Zero rates don’t really make monetary policy more difficult, they make interest rate-oriented monetary policy more difficult… Permanent QE is just as effective as ever. Exchange rate depreciation is just as effective as ever, inflation targeting is just as effective as ever, NGDP targeting is just as effective as ever, commodity price targeting is just as effective as ever.

The strangest thing is that Ben Bernanke agrees with Sumner on this point. Just today we learn of his written reply to a Brad DeLong question on why the Fed has not adopted an explicit 3% inflation target (something that would have done wonders to prevent the great nominal spending crash of late 2008, early 2009):

…The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored. [Emphasis added]

So Bernanke agrees with Sumner in principle but is afraid of inflation expectations becoming unmoored. A look at the average 10-year inflation forecast from the Survey of Professional Forecasters says Bernanke should not be worried about inflation expectations. They have been anchored relatively well since 1997 around 2.5 percent:

Too bad Paul Krugman was not beating his influential drum with a message of inflation targeting–or in my dream world nominal income targeting–over the past year or so. Maybe others would have joined in and forced Bernanke and the Fed to think more about this option. Krugman admitted recently it would have been the first-best economic solution to the current crisis, but avoided doing so because he thought it would be a second-best political solution. (He thought expansionary fiscal policy would be more politically feasible.) Even if Krugman and other observers have been pushing the unconventional monetary policy message more forcefully over the past year, it is still not clear the Fed would have responded. David Wessel in his new book reports that Bernanke came into the Fed wanting to target inflation. He faced, however, strong opposition and (unlike his predecessor) wanted to be a consensus builder at the Fed. He did not want to force his hand on the FOMC.

Update: Scott Sumner, Brad DeLong, Free Exchange, and Will Wilkinson comment on Bernanke’s response.

(1) By 2003 economic conditions did not justify the low-interest rate policy. Aggregate demand (AD) growth was robust, productivity growth was accelerating, and the ouput gap was near zero by mid 2003. The following figure shows the robust AD growth rate–measured by final sales of domestic product–and how the federal funds rate markedly diverged from it in 2003 and 2004 (marked off by the lines):

Note this rapid growth in AD indicates there was no threat of a deflationary collapse. Then what about the low inflation? That came from the robust productivity gains, not weak AD growth. The following figures shows the year-on-year growth rate of quarterly total factor productivity (TFP) for the United States. The data comes John Fernald of the San Francisco Fed:

This figure shows the TFP growth rate did slow town temporarily in 2001 but resumed and even picked up its torrent pace for several years. It is also worth pointing out that this surge in productivity growth was both widely known and expected to persist. Productivity gains, then, were the reason for the lower actual and expected inflation. [It is also worth noting that productivity growth typically means a higher real interest rate which serves to offset the downward pull of the expected inflation component on the nominal interest rate. In other words, deflationary pressures associated with rapid productivity gains do not necessarily lead to the zero lower bond problem for the policy interest rate (Bordo and Filardo, 2004).] The big policy mistake here, then, is that the Fed saw deflationary pressures and thought weak aggregate demand when, in fact, the deflationary pressures were being driven by positive aggregate supply shocks. The output gap as measured by Laubach and Williams also shows a near zero value in 2003 that later becomes a large positive value. As Bernanke notes, though, there was a jobless recovery up through the middle of 2003. This can, however, be traced in part to the rapid productivity gains. The rapid productivity gains created structural unemployment that took time to sort out, something low interest rates would not fix. In short, it is hard to argue economic conditions justified the low interest rate by 2003.

(2) A forward looking Taylor Rule does not close the case that the stance of monetary policy during 2003-2005 was appropriate. Bernanke cleverly constructs an “improved” Taylor rule that has a forward looking inflation component to it and finds monetary policy was actually appropriate during this time. Now a forward looking rule does make sense but invoking it now appears as an exercise in ex-post data mining to justify past policy choices. Regardless of this Taylor Rule’s merits, there is still reason to believe Fed policy was too accommodative during this time. As mentioned above, productivity growth accelerated and it is a key determinant of the natural or equilibrium real interest rate. Typically, higher productivity growth means a higher equilibrium real interest rate. The Fed however, was pushing real short-term interest rates down–a sure recipe for some economic imbalance to develop. Below is a figure that highlights this development. It shows the difference between the year-on-year growth rate of labor productivity and the ex-post real federal funds rate with a black line. A large positive gap–i.e. productivity growth greatly exceeds the real interest rate–emerges during the 2003-2005 period. This gap is also seen using the difference between an estimated natural real interest rate (from Fed economists John C. Williams and Thomas Laubach) and an estimated ex-ante real federal funds rate (constructed using the inflation forecasts from the Philadelphia Fed’s Survey of Professional Forecasters):

