The Perils of Prophecy

J. Bradford DeLong

27 June 2012

BERKELEYWe economists who are steeped in economic and financial history – and aware of the history of economic thought concerning financial crises and their effects – have reason to be proud of our analyses over the past five years. We understood where we were heading, because we knew where we had been.

In particular, we understood that the rapid run-up of house prices, coupled with the extension of leverage, posed macroeconomic dangers. We recognized that large bubble-driven losses in assets held by leveraged financial institutions would cause a panicked flight to safety, and that preventing a deep depression required active official intervention as a lender of last resort.

Indeed, we understood that monetarist cures were likely to prove insufficient; that sovereigns need to guarantee each others’ solvency; and that withdrawing support too soon implied enormous dangers.

We knew that premature attempts to achieve long-term fiscal balance would worsen the short-term crisis – and thus be counterproductive in the long-run. And we understood that we faced the threat of a jobless recovery, owing to cyclical factors, rather than to structural changes.

On all of these issues, historically-minded economists were right. Those who said that there would be no downturn, or that recovery would be rapid, or that the economy’s real problems were structural, or that supporting the economy would produce inflation (or high short-term interest rates), or that immediate fiscal austerity would be expansionary were wrong. Not just a little wrong. Completely wrong.

Of course, we historically-minded economists are not surprised that they were wrong. We are, however, surprised at how few of them have marked their beliefs to market in any sense. On the contrary, many of them, their reputations under water, have doubled down on those beliefs, apparently in the hope that events will, for once, break their way, and that people might thus be induced to forget their abysmal forecasting track record.

So the big lesson is simple: trust those who work in the tradition of Walter Bagehot, Hyman Minsky, and Charles Kindleberger. That means trusting economists like Paul Krugman, Paul Romer, Gary Gorton, Carmen Reinhart, Ken Rogoff, Raghuram Rajan, Larry Summers, Barry Eichengreen, Olivier Blanchard, and their peers. Just as they got the recent past right, so they are the ones most likely to get the distribution of possible futures right.

But we – or at least Ihave gotten significant components of the last four years wrong. Three things surprised me (and still do). The first is the failure of central banks to adopt a rule like nominal GDP targeting or its equivalent. Second, I expected wage inflation in the North Atlantic to fall even farther than it has toward, even if not to, zero. Finally, the yield curve did not steepen sharply for the United States: federal funds rates at zero I expected, but 30-Year US Treasury bonds at a nominal rate of 2.7% I did not.

The failure of central banks to target nominal GDP growth remains incomprehensible to me, and I will not write about it until I think that I have understood the reasons. As for wages, even with one-third of the US labor force changing jobs every year, sociological factors and human-network ties appear to exercise an even stronger influence on the level and rate of change – at the expense of balancing supply and demand – than I would have expected.

The third surprise, however, may be the most interesting. Back in March 2009, the Nobel laureate Robert Lucas confidently predicted that the US economy would be back to normal within three years.

A normal US economy has a short-term nominal interest rate of 4%. Since the ten-year US Treasury bond rate tends to be one percentage point above the average of expected future short-term interest rates over the next decade, even the expectation of five years of deep depression and near-zero short-term interest rates should not push the 10-Year Treasury rate below 3%.

Indeed, the Treasury rate mostly fluctuated between 3% and 3.5% from late 2008 through mid-2011. But, in July 2011, the ten-year US Treasury bond rate crashed to 2%, and it was below 1.5% at the start of June. The normal rules of thumb would say that the market is now expecting 8.75 years of near-zero short-term interest rates before the economy returns to normal. And similar calculations for the 30-year Treasury bond show even longer and more anomalous expectations of continued depression.

The possible conclusions are stark. One possibility is that those investing in financial markets expect economic policy to be so dysfunctional that the global economy will remain more or less in its current depressed state for perhaps a decade, or more. The only other explanation is that even now, more than three years after the US financial crisis erupted, financial markets’ ability to price relative risks and returns sensibly has been broken at a deep level, leaving them incapable of doing their job: bearing and managing risk in order to channel savings to entrepreneurial ventures.

Neither alternative is something that I would have predicted – or even imagined.

J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau for Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates.

