martes, septiembre 17, 2013



Did Capitalism Fail?

Roman Frydman, Michael D. Goldberg

13 September 2013

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NEW YORKUntil six days before Lehman Brothers collapsed five years ago, the ratings agency Standard & Poor’s maintained the firm’s investment-grade rating of “A.” Moody’s waited even longer, downgrading Lehman one business day before it collapsed. How could reputable ratings agencies – and investment banksmisjudge things so badly?
Regulators, bankers, and ratings agencies bear much of the blame for the crisis. But the near-meltdown was not so much a failure of capitalism as it was a failure of contemporary economic models’ understanding of the role and functioning of financial markets – and, more broadly, instability – in capitalist economies.
These models provided the supposedly scientific underpinning for policy decisions and financial innovations that made the worst crisis since the Great Depression much more likely, if not inevitable. After Lehman’s collapse, former Federal Reserve Chairman Alan Greenspan testified before the US Congress that he hadfound a flaw” in the ideology that self-interest would protect society from the financial system’s excesses. But the damage had already been done.
That belief can be traced to prevailing economic theory concerning the causes of asset-price instability – a theory that accounts for risk and asset-price fluctuations as if the future followed mechanically from the past. Contemporary economists’ mechanical models imply that self-interested market participants would not bid housing and other asset prices to clearly excessive levels in the run-up to the crisis. Consequently, such excessive fluctuations have been viewed as a symptom of market participants’ irrationality.
This flawed assumption – that self-interested decisions can be adequately portrayed with mechanical rulesunderpinned the creation of synthetic financial instruments and legitimized, on supposedly scientific grounds, their marketing to pension funds and other financial institutions around the world. Remarkably, emerging economies with relatively less developed financial markets escaped many of the more egregious consequences of such innovations.
Contemporary economists’ reliance on mechanical rules to understand – and influenceeconomic outcomes extends to macroeconomic policy as well, and often draws on an authority, John Maynard Keynes, who would have rejected their approach. Keynes understood early on the fallacy of applying such mechanical rules. “We have involved ourselves in a colossal muddle,” he warned, “having blundered in the control of a delicate machine, the working of which we do not understand.”
In The General Theory of Employment, Interest, and Money, Keynes sought to provide the missing rationale for relying on expansionary fiscal policy to steer advanced capitalist economies out of the Great Depression. But, following World War II, his successors developed a much more ambitious agenda. Instead of pursuing measures to counter excessive fluctuations in economic activity, such as the deep contraction of the 1930’s, so-called stabilization policies focused on measures that aimed to maintain full employment. The “New Keynesianmodels underpinning these policies assumed that an economy’struepotential – and thus the so-called output gap that expansionary policy is supposed to fill to attain full employment – can be precisely measured.
But, to put it bluntly, the belief that an economist can fully specify in advance how aggregate outcomes – and thus the potential level of economic activity – unfold over time is bogus. The projections implied by the Fed’s macro-econometric model concerning the timing and effects of the 2008 economic stimulus on unemployment, which have been notoriously wide of the mark, are a case in point.
Yet the mainstream of the economics profession insists that such mechanistic models retain validity. Nobel laureate economist Paul Krugman, for example, claims that “a back-of-the-envelope calculation” on the basis of “textbook macroeconomicsindicates that the $800 billion US fiscal stimulus in 2009 should have been three times bigger.
Clearly, we need a new textbook. The question is not whether fiscal stimulus helped, or whether a larger stimulus would have helped more, but whether policymakers should rely on any model that assumes that the future follows mechanically from the past. For example, the housing-market collapse that left millions of US homeowners underwater is not part of textbook models, but it made precise calculations of fiscal stimulus based on them impossible. The public should be highly suspicious of claims that such models provide any scientific basis for economic policy.
But to renounce what Friedrich von Hayek called economists’pretense of exact knowledge” is not to abandon the possibility that economic theory can inform policymaking. Indeed, recognizing ever-imperfect knowledge on the part of economists, policymakers, and market participants has important implications for our understanding of financial instability and the state’s role in mitigating it.
Asset-price swings arise not because market participants are irrational, but because they are attempting to cope with their ever-imperfect knowledge of the future stream of profits from alternative investment projects. Market instability is thus integral to how capitalist economies allocate their savings. Given this, policymakers should intervene not because they have superior knowledge about asset values (in fact, no one does), but because profit-seeking market participants do not internalize the huge social costs associated with excessive upswings and downswings in prices.
It is such excessive fluctuations, not deviations from some fancifultruevaluewhether of assets or of the unemployment rate – that Keynes believed policymakers should seek to mitigate. Unlike their successors, Keynes and Hayek understood that imperfect knowledge and non-routine change mean that policy rules, together with the variables underlying them, gain and lose relevance at times that no one can anticipate.
That view appears to have returned to policymaking in Keynes’s homeland. As Mervyn King, the former governor of the Bank of England, put it, “Our understanding of the economy is incomplete and constantly evolving. To describe monetary policy in terms of a constant rule derived from a known model of the economy is to ignore this process of learning.” His successor, Mark Carney, has come to embody this view, eschewing fixed policy rules in favor of the constrained discretion implied by guidance ranges for key indicators.
Rather than trying to hit precise numerical targets, whether for inflation or unemployment, policymaking in this mode attempts to dampen excessive fluctuations. It thus responds to actual problems, not to theories and rules (which these problems may have rendered obsolete). If we are honest about the causes of the 2008 crisis – and serious about avoiding its recurrence – we must accept what economic analysis cannot deliver in order to benefit from what it can.
Roman Frydman is Professor of Economics at New York University. He is the co-author of Imperfect Knowledge Economics and Beyond Mechanical Markets.