This figure indicates the real federal funds rate was far below the neutral interest rate level during this time. These ECB economists agree. Further evidence that Fed policy was not neutral can be found in the work of Tobias Adrian and Hyun Song Shin who show that via the “risk-taking” channel the Fed’s low interest rate help caused the balance sheets of financial institutions to explode.

(3) There is evidence (not mentioned by Bernanke) that points to a link between the Fed’s low interest rate policy and the housing boom. For starters, here is a figure from a paper that I am working on with George Selgin. It shows the gap discussed above between TFP growth and the real federal funds rate and the growth rate of housing starts 3 quarters later:

Also, below is a figure plotting he federal funds rate against the effective interest rates on adjustable rate mortgages, an important mortgage during the housing boom:

They track each other very closely. Bernanke, however, argues it was not so much the interest rates as it was the types of mortgages available that fueled the housing boom. My reply to this response is why then were these creative mortgages made so readily available in the first place? Could it be that investors were more willing to finance such exotic mortgages in part because of the “search for yield” created by the Fed’s low interest policy?

(4) While there is some truth to saving glut view, the Fed itself is a monetary superpower and capable of influencing global monetary conditions and to some extent the global saving glut itself. As I have said before on this issue:

The Fed is a global monetary hegemon. It holds the world’s main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed’s monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

With that background I turn to Guillermo Calvo who argues the build up of foreign exchange by emerging markets for self insurance purposes–a key piece to the saving glut story–only makes sense through 2002. After that it is loose U.S. monetary policy (in conjunction with lax financial regulation) that fueled the global liquidity glut and other economic imbalances that lead to the current crisis:

A starting point is that the 1997/8 Asian/Russian crises showed emerging economies the advantage of holding a large stock of international reserves to protect their domestic financial system without IMF cooperation. This self-insurance motive is supported by recent empirical research, though starting in 2002 emerging economies’ reserve accumulation appears to be triggered by other factors.² I suspect that a prominent factor was fear of currency appreciation due to: (a) the Fed’s easy-money policy following the dot-com crisis, and (b) the sense that the self-insurance motive had run its course, which could result in a major dollar devaluation vis-à-vis emerging economies’ currencies.

Calvo’s cutoff date of 2002 makes a lot sense. By 2003 U.S. domestic demand was soaring and absorbing more output than was being produced in the United States. This excess domestic demand was fueled by U.S. monetary (and fiscal) policy and was more the cause rather than the consequence of the funding coming from Asia.

Conclusion: Bernanke fails to make a KO of Fed critics with this speech.

Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure risk.

Tobias Adrian and Hyun Song Shin also explore this channel in their paper:

We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the “risk-taking channel” of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. We find short-term interest rates to be important in influencing the size of financial intermediary balance sheets.

Both papers above empirically show the low federal funds rates were very important to the excessive leverage and big bets made by financial institutions during this time. Barry Ritholtz provides a nice summary of this channel in a recent post:

What Bernanake seems to be overlooking in his exoneration of ultra-low rates was the impact they had on the world’s Bond managers — especially pension funds, large trusts and foundations. Subsequently, there was an enormous cascading effect of 1% Fed Funds rate on the demand for higher yielding instruments, like securitized mortgages…

An honest assessment of the crisis’ causation (and timeline) would look something like the following:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.

5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.

6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.

7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;

8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.

9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.

10. Once home prices began to fall, all of the above fell apart.

[...]