The Impotence of the Federal Reserve
Martin Feldstein

27 June 2012

CAMBRIDGEThe United States Federal Reserve’s recent announcement that it will extend its “Operation Twist” by buying an additional $267 billion of long-term Treasury bonds over the next six months - to reach a total of $667 billion this year - had virtually no impact on either interest rates or equity prices. The market’s lack of response was an important indicator that monetary easing is no longer a useful tool for increasing economic activity.

The Fed has repeatedly said that it will do whatever it can to stimulate growth. This led to a plan to keep short-term interest rates near zero until late 2014, as well as to massive quantitative easing, followed by Operation Twist, in which the Fed substitutes short-term Treasuries for long-term bonds.

These policies did succeed in lowering long-term interest rates. The yield on ten-year Treasuries is now 1.6%, down from 3.4% at the start of 2011. Although it is difficult to know how much of this decline reflected higher demand for Treasury bonds from risk-averse global investors, the Fed’s policies undoubtedly deserve some of the credit. The lower long-term interest rates contributed to the small 4% rise in the S&P 500 share-price index over the same period.

The Fed is unlikely to be able to reduce long-term rates any further. Their level is now so low that many investors rightly fear that we are looking at a bubble in bond and stock prices. The result could be a substantial market-driven rise in long-term rates that the Fed would be unable to prevent. A shift in foreign investors’ portfolio preferences away from long-term bonds could easily trigger such a run-up in rates.

Moreover, while the Fed’s actions have helped the owners of bonds and stocks, it is not clear that they have stimulated real economic activity. The US economy is still limping along with very slow growth and a high rate of unemployment. Although the economy has been expanding for three years, the level of GDP is still only 1% higher than it was nearly five years ago, when the recession began. The GDP growth rate was only 1.7% in 2011, and it is not significantly higher now. Indeed, recent data show falling real personal incomes, declining employment gains, and lower retail sales.

The primary impact of monetary easing is usually to stimulate demand for housing and thus the volume of construction. But this time, despite historically low mortgage interest rates, house prices have continued to fall and are now more than 10% lower in real terms than they were two years ago.

The level of real residential investment is still less than half its level before the recession began. The Fed has noted that structural problems in the housing market have impaired its ability to stimulate the economy through this channel.


Business investment is also weak, even though large corporations have very high cash balances. With so much internal liquidity, these businesses are not sensitive to reductions in market interest rates. At the same time, many very small businesses cannot get credit, because the local banks on which they depend have inadequate capital, owing to accrued losses on commercial real-estate loans. These small businesses, too, are not helped by lower interest rates.

The Fed’s monetary easing did temporarily contribute to a weaker dollar, which boosted net exports. But the dollar’s decline has more recently been reversed by the global flight to safety by investors abandoning the euro.

Even if the US economy continues to stumble in the months ahead, the Fed is unlikely to do anything more before the end of the year. The next policy moves to help the economy must come from the US Congress and the administration after the November election.

Nonetheless, what needs to be done is already clear. The cloud of a sharp rise in personal and corporate income-tax rates, now scheduled to occur automatically at the start of 2013, must be removed. The projected increase in the long-term fiscal deficit must be reversed by stemming the growth in transfers to middle-class retirees. Fundamental tax reform must strengthen incentives, reduce distortingtax expenditures,” and raise revenue. Finally, the relationship between government and business, now quite combative, must be improved.

If these things happen in 2013, the US economy can return to a more normal path of economic expansion and rising employment. At that point, the Fed can focus on its fundamental mandate of preventing a rise in the rate of inflation. Until then, it is powerless.

06/29/2012 07:04 PM

Yes, for Now

Merkel Knows the Dealing Isn't Done

By Carsten Volkery in Brussels

To the delight of investors and relief of her euro-zone counterparts, German Chancellor Angela Merkel made some key concessions at Friday's EU summit. But the celebration is premature because she has still left herself plenty of room for maneuver.


German Chancellor Angela Merkel rarely sees these kinds of negative headlines when returning from European Union summits. During her over six years as the head of Germany's government, she has usually been able to put a positive spin on even unpopular compromises.

But at the most recent emergency gathering of European heads of state and government, which was held in Brussels and lasted until the wee hours of Friday morning, she had a hard time doing exactly that. Reactions back home were devastating, and there were even calls for pushing back key parliamentary votes on the permanent euro bailout fund, known as the European Stability Mechanism (ESM), as well as Merkel's fiscal pact scheduled for Friday evening. In fact, the vehemence of the attacks seems to have taken even Merkel's advisers by surprise.

