Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts. [link]

For GMAN 312 students, we talked about the efficient markets hypothesis, and lo and behold, Krugman says something a lot similar to what we discussed in class:

The field was dominated by the “efficient-market hypothesis,” promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information. (The price of a company’s stock, for example, always accurately reflects the company’s value given the information available on the company’s earnings, its business prospects and so on.) And by the 1980s, finance economists, notably Michael Jensen of the Harvard Business School, were arguing that because financial markets always get prices right, the best thing corporate chieftains can do, not just for themselves but for the sake of the economy, is to maximize their stock prices. In other words, finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a “casino.” [link]

Furthermore, we’ll be looking at the CAPM next week. So it’s timely that Krugman mentions it in his article. (Recall all that I said in class last week about model abuse, the underlying assumptions and being very, very careful when using models to understand markets).

These events, however, which Keynes would have considered evidence of the unreliability of markets, did little to blunt the force of a beautiful idea. The theoretical model that finance economists developed by assuming that every investor rationally balances risk against reward — the so-called Capital Asset Pricing Model, or CAPM (pronounced cap-em) — is wonderfully elegant. And if you accept its premises it’s also extremely useful. CAPM not only tells you how to choose your portfolio — even more important from the financial industry’s point of view, it tells you how to put a price on financial derivatives, claims on claims. The elegance and apparent usefulness of the new theory led to a string of Nobel prizes for its creators, and many of the theory’s adepts also received more mundane rewards: Armed with their new models and formidable math skills — the more arcane uses of CAPM require physicist-level computations — mild-mannered business-school professors could and did become Wall Street rocket scientists, earning Wall Street paychecks. [link]

To see what “these events” are, you’re going to have to read the article. Enjoy.

The pros and cons of a weakening dollar were discussed in the following (July 3rd) Marketplace podcast:

U.S. exports are up and imports are down as a result of the dollar losing so much of its value against the euro. Who comes out ahead and who falls behind? Jeremy Hobson reports. [link]

Professor Robert Reich talked about a long-term stimulus package, as opposed to the current one in this (July 2nd) Marketplace podcast:

The economic stimulus was just a drop in the bucket. If Congress really wants to get the economy back on its feet, commentator Robert Reich has some summer homework for them. [link]

The Wall Street Journal has some numbers on monthly consumption, and consumer confidence, showing a slight increase in consumption (presumably from the stimulus package), but a sharp drop in consumer confidence:

Those charts, as well as several other economic indicators can be found on the Wall Street Journal‘s Economic Indicators page.

In class today, we talked about some of the non-mathematical problems with the Consumer Price Index – having more to do with the actual construction of the basket itself, rather than with the appropriate weights. Professor Menzie Chinn on the Econbrowser blog:

This post focuses on issue separate from the mathematics of the index forumulation, and has to do with what the typical weights at any given instant in time should pertain to. Should one use the expenditure weights that pertain to all the households aggregated in the economy? Or should one use the expenditure weights that pertain to the “typical” household?  [link]

And finally, we discussed a new post by Stefan Tangermann on the Vox blog, that attributes rises in food prices to policies directed towards biofuels, and not coming from speculation and increased demand:

New research shows that India, China, and speculators are not the culprits in the food price explosion. Biofuels were a significant element in the 2005-2007 food price surge as they accounted for 60% of the growth in global consumption of cereals and vegetable oils. …new research also shows that biofuel support policies are disappointingly ineffective on environmental grounds, [and] governments should reconsider them. [link]

…researchers looked at what happened in 20 antenatal clinics in western Kenya when some gave away insecticide-treated bednets, an anti-malaria therapy, and others sold them for different prices. Their conclusion was that free distribution is far more effective in getting people to use bednets than charging even a nominal sum would be. [link]

That argument for charging people for this is simply that if people pay for something they will value it more. Of course, nothing is as it seems, and it turns out that in the part of the country that they were given away people already owned millions of bednets, so the value was already known. Furthermore, most of the recipients were pregnant women – which is good – but if you want to eradicate malaria then you want them to be universally distributed. So we are back to Square One. The experiment worked in this part of the country, but is it worthwhile to distribute bednets across the nation? Unknown.