Inadequate regulations and “nonfeasance” in enforcing existing regs were, as Chairman Bernanke asserts, a major factor. But in the crisis timeline, the regulatory and supervisory failures came about AFTER the 1% Fed rates had set off a mad scramble for yields. Had rates stayed within historical norms, the demand for higher yielding products would not have existed — at least not nearly as massively as it did with 1% rates.

Now Ritholtz acknowledges there were many factors at work during this boom. However, he makes the point, and I agree, that we have failed to learn a key lessons from this crisis if we move forward with the view that the low interest rates were of no consequence during the housing boom.

Jan. 5 (Bloomberg) — John Taylor, creator of the so-called Taylor Rule for guiding monetary policy, disputed Federal Reserve Chairman Ben S. Bernanke’s argument that low interest rates didn’t cause the U.S. housing bubble.

“The evidence is overwhelming that those low interest rates were not only unusually low but they logically were a factor in the housing boom and therefore ultimately the bust,” Taylor, a Stanford University economist, said in an interview today in Atlanta.

Taylor, a former Treasury undersecretary, was responding to a speech by Bernanke two days ago, when he said the Fed’s monetary policy after the 2001 recession “appears to have been reasonably appropriate” and that better regulation would have been more effective than higher rates in curbing the boom.

[...]

“It had an effect on the housing boom and increased a lot of risk taking,” said Taylor, 63, who was attending the American Economic Association’s annual meeting.

Taylor echoed criticism of scholars including Dean Baker, co-director of the Center for Economic and Policy Research in Washington, who say the Fed helped inflate U.S. housing prices by keeping rates too low for too long. The collapse in housing prices led to the worst recession since the Great Depression and the loss of more than 7 million U.S. jobs.

[...]

“Low rates certainly contributed to the crisis,” Baker said in an interview on Jan. 3. “I don’t know how he can deny culpability. You brought the economy to the brink of a Great Depression.”

Nice to hear from Dean Baker too. Read the rest of the article here

I have this terrible fear that once I graduate from college, I will not remember all of the wonderful things I have learned. I went through Econ withdrawal during our one month winter-session, so I can’t imagine how I will feel once I graduate.

Therefore, I have decided to keep this blog to remind myself of the interesting things that I learn from the people of Pendleton 4th. (Econ dept) I think Econ is fun in itself, but sometimes I try to make it more fun by making weird analogies…maybe you will think it’s fun too. Maybe you’ll even learn something from me. That’s a rare occurrence. I feel like I’m always the one doing all the learning.

Anyway, I’ll probably post random events in life as well so as to make my blog not too nerdy…

Behind his white beard, Federal Reserve chairman Ben Bernanke has a wry sense of humour. On reading his recent speech to the American Economic Association, in which he defended the Fed’s actions during the housing bubble, I initially suspected it was a practical joke. Rather than conceding that he and his predecessor, Alan Greenspan, made a hash of things between 2002 and 2006, keeping interest rates too low for too long, he said the Fed’s policies were reasonable and the main cause of the rise in house prices was not cheap money but lax supervision.

Searching in vain for a punch line, I was reminded of Talleyrand’s quip about the restored Bourbon monarchs: “They have learned nothing and forgotten nothing.” Mr Bernanke is far smarter than Louis XVIII and Charles X, two notorious boneheads, and has done a good job of firefighting. But his unwillingness to admit the Fed’s role in inflating the housing and broader credit bubble raises serious questions about his judgment.

The individual elements of his presentation were questionable enough… but most disturbing was its failure to address the larger picture: from the mid-1990s, the Fed adopted a stance that encouraged irresponsible risk-taking. In periods of growth, it raised interest rates slowly, if at all, stubbornly refusing to acknowledge the course of asset prices. But when a recession or financial blow-up beckoned, it slashed rates and acted as a lender of last resort.

On Wall Street, this asymmetric approach came to be known as “the Greenspan put”. It gave financial institutions the confidence to raise their speculative bets, using borrowed cash to do it. None of the Fed’s actions since then have addressed this central issue of moral hazard. Indeed, the problem may have become worse. For all the damage that the financial industry has inflicted on itself, when disaster arrived the Greenspan/Bernanke put did pay off. By slashing the funds rate and providing emergency credit facilities to stricken financial firms, the Fed further entrenched the perception that its ultimate role is to provide a safety net for Wall Street.

