Japan in the US? Seven Faces of “The Peril”

The latest via the St.Louis Fed

Abstract (Via James Bullard)

In this paper the author discusses the possibility that the U.S. economy may become enmeshed in a Japanese-style deflationary outcome within the next several years. To frame the discussion, the author relies on an analysis that emphasizes two possible long-run steady states for the economy: one that is consistent with monetary policy as it has typically been implemented in the United States in recent years and one that is consistent with the low nominal interest rate, deflationary regime observed in Japan during the same period. The data considered seem to be quite consistent with the two steady-state possibilities. The author describes and critiques seven stories that are told in monetary policy circles regarding this analysis and emphasizes two main conclusions: (i) The Federal Open Market Committee’s “extended period” language may be increasing the probability of a Japanese-style outcome for the United States and (ii), on balance, the U.S. quantitative easing program offers the best tool to avoid such an outcome.

Additional Excerpts (Via James Bullard):

Seven Faces Of Peril

1. Denial

I think it is fair to say that, for many who have been involved in central banking over the past two or three decades, it is difficult to think of Japan and the United States in the same game, as Figure 1 suggests. For many, the situation in Japan since the 1990s has been a curiosum, an odd outcome that might be chalked up to particularly Byzantine Japanese politics, the lack of an inflation target for the Bank of Japan (BOJ), a certain lack of political independence for the BOJ, or some other factor specific to the Land of the Rising Sun. The idea that U.S. policymakers should worry about the nonlinearity of the Taylor-type rule and its implications is sometimes viewed as an amusing bit of theory without real ramifications.

2. Stability

There is another version of the denial view that is somewhat less extreme but nevertheless still a form of denial in the end. It is a view that I have been associated with in my own research. In this view, one accepts the zero bound on nominal interest rates and the other details of the analysis by Benhabib, Schmitt-Grohé, and Uribe. One accepts that there are two steady states. How – ever, the steady states have stability properties associated with them in a fully dynamic analysis, and the argument is that the targeted steady state is the stable one, while the unintended, low nominal interest rate steady state is unstable. Therefore, according to this argument, one should expect to observe the economy in the neighborhood of the targeted steady state and need not worry about the unintended, low nominal interest rate steady state.

3. The FOMC in 2003

In Figure 1, a set of data points is circled. These data are labeled “2003-2004” and are associated with a policy rate at 1.0 percent and the inflation rate between 1.0 and 1.5 percent. This episode was the last time the FOMC worried about a possible bout of deflation. While core inflation did move to a low level during this period—not quite as low as the current level—inflation moved higher later and interest rates were increased. This episode surely provides comfort for those who think the Japanese-style outcome is unlikely. It suggests that the economy will ultimately return to the neighborhood of the targeted steady state, perhaps even indicating that the stability story is the right one after all. The 2003 experience did not involve a near-zero policy rate, however.

4. Discontinuity

If the problem is the existence of a second, unintended steady state—and this is partly caused
by the choice of a policy rule that is controlled by policymakers—why not just choose a different policy rule? This can, in fact, be done and was discussed by Benhabib, Schmitt-Grohé, and Uribe in their original paper. Furthermore, some parts of the current policy discussion have exactly this flavor.

….Of course, this policy looks unusual and perhaps few would advocate it, but again we are trying to avoid all those circles down there in the southwest portion of the diagram. The discontinuouspolicy has the great advantage that it is a very simple way to ensure that the unintended, low nominal interest rate steady state no longer exists. The only point in the diagram where the Fisher relation and the policy rule can be in harmony is the targeted equilibrium. This would remove the unintended steady state as a focal point for the economy.