This is of course a problem of random selection. Listening to Terry Gross’ Fresh Air on NPR the other day, I heard an interview with Elizabeth Pisani, an epidemiologist who is battling AIDS across the world. She was telling the story of a survey done by her group in Southeast Asia, to find out the average number of clients that prostitutes got per week. They were surprised by how low the numbers were – something like three per day (if I remember correctly).

Speaking later with another prostitute, she found out that the women she interviewed were so-called “dogs”. The very fact that they were available to be interviewed by her team showed that they were not in high demand. This skewed the numbers downwards. When they randomized it a little more, by asking different women at different times and so forth, they got much higher numbers. Here’s the show, if you want to listen to more.

Perhaps if there is enough research done into a particular culture/country/region to ensure that the trials will be truly randomized then one might be able to claim that macroeconomists can also run experiments, just like microeconomists. Then again, who was it that said that all macro is micro, anyway?

Starbucks Coffee, one of the success stories of the booming economy and now global symbols of prosperity, is suffering. John Borden of Eyes Not Sold reports that over the last twelve months Starbucks stock has gone down 41% while the S&P 500 is down 3%. Howard Schulz, now beginning his second term as Starbucks’ CEO, reported to Time’s blog,

“for the first time in our history as a company, we have negative traffic this year vs. last.” [link]

Is this a bad sign?

An individual’s daily grande vanilla nonfat latte is a luxury good whose consumption depends on disposable income. Though some would place their latte above other essential items in terms of priority, the marginal propensity to consume lattes becomes lower with permanent decreases in income. Schulz blames the macroeconomy for the Starbucks’ declining performance: Schulz told Time,

“The current economic environment is the weakest in our company’s history, marked by lower home values, and rising costs for energy, food and other products that are directly impacting our customers.” [link]

If disposable income decreases, the daily Starbucks is one of the first things to go.

In his interview with Time, Schulz explained that there is little room for adjustment of Starbucks coffee prices. This is partly due to fairness towards their employees, who enjoy relatively high wages and good benefits. But Schulz also said that Starbucks tested different methods of decreasing prices (like offering $1 coffee or free refills), and “wasn’t happy with the results.” Sticky price logic tells us that, since prices can’t adjust, a decrease in Starbucks consumption will have a multiplier effect. The first response will be a decrease in production, leading to a decrease in employment as fewer baristas are needed, which eventually leads to a decrease in national income. And a decrease in national income, or GDP, that remains consistent over the course of a few months indicates a recession.

Leamon Crooms, posting on the Inside Arizona Business blog, argues that the decrease in consumption of Starbucks is something we should pay attention to. He describes the “Starbucks Recession Indicator,” which shows that:

A recession is approaching if your neighbors are buying fewer and smaller non fat lattes. A recession is here if you are buying fewer and smaller lattes. [link]

If this is true, the drop in Starbucks’ stock prices is something to worry about, particularly if the drop is matched among other luxury brands. Perhaps here we would see a substitution effect towards relatively more inexpensive goods (Dunkin Donuts drip coffee, for example). This increased consumption of drip coffee could mitigate some of the ripple effects, but a recession still seems inevitable.

In the international furor surrounding the 2008 Olympics in China, I find myself in the rare position of agreeing with Bush’s steady line of support for Beijing. The reasons, I think, are in part economic. Here’s how I see it:

In a recent article in The Economist, the debate over what is driving China’s economic growth seems to be coming to a close: while some economists maintain that China’s astronomic growth rate in the last decade is mainly attributable to exports, The Economist makes a strong case to the contrary: That growth has never been led by the export economy and is primarily driven by increasing domestic demand consisting of investment and especially consumption (particularly as of late).

Between 2005 and 2007 exports only contributed 2 to 3 percentage points to GDP, whereas domestic demand contributed 8 or 9. And, even with slowing exports to America, increase in domestic demand buttressed GDP—thus the percentage drop in annual GDP for 2007 due to decreasing American imports was only slight. Surprisingly, one Beijing-based firm expects that net exports will drop to zero in 2008 while imports are surging (up by 8%), which serves to significantly undermine the preconception that growth is driven by exports.

So, why support the Olympics, despite the propitious occasion to cite China’s domestic human rights abuses and foreign policies? The main reason, as I see it, is that we want to continue to be one of China’s main trading partners. As China diversifies its portfolio of countries which it can turn to for various resources, goods, and services, it becomes more preferential in its trade agreements, potentially opting away from the US for products it could procure elsewhere and at a cheaper price. Additionally, as China becomes richer, the kinds of products that will comprise its imports will be those of higher value—essentially, the ones America and Western Europe are most capable of supplying.