Unlike his predecessor, Mr Bernanke recognises the problem of excessive speculation and the massive externalities its sudden reversal can impose. In that sense, intellectual progress has been made. But he and his deputy, Donald Kohn, still refuse to acknowledge the Fed’s role in motivating reckless behaviour…

This is not entirely true, at least for Donald Kohn. In a November 2007 speech Kohn hints at this possibility via a comment on the Fed’s role in creating the Great Moderation:

The victim of my own success tone is slightly annoying here, but at least Kohn alludes to some of the concerns associated with the Greenspan put. Still, Cassidy’s bigger point holds: the Fed has yet to fully account for its role in causing investors to underestimate aggregate risk and, as a result, make decisions that contributed to the financial crisis on 2008-2009.

I was trying to tell one of Parag’s friends about how raising taxes is like gaining weight, but completely butchered it. Now that I’m sober, I can explain:
Raising taxes is like gaining weight b/c:
When you raise taxes, disposable income decreases. Therefore, consumption decreases. When you gain weight, you’re like “shit, I need to stop eating.” Consumption decreases.
However, when you raise taxes, national savings increases. Interest rates fall, and consumption is also sensitive to interest rates. Low interest rates mean people will be less compelled to save [b/c return on their money is smaller] and consumption may increase. The degree to which consumption goes up depends on the elasticity of consumption with respect to interest rates. When you’re fatter, you have to eat more to sustain yourself. How much more you have to eat to sustain your bigger self is like elasticity of consumption with respect to interest rates. Consumption may increase.
Lower interest rates also tend to increase investment [businesses borrow more to invest b/c rates are low]. When you’re fatter, you need to invest in a new wardrobe b/c all your old clothes don’t fit anymore.

Edit: Someone read this and pointed out that an important assumption is that G remains constant. He’s possibly nerdier than I am. Loves it.

On to more relevant things:
Keynes has been brought up a lot since Obama’s inauguration.
Fun facts (You know that feeling ppl get when they read trashy magazines? This is like celebrity gossip to me): Keynes was really dirty [like, mind in the gutter all the time], he was gay for a while, but then got married to a woman and stayed faithful to her for the rest of his life, he was really elitist and only respected men from Cambridge [sometimes he made exceptions for Oxford men], he believed that America should be run by a group of guys from Cambridge b/c he didn’t think anyone in America was smart enough to run the country.

Ideology: The General Theory of Employment, Interest and Money.
People keep saying that Keynes believed that the gov’t could spend its way out of recession. But that’s not really true. Keynes just pointed out that you get the full multiplier effect [either (1/1-b)(delta G) or (b/1-b)(delta T)] when investment is inelastic and liquidity preferences are absolute. Someone on NPR called it “kindergarten keynesianism.” I thought that was cute.

So I guess people think investment is inelastic and liquidity preferences are absolute. Nobody’s really investing, and the Fed has been pumping so much liquidity into the system that the term “liquidity crisis” has been abandoned. There’s liquidity, it’s just not making its way into the real economy.

I think the most convincing piece of evidence that Keynes was right is FDR’s spending during the Great Depression. But was it Keynesian spending that did the trick? Were we even “saved” from the Great Depression b/c of it? Tyler Cowen [Marginal Revolution] points out that the numbers may look good, but we have to wonder why they look so good.

For example, a higher GDP looks good. But what if it just reflects how much money the gov’t spent on war materials? [WWII]
Unemployment went down, but that’s b/c people were fighting and dying instead of being unemployed in the labor force.

Martin Feldstein thinks the Stimulus Plan could be bad news bears. [inflation will kick in as soon as the real economy gets moving again and we don't want to be like Zimbabwe. They just took 12 zeros off their currency. They have an inflation rate of 231,000,000%!]

This is Greg Mankiw’s preferred plan.

I’m having a hard time finding economists who are in favor of the Stimulus Plan in its current form…
Anyone?