5. Traditional Policy

According to the Bank of England,15 for 314 years the policy rate was never allowed to fall below 2.0 percent. During more than three centuries the economy was subject to large shocks, wars, financial crises, and the Great Depression— yet 2.0 percent was the policy rate floor until very recently. A version of this policy is displayed in Figure 5. This policy rule does not eliminate the unintended steady state; it simply moves it to be associated with a higher level of inflation. In the figure, this point occurs at an interest rate of 2.0 percent and an inflation rate of 1.5 percent (the center arrow in the figure). This policy seems very reasonable in some ways. To the extent that one of the main purposes of the interest rate policy is to keep inflation low and stable, this policy creates two steady states, but the policymaker may be more or less indifferent between the two outcomes. Then one has to worry much less about the possibility of becoming permanently trapped in an unintended, deflationary steady state. This policy prevents the onset of interest rates that are “too low.”

6. Fiscal Intervention Given the Situation in Europe
In the academic literature following the 2001 publication of the perils paper, some attempt was made to provide policy advice on how to avoid the unintended steady state of Figure 1.17 This advice was given in the context of trying to preserve the desirable qualities of the Taylor-type interest rate rule in the neighborhood of the targeted steady state. That is, even though interest rate rules are the problem here, the advice is given in the context of those rules—as opposed to simply abandoning them altogether.

7. Quantitative Easing

The quantitative easing policy undertaken by the FOMC in 2009 has generally been regarded as successful in the sense that longer-term interest rates fell following the announcement and implementation of the program.20 Similar assessments apply to the Bank of England’s quantitative easing policy. For the United Kingdom in particular, both expected inflation and actual inflation have remained higher to date, and for that reason the United Kingdom seems less threatened by a deflationary trap. The U.K. quantitative easing program has a more state-contingent character for rates to bottom out at a level somewhat higher than zero, as the traditional policy rule does. Of course, a policy rule like the one depicted in Figure 5 does not allow as much policy accommodation in the face of shocks to the economy at the margin. But is it worth risking a “lost decade” to get the extra bit of accommodation?

Click Here To Read: Japan in the US? Seven Faces of “The Peril”

Disclosure, Trust and Persuasion in Insurance Markets

Abstract (via David de Meza, Bernd Irlenbusch, Diane Reyniers @ IZA)

This high-stakes experiment investigates the effect on buyers of mandatory disclosures concerning an insurance policy’s value for money (the claims ratio) and the seller’s commission. These information disclosures have virtually no effect despite most buyers claiming to value such information. Instead, our data reveal that whether the subject is generally trusting plays an important role. Trust is clearly associated with greater willingness to pay for insurance. Unlike in previous work, trust in our setting is not about obligations being fulfilled. The contract is complete, simple and the possibility of breach is negligible. However, as for much B2C insurance marketing, face-to-face selling plays a crucial role in our experimental design. Trusting buyers are more suggestible, so take advice more readily and buy more insurance, although they are no more risk averse than the uninsured. Moreover, trusting buyers feel less pressured by sellers, and are more confident in their decisions which suggests that they are easier to persuade. Therefore, in markets where persuasion is important, public policy designed to increase consumer information is likely to be ineffective.

Favorite Bit

In our experiment, seller persuasion, not just intrinsic risk preference, is a major influence on insurance decisions. Whether an individual is insured depends on which seller they are matched with. Some sellers are particularly effective and trusting buyers are especially susceptible to seller influence.

Click Here To Read: Disclosure, Trust and Persuasion in Insurance Markets

Is it worth it: Does corruption influence firm productivity?

Synopsis Via Donato de Rosa Nishaal Gooroochurn Holger Gorg @ Voxeu

Does it pay to be corrupt? This column presents evidence from 22 emerging economies in Europe and the former Soviet Union on the effects of corruption on firm productivity. It finds that in a highly corrupt country, bribing officials actually has a negative effect on productivity, whereas in countries with strong institutions, it can open doors that competitors dare not touch.

Excerpt- Conclusion

So does this analysis draw the conclusion that corruption is profitable for some countries? No! Definitely not. Our analysis only focuses on the short-term microeconomic scales for firms that paid grease money. Long-term effects and general equilibrium effects are not assessed. So, for example, it is possible that corrupt practices prevent resources and skills to be used in an optimal macroeconomic sense. Thus the macroeconomic entrepreneurial activity of a country suffers. The macroeconomic costs of corruption can thus be substantial, as shown in Dreher and Schneider (2010), for example. The importance of country effects for microeconomic performance also suggests that piecemeal anti-corruption measures may be ineffective in the absence of a comprehensive approach to reforming state institutions.