Merkel launched her counterattack on Friday afternoon. In a post-summit press conference, she said one first has to sort things out after such a long night, and she tried to counter the impression that she had been out-maneuvered by Italian Prime Minister Mario Monti and Spanish Prime Minister Mariano Rajoy.

Merkel underscored that she had pressed to make sure that the rules of the ESM were adhered to. She said she had successfully defended the ESM's preferred creditor status and that only a single exception would be made, for Spain. Likewise, she noted that, if at all, the ESM would only provide direct assistance to private banks after a long process of setting up a banking supervision mechanism, and that Germany would have several opportunities to exercise its veto during this process.

Yet Another Broken Taboo

Though they were worth a shot, Merkel's efforts to reframe the debate came too late. The impression that she had stumbled in Brussels yet again had already had too much time to sink in. With her concessions to allow for a relaxation of the ESM's loans-only-for-oversight conditions and allowing the bailout fund to potentially provide direct aid to banks, Merkel has led the euro zone one more step along the path toward a pooling of debt, an IOU-nion.

This is not the first time that Merkel has surrendered what had been repeatedly heralded as Germany's final line in the sand. Every step of the campaign to rescue the euro over the last two years has gone from being a taboo to a done-deal that triggers massive public outrage. Indeed, one could even go further and say that the entire history of European integration has been a series of broken taboos.

What's more, in this game of high-stakes negotiations lasting until 4 o'clock in the morning, Merkel was also holding what were simply bad cards. She urgently needed her counterparts to agree to the growth pact if she was to have any chance of having Germany's parliament, the Bundestag, approve her fiscal pact in a vote scheduled for Friday evening. Time was short, and she needed an agreement. Knowing this, Monti laid his dagger on her chest.

Once known, the decisions ignited a pyrotechnic display on the financial markets. Investors were thrilled that the intractable Germans had finally yielded some ground. At least for now, Monti's calculation has paid off: The pressure on Italian and Spanish sovereign bonds has slackened.

However, when it comes to whether the ESM will be able to provide direct assistance to private banks, at least on paper, Merkel has left one door open. Granted, the basic parameters have already been set.

But the ESM will only be allowed to lend to private banks once a European banking supervision mechanism has been put into place -- and that could take a long time. There are still "difficult negotiations" ahead, Merkel said, adding that this "will not be resolved in 10 days." Given this situation, reports about how such measures could immediately help Spanish banks are incorrect.

The Long Road Ahead

First, the European Commission and the European Central Bank (ECB) have to work out a concrete proposal for such a supervisory mechanism. Among other things, they have to decide whether the new organization will be part of the ECB or independent. Then the heads of the 17 euro-zone countries will have to approve it, which is supposed to happen by the end of this year. If the German government believes that the new organization doesn't have sufficient powers of oversight, it can put the kibosh on the plans.

Germany will maintain an additional veto right even after the supervisory agency has been established. Each time direct aid for a bank is requested, the German government and the Bundestag can say no. Merkel pointed this out in Brussels in order to counter criticism that she gave in. She added that, under these conditions, the bank aid was not a short-term measure to push down the high interest rates on Spanish sovereign bonds but, rather, a "medium-term measure."

The only immediate help for Spain is the agreed to waiver of the ESM's preferred creditor status (solely for that country), which gives the euro-zone countries no advantages over Spain's other creditors. Since all creditors will bear an equal share in the losses if Spain defaults on its loans, this makes Spanish bonds less risky for private investors.

On the whole, the summit was a victory for the southern European countries. The summit's decisions will reduce the IMF's influence in Europe and give the European Commission a leading role in supervising reform efforts. One thing is clear: IMF officials will not seize control in Rome or Madrid.

Since the beginning of the euro crisis, this possibility has been a thorn in the side of Mediterranean countries. Merkel, on the other hand, always wanted IMF participation because she doesn't believe that EU monitors will be as ruthless.

A frosty reception is awaiting her in Berlin, where the parliamentary vote is anxiously awaited.

The Impending Pension Problem

Pension liabilities are a massive hidden debt

Based on the research of Joshua Rauh And Robert Novy-Marx


Four trillion dollars. That is the shortfall of state and local government pension funds across the United States—the amount of money these governments have committed to workers but lack the funds to cover. According to Joshua Rauh, an associate professor of finance at the Kellogg School of Management, that massive number representshidden debt,” a means by which governments can run up debt off the balance sheet, bypassing balanced-budget laws. And it could spell big trouble in the years ahead.