There are Keynesian economists to be sure, but they seem to have their doubts. [NPR's Economy podcast from 2.6.09 features a few]

The end!
[I need to recover from last night]

Edit: someone just asked me what elasticity and liquidity were.
Elasticity: If your demand for something is very elastic, you will substitute that good for something else when the price goes up even a little bit. Like, my demand for pocky sticks is elastic.
If you have very INelastic demand for something, then you demand it regardless of increasing prices…like my demand for Apple products.
So if there are more substitutes for a good, your demand for that good tends to be more elastic.

Liquidity, or at least the way I used it in this blog entry, is just money. Usually, it’s how easily an asset can be converted into money. So an illiquid asset would be like, a painting.

Anyway, before I came to college, I remember feeling sorry for my dad whenever his beeper would go off in the middle of the night. (He’s an anesthesiologist) I haven’t had that feeling in a while b/c I’ve been away from home, but immediately after his b’day dinner two weeks ago, his beeper made that stupid broken up G flat chord noise and I felt so bad for him. I had always thought my dad’s life sucked, so when he was diagnosed with cancer 6 years ago, I wasn’t all that surprised when he said he just wanted to die. However, he seems to have beaten some very impressive statistics.

For example, the probability of an individual staying at work after being affected by a major disease is -0.06 during the first two years of the disease’s onset, and has a t-stat of 2.24. The probability of that individual staying at work the following two years is -0.16 with a t-stat of 7.67! Not gonna lie. I’m pretty impressed by my dad.

Thus, as I look for jobs, I am resigned to thinking that maybe I will have to get someone coffee everyday. Maybe I won’t get paid as much as I feel I deserve. But if my dad could do med school twice (once in S.Korea and once in the States) and has continued to stick to this job that he hates, then I can suck it up and deal with picking up phones for a year or two. Besides, beggars can’t be choosers. Unemployment hit 7.6% (its highest in 16 years).

Firstly, not everyone who makes a shit ton of money is corrupt/doesn’t deserve it. Income inequality is sad, but is it unfair?

In “The Conscience of a Liberal,” Paul Krugman argues that poor institutions are to blame and that “movement conservatism” has been contributing to income inequality. He gives the “Great Compression” as an example of how great institutions can make this world a happier, more equal place. Now, Paul Krugman is a Nobel Laureate, and I’m a half-person who only started taking Econ classes 2 years ago, so don’t eat up everything I say here, Jess. Haha. But here’s my response to Paul Krugman’s view:

Although the “Great Compression” of World War II is largely attributed to such institutional changes as the creation of the NWLB, NIRA, a redistributive tax code, and the introduction of health care benefits, one can not argue that the inverse is also necessarily true.
The equality that is characteristic of the “Great Compression” can also be explained by simple supply and demand for unskilled vs. skilled workers.
During World War II, the composition of labor markets changed drastically as the relative demand for unskilled labor increased and the supply decreased. The egalitarian structure of society was retained even after the institutions of World War II were dissolved b/c although the relative demand for skilled labor increased after the war, the relative supply increased at a faster rate [Piketty, Thomas, and Emmanuel Saez. "Income Inequality in the United States, 1913-1998." Quarterly Journal of Economics CXVIII (2003): 1-37.]

Currently, DEMAND for skilled labor outpaces supply. The wages of American educated workers are some of the highest in the world as a result of increasing demand and increasing scarcity value. The richest 1 percent of wage earners received 80% of all income gains from 1980 to 2005 [Piketty-Saez]. The gap between the median earnings of men with B.A. degrees and that of all full-time male workers has also increased from 14% in 1967 to 120% in 2005 [Levy, Frank, and Peter Temin. "Inequality and Institutions in 20th Century America." National Bureau of Economic Research: 1-42.]

Globalization has also increased the elasticity of demand for low-skilled workers as firms gain access to foreign labor markets, thus decreasing the comparative viability of the domestic low-skilled labor force. And since labor is not subject to arbitrage to the extent that tradable goods are, institutions that skew the price mechanism [minimum wage laws] further exacerbate the loss of income accruing to low-skilled labor. Although minimum wage is meant to protect the lower income brackets, it actually creates excess supply of low-skilled workers in the domestic market and pushes firms to take advantage of cheaper low-skilled labor abroad. In 1974, a 25% increase in the minimum wage, from $1.60 to $2.00 was correlated with an increase in the unemployment rate in the U.S. from roughly 5.0% to 7.2% ["Why the Minimum Wage Law Causes Unemployment." NCPA. National Center for Policy Analysis. 18 Sept. 2008 ]
Edit: Larry Summers also finds that wages above market rate increase rigidity in the labor market/may increase long term unemployment.