Michael D. Goldberg is Professor of Economics at the University of New Hampshire. He is the co-author of Imperfect Knowledge Economics and Beyond Mechanical Markets.

September 15, 2013 8:30 pm

Quantitative easing: Tale of the taper
The Federal Reserve is wrestling with how to step away from the monetary policy that has defined the response to the financial crisis around the world
The US Federal Reserve building©AP
Waving the flag: The US Federal Reserve has had three bouts of quantitative easing to boost the economy and cut unemployment
The end of quantitative easing has been declared many times since the end of the Great Recession. This week, however, the final act may truly begin.
The US Federal Reserve meets on Tuesday and Wednesday to debate the possibility of starting to “taper” its third round of asset purchasesknown as QE3down from the current pace of $85bn a month.
A decision to do so is not certain because there are still some doubts about the health of the economy. But it would mark the first step away from the monetary policy that has come to define the aftermath of the financial crisis all around the world.

With economies still weak, governments unwilling or unable to mount further fiscal stimulus, and short-term interest rates trapped at zero, QE became the default policy. Under QE, a central bank buys long-term assets with the aim of reducing the supply of them available to private investors, driving up their price, and thus driving down long-term interest rates in order to stimulate the economy.

The Fed has carried out repeated rounds of the policy. After buying more than $1tn in assets during the crisis, it launched a $600bn QE2 at the end of 2010, followed by Operation Twist to move into longer-term assets during 2011, and finally QE3 in September 2012. As of last week, the Fed’s balance sheet had reached $3.7tn, compared with about $1tn before the recession.

By itself, the choice to taper is a small step. To do so now, rather than at the Fed’s next meetings in October or December, will make a marginal difference of $50bn-$100bn in the total assets that the Fed will acquire by the end of its programme. The Fed thinks that cumulative total is what sets monetary policy.

But the symbolic effect is huge. A taper would signal the passing of “peak QE” in the world’s largest economy. Although it is always possible that the economy will weaken, and the Fed will pick up its pace of asset buying again, that is less likely now the economic recovery is four years old and the unemployment rate down to 7.3 per cent.