In terms of the exchange rate, about a week ago the yuan dropped below 7 for the first time. Loosening of the exchange rate makes imports cheaper and exports more expensive, allowing for increased US exports to China. This is also good news for the US, as growth of China’s trade surplus slowed significantly over 2007.

The political dimension completely aside, to compromise this trade relationship seems potentially quite costly. If China is trending towards greater import demand, greater high-value products, and greater international leverage, to sour economic relations seems unwise.

China is one the world’s largest manufactures and currently holds an important position within the global market. Through the past decade, China’s immense double digit GDP growth has caused it to become the role model for all developing countries. In most classes that I have taken on the development of China and the Chinese economy, China’s significant growth rates and profitability have always been emphasized. However, an article recently published in the New York Times offers an explanation which may change your opinion of the Chinese economy and of China’s reports on its growth rate.

Despite repeated denials from Chinese government economists, a variety of Western economic studies have suggested that the Chinese government “smoothes” its economic data — exaggerating performance in weak quarters and understating growth in during booms so as to present an image of stability. [link]

The practice of “smoothing” suggests that China may not have always experienced such stable growth, which the rest of the world believes. Instead, this article suggests that the Chinese manipulates their growth data to portray stability which they may not actually have. I am not saying that all of the data which China reports are therefore absolutely inaccurate, but this article offers a degree of skepticism of which investors should be aware.

Stephen Green, an economist in the Shanghai office of Standard Chartered Bank, said he suspected that the true Chinese economic growth rate in the first quarter might have slowed a little more than the government acknowledged.

The Chinese government is known to be notorious for regulating the flow of information to the rest of the world. The amount of problems which the Chinese economy is still punctured with, such as their weak banking system, along with their highly unregulated stock market, really puts China in a risky position within the global community unless certain institutions are implemented to address these problems. These problematic issues suggest that it is very likely that “smoothing” does actually take place within the Chinese economy, and I am sure that in the long run, this can become a serious issue if inaccurate data is reported often.

In dealing with an overheating economy and the scares of inflation, China is also hurting from the current global economic downturn. Those who invest in China must realize that a profitable economy or market does not last, that is just how the business cycle works. However, as a socialist country with an authoritarian regime controlling the correct and the flow of information, the rest of the world must be wary of the manipulated data and reports which the Chinese government may be feeding the public.

In this critique of George Bush’s economic stimulus plan, economist Frank Shostak sets out to debunk the myths of the Keynesian philosophy. Specifically, he levels a common-sense attack at the concept of the “spending multiplier” which the success of the stimulus package is predicated on.

Recall that the spending multiplier is the change in Y that results from a change in autonomous spending. The degree to which Y changes is dictated by the MPE, the slope of the planned expenditure line. The goal of the Bush stimulus plan is to increase consumer spending by increasing the disposable income of low- and middle-income consumers. Under the assumption that these individuals have a high propensity to consume, the logic is that the increase in consumption will result in a cascading series of transactions between firms and households that will stimulate production thereby increasing Y.

According to Shostak’s characterization, the multiplier model indicates that increasing savings is bad for the economy and that the Keynesian philosophy says that only demand for consumer goods drives economic growth. Shostak takes exception to both of these points. He argues that the reasoning behind the multiplier effect demands that something be derived from nothing. The cascading series of transactions does not result in the creation of new wealth; it only redistributes the amount of real savings that is already tied up in consumer goods. Furthermore, rather than production being driven by demand, production can only truly increase by investing in capital. Therefore, the stimulus package, which is intended to increase the demand for consumer goods, will be fruitless unless the increase in disposable income is reinvested in capital.

Shostak’s argument against the multiplier makes as much sense to me as the level of emphasis our textbook places on the multiplier’s importance. That is to say I’m as easily swayed one way as the other. To me, determining whether or not the stimulus package is a good idea is much more simple. Decreasing taxes at a time of heightened government expenditure really just means that Bush intends to send us Chinese yen cleverly disguised as U.S. dollars.