Also, rent-seeking behavior is railed upon when observed in developing countries with corrupt gov’ts, etc. But how is the auto industry in the U.S. any different?
Subsidies and bailouts which also work contrary to market mechanisms, increase the opportunity cost of propping up U.S. industries that have become increasingly non-competitive at the global level. For example, in 1979, Chrysler faced financial difficulty as oil prices rose making its fuel inefficient vehicles unappealing to consumers. Congress and the Carter administration granted Chrysler an unprecedented subsidized loan which saved Chrysler; it has since been described as a case of moral hazard in which risky behavior can be defined as the absence of innovation. Furthermore, such subsidies and bailouts provide temporary solutions to the sectoral shifts that the economy must eventually address. As global markets lower the value of non-competitive U.S. sectors such as manufacturing, income inequality can only increase as wages in those sectors decrease. Innovation is the only way by which such “dying” sectors, which witness decreased productivity in the U.S., can achieve sustainability. [see Schumpeter for further inspiration] Since real wages reflect productivity, by addressing sectoral shifts in the economy we are pursuing policies that would mitigate income inequality.

Increased re-education and training programs for displaced workers as well as improvements in the education system for the future labor force will allow workers to take advantage of the sectoral shift as opposed to resorting to protectionist policies. During this transition, measures to decrease income inequality include less xenophobic views on imported skills and more means tested policies, such as the EITC that do not skew price mechanisms. Policies that take advantage of changing markets will allow the U.S. to continue to be viable in a global economy.
[Read "The Age of Turbulence" by Alan Greenspan for more on skill biased technological change. He's a great writer. It's a great book. He's so cute. When he first started working in D.C. he would go back to NYC on weekends to water his plants AND visit his mom. WHO does that?! ALAN GREENSPAN.]

So I think “Buy American” sucks and just keeps us from eating yummy Roquefort cheese, and I think rent-seeking industries should just get their shit together and step up.

I’m not saying I support inequality, and that I want some people to be way poorer than others. The purpose of this post was to get you to think about why inequality upsets you. Maybe the reasons will be a little different than what you thought before you read this post.

Special thanks to Chanda for contributing to research/creation of this blogpost. So, if you were bored, you can blame her. Haha. Just kidding.

Of course Alan Greenspan is on the list, as are former Presidents Clinton and W. Bush. Phil Gramm took first place.

Bush is often credited with having shred the regulatory system. During the first presidential debate, Obama said: “The Bush administration has shred the regulatory system.” “Senator McCain thinks that regulation is always bad.”

But does Bush really deserve that much credit?

Although Obama sought to connect the current financial downturns to McCain and the Republicans’ aversion to regulations with respect to the private sector, there is much evidence to suggest that the regulatory system has been railed against since the 1980s.

In response to the collapse of banks during the Great Depression, Congress passed the Glass-Steagall Act in order to separate the activities of investment and commercial banks. However, as international markets grew, Glass-Steagall became increasingly burdensome as it precluded companies from acquiring both the skills of investment banks and the capital of commercial banks. Under the Clinton administration, the Gramm-Leach-Blilely Act of 1999 was passed, repealing the Glass-Steagall restrictions and amending the Bank Holding Company Act [allowing inter-state mergers]. These, as well as the Commodity Futures Modernization Act [which allowed single-stock futures], allowed for banks to acquire significantly larger amounts of capital that could then be invested in mortgages. However, Gramm-Leach-Bilely had little effect on firms such as Bear Stearns and Lehman Brothers which continued to function solely as investment banks. The fact that they were the first to collapse suggests that the financial sector has been affected by factors other than the regulatory system, or lack thereof.

