & Poor’s. That is more than double the premium they paid last January. Companies with so-called junk credit ratings are paying a 15 percent premium. “That’s an extraordinary spread,” said Diane Vazza, head of global fixed-income research at Standard & Poor’s. “That’s unprecedented in the speculative-grade market.”

Sloped Curve takes these market rates to suggest that Paul Krugman is wrong about the liquidity trap argument:

Professor Krugman is also discussing only one side of the issue when it comes to where the economy is today. Professor Krugman is taking the fact that the US is in a liquidity trap for granted, and that the US is wrestling with the zero-lower-bound for interest rates, even though there are obvious reasons for why you would argue that the US is not in or near a liquidity trap ... the economic actors are not exposed to 0% interest rates. No final loans to private individuals or companies are made at or near a 0% interest rate ... There is another phenomenon, that is not a liquidity trap, but that can also create disinflation and even short-lived deflation. The phenomenon is a credit crunch. In a credit crunch credit becomes hard and/or expensive to come by, and this dampens the willingness to borrow, spend and invest. The difference between a liquidity trap and a credit crunch is that in a liquidity trap people have ample access to cheap credit and still choose to not borrow money, while in a credit crunch people do not borrow money either because they can't or because they view borrowing as too expensive. The basic attributes of these two phenomena are such that they are mutually exclusive. In a credit crunch you have limited access to cheap credit, in a liquidity trap you have ample access to nearly free credit; you can't have both.

I would beg to differ that one cannot have both as we are talking not only about interest rates are very different types of financial instruments but also about very different aspects of monetary policy. Our graphs are based on the monthly averages of interest rates on 20-year government bonds, AAA corporate bond rates, and BBB from January 1994 to December 2008. If we go back to 2001, it is interesting to note that the interest rate on BBB debt as of October 2001 was about the same as the interest rate as of January 2001 despite the fact that both AAA rates and rates on 20-year Federal bonds fell slightly. You may recall that this was the period where short-term rates fell dramatically but longer-term rates fell more modestly. But the big story was the climb in credit spreads – especially the BBB spread (BBB-s) which began in 2000 and continued through 2002. During the current recession, long-term Federal bond rates have fallen more dramatically but interest rates for companies with credit ratings of BBB or lower have increased as credit spreads have skyrocketed.

Traditional monetary policy can lower risk-free interest rates but recessions are also often associated with rising default risk. This recession in particular seems to have one of its underlying causes being increases in default risk and the associated troubles facing our financial institutions. Maybe this is why Ben Bernanke is frustrated with certain politicians not getting the need to release the remaining TARP funds:

This may be as close as we’re going to get to a Fed chairman labeling some in Congress as irresponsible. Sure, Federal Reserve Chairman Ben S. Bernanke was typically careful with his wording in a Jan. 13 speech in London. “The public in many countries” is “understandably concerned” that government is spending money to rescue the financial industry, “when other industries receive little or no assistance,” Bernanke said. After explaining how the world economy “is critically dependent on the free flow of credit,” Bernanke issued his challenge: “Responsible policy makers must therefore do what they can to communicate to their constituencies why financial stabilization is essential for economic recovery and is therefore in the broader public interest.” Three days after that speech, 33 of 39 Republican senators ignored Bernanke’s warning and voted against releasing the remaining $350 billion in Troubled Asset Relief Program money. (So did eight Democrats, mostly liberals, plus independent Bernie Sanders of Vermont.) Fortunately, that left enough supporters, mostly Democrats, to clear the release of the much-needed money. Too many senators shrugged their shoulders at Bernanke’s wise words.

As one of the fiscal stimulus critics that Greg Mankiw loves to cite, Gary Becker writes:

It is relevant in answering this question that the origins of this recession were in the financial sector, and especially in the excessive mortgage credit to sub prime and other borrowers. The widespread collapse of the financial sector, and the wholesale retreat from risky assets, clearly has called for a highly pro-active Fed. But it is not obvious why this should lead to greater confidence in the power of government spending stimulus packages. Of course, perhaps the prior emphasis on crowding out, and skepticism toward the stimulating effects of government spending, were wrong, or that recessions were too short and mild after the 1981-82 recession to call for Keynesian-type stimulus packages.

Becker has already been criticized for failing to note that interest rates were very high in 1982 but are nearly zero now. But he may indeed be right for the type of non-traditional monetary policy being advocated by our FED chairman today. Alas, many in the Republican Party are against both fiscal stimulus and this non-traditional monetary policy. I just don’t get it!

Update: Paul Krugman is kind enough to link to my post and then writes:

Well, my definition of a liquidity trap is, purely and simply, a situation in which conventional monetary policy — open-market purchases of short-term government debt — has lost effectiveness. Period. End of story. Now, if you prefer a different definition of a liquidity trap, OK; call our current situation a banana, instead. But changing the name does not change the essential fact — namely, conventional monetary policy has lost effectiveness. Yes, there are other things the Fed could do — and it’s doing them, on an awesome scale. But they’re controversial, precisely because, unlike conventional monetary policy, they involve picking and choosing among potentially risky investments. And there’s a much stronger case for fiscal policy than in normal times, because we don’t know how well these unconventional measures will work.

Might I add that I agree with Paul 100%!

The Fed as Financial Regulator

The Washington Post reports about a move afoot to give the Federal Reserve more regulatory power over the financial system.

http://www.washingtonpost.com/wp-dyn/content/article/2009/01/25/AR2009012501686.html?hpid=topnews

Considering that the Federal Reserve is supposed to be independent of the government, it would seem that getting such powers to the Fed would be ill-advised.

In addition, considering that the Fed's posture in the bailout makes the Treasury Department looks like a paragon of transparency, giving such powers to the Fed seems even more questionable.

When the Democrats promised change, I thought they meant change for the better. Maybe I was wrong.

Observations on China

I'm just now getting my energy back after my trip to China and a bout of food poisoning that I brought back. I hope I can be more attentive to the blog.

Just as an experiment, I tried to record a 15 minute discussion about my observations of China. I have to warn you that you should not expect any deep insights from fairly quick trip in which I spent most of my time in the corridors of various universities.

http://www.archive.org/details/ObservationsOnChina