It was noted in lecture that we shouldn’t care about the costs of occasional, expected inflation because the negative effects of an increase in the overall price level of the economy are subtle. However, we should care about sustained, long-term inflation because one important effect can be an increase in unemployment. This is explained by Milton Friedman’s natural rate hypothesis, which is interpreted by Paul Krugman as occurring

…after a sustained period of inflation, people would build expectations of future inflation into their decisions, nullifying any positive effects of inflation on employment. For example, one reason inflation may lead to higher employment is that hiring more workers becomes profitable when prices rise faster than wages. But once workers understand that the purchasing power of their wages will be eroded by inflation, they will demand higher wage settlements in advance, so that wages keep up with prices. As a result, after inflation has gone on for a while, it will no longer deliver the original boost to employment. In fact, there will be a rise in unemployment if inflation falls short of expectations. [link]

Therefore, there is a short-term benefit of increases in wages (whether psychological or real) that are caused by inflation, but in the long-run expectations may change due to the likelihood of unemployment that is induced by inflation.

Additionally, sustained, unexpected inflation affects baseline investment. Arguably, investment decisions will be affected by inflation that occurs over a long period of time even if it is “unexpected.” Creditors would be harmed by the loss in purchasing power on the loan payments they receive. At the same time, the unexpected inflation would allow borrowers to have less of a burden in paying off their debts. As a result, optimism within the business community will rise after a sustained period of inflation. This will increase baseline investment in order to take advantage of the loans that have become less burdensome. Consequently, as baseline investment increases so too will the real interest rate. According to the flexible-price model, this change in the real interest rate will affect the equilibrium of the flow-of-funds and flow-of-output approaches, which allows potential output to equal actual output.

It is also worth noting that Friedman argues that only a high rate of growth in the money supply can lead to long-term, sustained inflation. Friedman summarized this idea when he stated that

…inflation is always and everywhere a monetary phenomenon. [link]

As a result, governments should not be blamed for sustained inflation because their policies, unlike the Federal Reserve, do not have long-term affects on the money supply. Therefore, the negative costs to politicians due to the belief by voters that inflation is a sign of government mismanagement are unwarranted.

The perma-link to the podcast is:
http://www.econtalk.org/archives/2008/03/cowen_on_moneta.html

For this assignment, I want you to listen to the podcast. Specifically, at around 44:15 or so, the conversation turns to the gold standard.

Because the currency value is not kept up with a regimented amount of gold, some argue that the whole thing is a house of cards. No backing. … Gold standard argument: some psychological. Some believe price level will be more stable and there would be fewer business cycles because the supply of gold is pretty stable. Slower to mine it than to print paper money. But look at the price of gold–it’s very volatile. On a gold standard, the price level would thus be volatile.

Listen to the entire conversation on the gold standard (not just the above excerpt). After that, write fifty words or so as a comment on this post, about what you think would be advantages and disadvantages of adopting a gold standard.

The link above will take you to the podcast, a transcript of the highlights and some interesting links. Feel free to research as many websites and articles as you want. This exercise is as much about getting you to think about the gold standard, as it is about motivating you to learn about it on your own.

Update A few details on this assignment:

1. It’s worth two points because it’s outside of your curriculum.
2. It’s due on Friday, April 18th (midnight-ish) Tuesday, April 22nd before class.

Suppose the Fed wants the funds rate to fall. To do this, it buys government securities from a bank. The Fed then pays for the securities by increasing that bank’s reserves. As a result, the bank now has more reserves than it wants. So the bank can lend these unwanted reserves to another bank in the federal funds market. Thus, the Fed’s open market purchase increases the supply of reserves to the banking system, and the federal funds rate falls. [link]

This question gets closest to what we were discussing in class. But there are a bunch of other things that are of interest too. Like, for instance, in answer to the question: “What about foreign currency operations?”

Purchases and sales of foreign currency by the Fed are directed by the FOMC, acting in cooperation with the Treasury, which has overall responsibility for these operations. The Fed does not have targets, or desired levels, for the exchange rate. Instead, the Fed gets involved to counter disorderly movements in foreign exchange markets, such as speculative movements that may disrupt the efficient functioning of these markets or of financial markets in general. For example, during some periods of disorderly declines in the dollar, the Fed has purchased dollars (sold foreign currency) to absorb some of the selling pressure. [link]

The handout is uploaded with the others from the semester. The same information can be found on the SF Fed’s website too, by clicking on the links above.