The big question is where the Fed goes from here. Despite the improvement, the economy is not fixed, unemployment is still high and the growth outlook is uncertain. Interest rates will need to stay low for some time. The Fed and Ben Bernanke, its departing chairman, have to find a way to send this signal on rates even as they start to wind asset purchases down.
How well the Fed succeeds at this delicate task will decide how disruptive tapering becomes. The mere possibility has already caused turmoil in emerging markets and a rush of companies scurrying to lock in low interest rates. Here are some of the main questions the Fed has to answer as it considers whether to turn taper talk into reality.

. . .

Is the US economy ready for a taper?

When the Fed launched its third round of quantitative easing in September 2012, it was different to the earlier programmes in a crucial way: QE3 was open-ended. The Fed would continue its asset purchases, at a clip of $85bn a month, until there was a “substantial improvement in the labour market outlook”.
That was a masterstrokemarkets dubbed itQE Infinity” and drove interest rates down lower than they have ever gone – but the Fed’s goals for QE3 were actually quite limited. Those goals have been a source of confusion ever since.
As Ben Bernanke explained last September, the idea was to give the stuttering economy a shove forwards, not nurse it back to full health. “We’re not going to be able to sustain purchases until we’re all the way back to full employmentthat’s not the objective,” the Fed chairman said at the time. “The idea is to quicken the recovery, to help the economy begin to grow quickly enough to generate new jobs and reduce the unemployment rate.”

The Fed began signalling QE3’s eventual end in March. By June, it was concerned enough about overheating markets to spell out a detailed plan, saying it would slow purchases later in the year if the economy kept adding jobs, growth stayed solid and inflation did not fall any further.

The question now is whether those conditions have been met. In many ways they have. The unemployment rate is 7.3 per cent compared with 7.6 per cent in June; second-quarter growth was stronger than expected; and inflation has stabilised in the past few months. Those are strong reasons to expect a tapering of asset purchases this month.

The one doubt, exacerbated by a feeble jobs report for August, is whether growth will be strong enough to keep unemployment falling in the months ahead. One way to address such worries is a small taper, then a pause if growth falters.

Compared with last autumn, the path back to maximum output – which the Fed puts at a 5.6 per cent unemployment rate looks much clearer. Even if QE3 gets a reprieve in September its time is nearly up.

. . .
Has QE3 worked?

The Fed, at least, is convinced that it has. In March, Mr Bernanke said most Fed officialsagreed that these purchases – by putting downward pressure on longer-term interest rates, including mortgage ratescontinue to provide meaningful support to economic growth and job creation”.

From the autumn of 2012 until the summer of 2013, 10-year Treasury notes traded with interest rates between 1.5 and 2 per cent, the lowest they have ever gone. Mortgage rates fell to record lows.

Further evidence that the policy moved market interest rates came at the first sign of reversing it in May: the 10-year yield is up by more than 100 basis points since then.

A trickier question is how far those low-interest rates spread. “The Fed’s purchases of long-term US Treasury bonds significantly raised Treasury bond prices, but has had limited spillover effects for private sector bond yields, and thus limited economic benefits,” argued academics Arvind Krishnamurthy and Annette Vissing-Jorgensen at this year’s annual monetary conference in Jackson Hole, Wyoming.
In general, the Fed rejects that analysis and there is some evidence that QE3 spurred the real economy. A boom in mortgage refinancing this year coincided with a pickup in the housing market. The strongest sectors of the economy, such as car sales, have been the most sensitive to interest rates.

There is no way to know what would have happened without QE3. It did not transform a weak economic recovery into a strong onegrowth has remained locked on a path around 2 per cent and the downward trend in the unemployment rate was in place before the policy started – but that may have been the best outcome given the tax rises and spending cuts Congress imposed at the start of 2013.

What QE3 does seem to have done is reveal the limits of using asset purchases as a tool to stimulate the economy. In February, Fed governor Jeremy Stein gave a speech warning about the dangers of credit market overheating. Growing worries about financial stability risks from QE3 have contributed to the move towards tapering.