In two recent papers, Rauh and Robert Novy-Marx, an assistant professor at the University of Rochester, show that these pensions are dangerously underfunded, that they are based on faulty economic assumptions, and that the impact to taxpayers could be significant. Ultimately, Rauh says, it could result in people leaving cities in order to avoid the fallout.

Questionable Logic at Fault

According to Rauh, the huge discrepancy between state and local government pension assets and liabilities comes from what is essentially bad accounting. The Governmental Accounting Standards Board (GASB), a nongovernmental group that sets guiding principles, allows these governments to measure the cost of providing pension benefits using expected returns on the assets in pension funds. They are allowed to say, in other words, that because a particular portfolio has historically delivered an 8 percent return, it will always deliver 8 percent. Under that questionable logic, you could assume that a mutual fund you bought in 1982 would have the same return for the next 30 years, and you could reduce the stated value of your debts accordingly.


“In the mid-’90s,” Rauh says, “the GASB legitimized this accounting that governments had been practicing for years. It’s very different from what would be done in the private sector, and very different from what logic says you should be able to do.”

“These problems have been put off into the future.” It is also, Rauh says, a self-perpetuating cycle.

"What short-sighted politicians want is to be able to spend money now that you don’t have to collect in tax revenues now. These problems have been put off into the future.”

Back in 2007, when Rauh and Novy-Marx first began work on a paper titledPublic Pension Promises: How Big Are They and What Are They Worth?”, equity markets were close to all-time highs. State and local governments claimed their pension systems were fully funded. “We looked and said, in fact they are assuming that the success that these funds have had, that the equity markets have had, over the last 30 years is just going to continue indefinitely. They’re assuming that every dollar in the pension fund is going to continue to grow without risk at 8 percent.”

Subsequently, of course, the financial crisis hit—and these same pensions lost $1 trillion in assets. Rauh and Novy-Marx are not the first to point out that government accounting differs from private-sector accounting. But they are the first to precisely measure it. Government reports, Rauh says, are “opaque and not standardized.”

One thing you want to know is the outflows. What has been promised every year in the future? That seems like something that any taxpayer should have the right to know. But they’re not required to disclose that.” So Rauh and Novy-Marx set out to reverse-engineer these cash flows and then to “stress-test the assumptions,” to discover what happens when they re-evaluated cash flows using real discount rates that account for risk in the markets. The answer—that $4 trillion figure—should, Rauh says, be a cause for concern.

Analyzing the Numbers

In another recent paper, “The Revenue Demands of Public Employee Pension Promises,” Novy-Marx and Rauh calculated the cost to taxpayers of the unfunded liabilities. People have trouble thinking in trillions,” Rauh says. “What does a trillion dollars really mean?” If you divide $4 trillion by the number of households in the United States, 150 million, it works out to $26,000 per household. But even that figure is hard to interpret, because it only reflects the present value.

So the researchers went further, to calculate the impact of that number on households in terms of increased taxes or decreased spending each year. On average, across the country, fully funding promised pensions could result in a tax hike of nearly $1,400 per household, every year.

Of course, the real amount would vary greatly by geography. As they write in the paper, “Taxpayers may leave the states that are the most burdened by the legacy liabilities and look for places with lower taxes and better public services.” Rauh plans to research these impacts.

If Chicago, for instance, faces a “day of reckoning” with its pensions and has to pay them out, residents might move to the suburbs to avoid paying higher taxes and facing cuts in services as the city struggles to meet its obligations. “That’s something that we expect to happen as state and local governments try to deal with these problems,” Rauh says. As people leave these areas, that only compounds the problem by reducing the tax baseleading to even greater tax increases for those who stay.

So what is the solution? The first thing, Rauh says, is to stop the problem from getting any worse. “If you have a friend who calls you up and says, ‘I have $100,000 in credit card debt, what can I do?,’ the first thing is to tell them to stop increasing the debt.” While there is no easy or pleasant solution, starting to pay down or renegotiate the debt is essential. “But it has to be recognized what the value of the debt is, what the value of the promises are. Then,” Rauh says, “we can think about how we can pay for it.”