Furthermore, when capital income on corporate debt is taxed once while equity returns are taxed twice, firms are more likely to take advantage of this asymmetry by issuing more debt than they normally would. These highly leveraged firms, and their inability to “self-regulate,” made the financial sector more fragile and more vulnerable to falling asset prices. Eliot Spitzer observes: “The reality is that unregulated competition drives corporate behavior and risk-taking to unacceptable levels. This is simply one of the ways in which some market participants try to gain a competitive advantage. As one lawyer for a company charged with malfeasance stated in a meeting in my office (amazingly, this was intended as a winning defense): “You’re right about our behavior, but we’re not as bad as our competitors.” [also, does the last paragraph of the Eliot Spitzer article not make you really sad? it makes me really sad...]

However, more regulation has not necessarily proven beneficial to the financial system as Obama might suggest. Contrary to Obama’s claim that the Bush administration shred the regulatory system, the Bush administration was responsible for the Sarbanes-Oxley Act of 2002 which includes the much abhorred Section 404. This law requires companies and their auditors to assess the companies internal controls, and although the costs of abiding by this law have been high, the benefits are not easily measurable. As a result, foreign firms withdrew from American markets; the number of the top twenty public offerings in the U.S. dropped from eight to one between 1996 and 2006. Furthermore, although Sarbanes-Oxley attempts to eliminate a certain degree of risk, the decline in short term equity premiums might have induced firms to seek higher returns in riskier investments. Mortgage-backed securities may have been further proliferated by firms seeking to hold their advantage under SOX which already caused U.S. firms to realize a lower rate of return than foreign firms.

So was it all Clinton and Gramm’s fault?

De-regulation under Gramm-Leach-Bliley may have allowed for such “sophisticated” and risky products to be created. However, as previously mentioned, the first banks to fall, Bear Stearns and Lehman, were little affected by GLB. Furthermore, as Bernanke stated the other day, such processes as securitization provide about half of the liquidity in our financial system.
Also, I would just like to point out that the President does not have control over the federal funds rate. The Fed is independent. As Professor Johnson tells us, when you say your prayers at night, give thanks for the independence of the Fed.

So maybe it was all Alan Greenspan’s fault for keeping interest rates so low for so long?

Greenspan set the fed funds rate so low in order to avoid a “lost decade” similar to that of Japan in the ’90s. Or similar to the Great Deflation [1870s-1890s] in the U.S.

Deflation:
“Too little money chasing too many goods.”
Deflation is when you can get more goods per dollar than before. [opposite of inflation]
So during deflationary periods, debtors are hurt and creditors are helped. Debtors are repaying loans in deflated dollars [dollars that are now worth more]. Creditors are being repaid in dollars that are worth more. Debtors tend to already be poorer than creditors, so the poorer are screwed even more.
The wealthy also tend to have smaller propensities to consume [they're more likely to save than those who are poor. b/c if you're poor, you're living hand to mouth, spending whatever you earn on necessities.] Ceteris paribus, [all else constant], this would lead Y to [output, or aggregate GDP] to fall.
Japan addressed its “lost decade” with inflation targeting.

Ben Bernanke is really hoping for some inflation right now. Something like Dorothy’s silver slippers…

Random thoughts
So my mom left for the Dominican Republic with her friends on Monday and it was her first trip without the fams and with a U.S. passport. Needless to say, she was really excited. I travel a lot more than my parents do – in planes, in cars. And my mom always tells me to call when I reach my destination. Usually I’m pretty good about remembering, but sometimes I forget and my mom will call me to yell at me. Then I get annoyed and say, “well, of COURSE I’m safe. What do you think happened, my plane crashed? Jeez.” But the night before my mom left, I pretty much prayed my ass off [which means a lot coming from me b/c I'm not one of those ppl who believes prayer is a legit method of birth control or anything] and I couldn’t fall asleep because I was so worried. And then I thought, it must be SO much worse for my mom when I travel, because I’m sure she loves me more than I love her. And I thought, OMG. I am NEVER forgetting to call my mom EVER again. So kids, call your parents when you get to your destinations. It takes 2 seconds.

The end.

Edit: Professor Johnson just assigned this reading for this week’s p-set!
This sentence makes me sad: “[Fisher] was prominent among the 1,028 economists who in vain petitioned Herbert Hoover to veto the infamous Smoot-Hawley tariff of 1930.”

Hindsight is 20/20.