With the UK having recently followed the Fed and adopted a “threshold” for the unemployment rate above which it will not raise interest rates, the focus of central bankers around the world is starting to switch away from QE and towards this kind of forward guidance about future policy.
. . .

How long are interest rates going to stay low?

What alarmed the Fed most about reaction to June’s tapering talk was the market’s expectation of an earlier interest rate rise.

In other words, the Fed’s taper forecast was taken as a reason to doubt its forward guidance.

As far as most Fed officials are concerned, any decision to taper asset purchases would have nothing to do with the timing of rate rises, which they do not expect to be justified until the economy is much closer to full employment. They are trying new ways to get that idea across.

There are two possible areas to work on: firmer guidance on when the Fed will first raise interest rates and information on how fast rates will rise once they start to go up.

For the first rate rise, the Fed’s main communication tool is the 6.5 per cent unemployment threshold, above which it will not raise interest rates. But if a lot of people who dropped out of the labour market start looking for jobs again then the Fed may want to keep rates low even when unemployment falls below 6.5 per cent.

The Fed could lower the 6.5 per cent threshold but there is not much appetite for that on the Federal Open Market Committee. An alternative is to add an inflation threshold as well, saying, perhaps, that the Fed will not raise interest rates if it forecasts inflation below its target of 2 per cent. That would help to rule out rate rises in scenarios where the unemployment rate dropped but the economy was still weak enough for there to be little upward pressure on inflation.

The Fed is starting to debate a broader question: if the damage from the financial crisis – its effect on household balance sheets, for example – could persist for another five years or more. That would mean a slow rise in interest rates back to their long-run level as the economy heals.

Communicating that is difficult, since the Fed only publishes forecasts for the next three years. It may start by drawing attention to the 2016 forecasts, due for their first release in September.

Markets may pay no attention – but the Fed has a loud voice and it tends to repeat itself until the message gets across.

. . .

How does the Fed handover affect policy?

The growing importance of forward guidance is a problem for the Fed.

While it is hard for central bankers to say something credible about their own plans for the future, it is even harder to say something credible about what other people will do.

That makes the importance of forward guidance a problem for Mr Bernanke because his term as chairman expires at the end of January 2014. Nor is his the only departure. Elizabeth Duke, Fed governor, has already left and Sarah Bloom Raskin is moving to the Treasury. Sandra Pianalto, the Cleveland Fed president who is scheduled to vote on the FOMC next year, has announced her retirement.
When it comes to making forecasts about what the Fed will do in 2015 or 2016 the problem is even more severe because no current governor is certain to be there. Janet Yellen, the Fed vice-chair, may leave if she is passed over for the top job; the Senate must reconfirm Jerome Powell for him to remain beyond January 2014; Harvard may want Jeremy Stein back; and Daniel Tarullo has already spent more than four years handling financial regulatory reform.
That constrains forward guidance in several ways. It means that formal guidance adopted by the committee and put in the FOMC statement is likely to work better than the forecasts of individual committee members. Future personnel will have a strong incentive to abide by whatever the current FOMC promises, if only so that their own promises are believed.

But the handover makes it all but impossible to make a credible pledge to behave irresponsibly in the future by allowing, for example, a period of above-target inflation. That is what many theoretical models call for, as a way of making up for low inflation in the past, but so far no central bank has found a way to implement it.

Instead, the Fed is likely to concentrate on areas where it can make a strong analytical case about how policy will change in future, which is likely to be shared by whoever takes over the top job. Larry Summers and Ms Yellen, the top two candidates, share a broad policy outlook even if they are likely to differ on many details.

Nonetheless, uncertainty about who will be chair – and this person’s commitment to current policy – is likely to make forward guidance less effective, highlighting the urgency of a nomination by President Barack Obama and a prompt Senate confirmation.

Copyright The Financial Times Limited 2013.