Click Here To Read: Is it worth it: Does corruption influence firm productivity?

Video: Joseph Stiglitz on Free Markets and the World Economy

Introduction (via Fora.Tv)

Visiting Nobel Laureate and global economist Professor Joseph Stiglitz believes Australia’s good fortune in being sheltered from the worst of the GFC means we may not fully comprehend its impact internationally.

On his tour of Australia, he comments on the state of the Australian economy, particularly in context of the Global Financial Crisis, the role of natural resources within this economy, and Australia’s response to global warming.

Professor Stiglitz travelled all over Australia for three weeks as the inaugural speaker for the Eminent Speaker Series, hosted by the Economic Society of Australia. The series has been initiated to provide an opportunity for industry professionals, government representatives and academics to hear from the world’s leading economists in an open forum.

Click Here To Watch The Video: Joseph Stiglitz on Free Markets & The World Economy

Carmen M. Reinhart & Kenneth Rogoff’s Latest: Debt and growth revisited

This is why I love Voxeu…

Synopsis (via Voxeu)

With the advanced economies at a critical juncture, some economists are urging more fiscal stimulus while others argue that raising debt levels will stunt growth. This column presents the Reinhart-Rogoff findings on the relationship between debt and growth based on data from 44 countries over 200 years with a focus on the debt-growth link during high-debt episodes.

Excerpted Conclusion (via Voxeu)

One need look no further than the stubbornly high unemployment rates in the US and other advanced economies to be convinced how important it is to develop a better understanding of the growth prospects for the decade ahead. We have presented evidence – in a multi-country sample spanning about two centuries – suggesting that high levels of debt dampen growth. One can argue that the US can tolerate higher levels of debt than other countries without having its solvency called into question. That is probably so.¹⁰ (see Reinhart and Reinhart 2007). We have shown in our earlier work that a country’s credit history plays a prominent role in determining what levels of debt it can sustain without landing on a sovereign debt crisis. More to the point of this paper, however, we have no comparable evidence yet to suggest that the consequences of higher debt levels for growth will be different for the US than for other advanced economies. It is an issue yet to be explored.

Click Here To Read: Carmen M. Reinhart  & Kenneth Rogoff’s Latest: Debt and growth revisited

Video: Ted Talk – A monkey economy as irrational as ours

About this talk (Via Ted)

Laurie Santos looks for the roots of human irrationality by watching the way our primate relatives make decisions. A clever series of experiments in “monkeynomics” shows that some of the silly choices we make, monkeys make too.

About Laurie Santos  (via Ted)

Laurie Santos studies primate psychology and monkeynomics — testing problems in human psychology on primates, who (not so surprisingly) have many of the same predictable irrationalities we do.

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Restraints On Capital Flows: What Are They?

This might help international investors & fellow economics aficionados…

Abstract (Via RAMKISHEN RAJAN)

Though there has been much general debate recently about the pros and cons of capital controls, there remains substantial confusion and uncertainty about what exactly is entailed by the term ‘restraining global capital flows’. Popular discussion around this has typically been long on rhetoric and loose generalisations and acutely short on specifics. The aim of this paper is therefore to help refine the debate somewhat by clarifying and systematically categorising the various concepts that have been discussed in policy circles and the popular media. Two specific country experiences with restraining capital flows, viz. Chile and Malaysia are highlighted and discussed, as are the recent and much publicised proposals for exchange controls (a la Paul Krugman) and a global currency transactions tax in the forms of a Tobin tax.

Click Here To Read: Restraints On Capital Flows: What Are They?