September 15, 2013

Give Jobs a Chance


This week the Federal Reserve’s Open Market Committee — the group of men and women who set U.S. monetary policy — will be holding its sixth meeting of 2013. At the meeting’s end, the committee is widely expected to announce the so-calledtaper” — a slowing of the pace at which it buys long-term assets.
Memo to the Fed: Please don’t do it. True, the arguments for a taper are neither crazy nor stupid, which makes them unusual for current U.S. policy debate. But if you think about the balance of risks, this is a bad time to be doing anything that looks like a tightening of monetary policy.
O.K., what are we talking about here? In normal times, the Fed tries to guide the economy by buying and selling short-term U.S. debt, which effectively lets it control short-term interest rates.

Sincé 2008, however, short-term rates have been near zero, which means that they can’t go lower (since people would just hoard cash instead). Yet the economy has remained weak, so the Fed has tried to gain traction through unconventional measuresmainly by buying longer-term bonds, both U.S. government debt and bonds issued by federally sponsored home-lending agencies.
Now the Fed is talking about slowing the pace of these purchases, bringing them to a complete halt by sometime next year. Why?
One answer is the belief that these purchases — especially purchases of government debt — are, in the end, not very effective. There’s a fair bit of evidence in support of that belief, and for the view that the most effective thing the Fed can do is signal that it plans to keep short-term rates, which it really does control, low for a very long time.
Unfortunately, financial markets have clearly decided that the taper signals a general turn away from boosting the economy: expectations of future short-term rates have risen sharply since taper talk began, and so have crucial long-term rates, notably mortgage rates. In effect, by talking about tapering, the Fed has already tightened monetary policy quite a lot.
But is that such a bad thing? That’s where the second argument comes in: the suggestions that there really isn’t that much slack in the U.S. economy, that we aren’t that far from full employment. After all, the unemployment rate, which peaked at 10 percent in late 2009, is now down to 7.3 percent, and there are economists who believe that the U.S. economy might begin to “overheat,” to show signs of accelerating inflation, at an unemployment rate as high as 6.5 percent. Time for the Fed to take its foot off the gas pedal?
I’d say no, for a couple of reasons.
First, there’s less to that decline in unemployment than meets the eye. Unemployment hasn’t come down because a higher percentage of adults is employed; it’s come down almost entirely because a declining percentage of adults is participating in the labor force, either by working or by actively seeking work. And at least some of the Americans who dropped out of the labor force after 2007 will come back in as the economy improves, which means that we have more ground to make up than that unemployment number suggests.
How misleading is the unemployment number? That’s a hard one, on which reasonable people disagree. The question the Fed should be asking is, what is the balance of risks?
Suppose, on one side, that the Fed were to hold off on tightening, then learn that the economy was closer to full employment than it thought. What would happen? Well, inflation would rise, although probably only modestly. Would that be such a bad thing? Right now inflation is running below the Fed’s target of 2 percent, and many serious economists — including, for example, the chief economist of the International Monetary Fund — have argued for a higher target, say 4 percent. So the cost of tightening too late doesn’t look very high.
Suppose, on the other side, that the Fed were to tighten early, then learn that it had moved too soon. This could damage an already weak recovery, causing hundreds of billions if not trillions of dollars in economic damage, leaving hundreds of thousands if not millions of additional workers without jobs and inflicting long-term damage as more and more of the unemployed are perceived as unemployable.
The point is that while there is legitimate uncertainty about what the Fed should be doing, the costs of being too harsh vastly exceed the costs of being too lenient. To err is human; to err on the side of growth is wise.
I’d add that one of the prevailing economic policy sins of our time has been allowing hypothetical risks, like the fiscal crisis that never came, to trump concerns over economic damage happening in the here and now. I’d hate to see the Fed fall into that trap.
So my message is, don’t do it. Don’t taper, don’t tighten, until you can see the whites of inflation’s eyes. Give jobs a chance.