Gross domestic product and its components in recessions

Abstract (Via Steven Gjerstad, Vernon L. Smith)

The recent economic crisis – already deservedly labeled the ‘great recession’ – continues to plague the health of the economy as a whole and has motivated us to probe its characteristic features and compare it to the typical economic downturn. Events during the boom and crash have been sharply delineated, progressing from (1) an unprecedented housing price bubble from 1997 to 2006, (2) rapid house price decline beginning early in 2007, (3) freezing of credit markets in August 2007, (4) rapid declines in equities prices and economic output by the middle of 2008, and (5) deterioration of the financial system in 2008 and an aggressive and unprecedented Federal Reserve intervention in the fall of 2008. This sequence of events has provided a fresh perspective with which to examine past economic cycles, and, we believe, is likely to change how economists, policy makers, investors, and others think about monetary policy, housing cycles, and business cycles. We find that eleven of the most recent fourteen economic downturns in the U.S. – from the great depression that began in 1929 to the great recession starting in late 2007 – were led by declines in housing investment. In these eleven downturns, housing investment declined before any other major component of GDP and its total decline before and during the recession was larger in percentage terms than the decline in any other major sector. In the 1945 recession – one of the three recessions in which housing was not implicated – national defense expenditures fell while all major components of private expenditure rose. The other two – in 1937-38 and 2001 – resulted primarily from declines in non-residential fixed investment that preceded and exceeded declines in any other major component of GDP. Figure 1 shows the percentage of GDP contributed by housing expenditures over the past 81 years. Although housing is not a large component of GDP – which may explain its limited role in accounts of recessions – it is volatile, it has declined before almost every recession, it has rarely declined substantially without a recession following soon afterward, and the extent of its decline emerges as a good predictor of the depth and duration of the recession that follows.2 In addition to its role as a leading indicator, and its volatility over the business cycle, housing investment has recovered faster than any other sector of the economy in every recession since 1921, with the single exception of the 1980 recession, which lasted only 12 months.

Click Here To Read: Gross domestic product and its components in recessions

Envy and Loss Aversion in Tournaments

When ” envy and loss aversion do not play a role in decision making” …so ideal so improbable.

Abstract ( Eisenkopf & Teyssier)

In tournaments, the large variance in effort provision is incompatible with standard economic theory. In our experiment we test theoretical predictions about the role of envy and loss aversion in tournaments. Our results, confirm that envy implies higher effort while loss aversion increases the variance of effort. Moreover, we show that standard theory provides a good explanation for competitive behavior when envy and loss aversion do not play a role in the decision making process.

Click Here To Read: Envy and Loss Aversion in Tournaments

Reserves and other early warning indicators work in crisis after all!!

Synopsis (Jeffrey Frankel George Saravelos)

Can “early warning indicators” predict which countries are most vulnerable to a crisis? This column examines more than 80 contributions to the pre-2008 literature on crisis indicators. It finds that the level of central bank currency reserves can help identify economies worst affected by crises. Other useful early warning indicators include real effective exchange rate overvaluation, current accounts, and national savings.

Introduction  (Jeffrey Frankel George Saravelos)

With aftershocks of the recent global financial earthquake still being felt in some parts of the world, it would be useful to have a set of “early warning indicators” to tell us what countries are most vulnerable. Many scholarly papers in the past have been devoted to identifying leading indicators of crises (e.g. Rose and Spiegel 2009a).

The bar for finding good indicators has sometimes been set too high. Nobody should be surprised that it is not easy to forecast crises with high reliability; the efficient markets hypothesis – under assault as it is – still warns us not to expect easy, low-risk opportunities for profits. Thus it is especially hard to predict the timing of the crisis.

But to say that such indicators are not 100% accurate is not to say they are entirely useless, as some economists do. A common assessment is that such indicators have failed in the sense that in each historical round of emerging-market crises seems to turn on a different set of factors. One can find particular variables that appear statistically significant for each round crises – those of 1982, 1994-2001, and 2008 – but the same variables do not perform well in the subsequent round. This is not the right conclusion to draw.

Click Here To Read: Reserves and other early warning indicators work in crisis after all!!