The Second Great Depression

Last October, we asked whether or not the world was heading for a Second Great Depression. Today a new piece by Messrs Eichengreen and O'Rourke addresses the question in much more detail. Their findings are sobering.

Why I love Warren Buffett

Who else can not only get away with this, but for such wisdom be revered by his audience, most of whom paid somewhere near $148k a pop to hear such gems. Warren Buffett on credit derivatives, which create dependence and entanglement across financial markets:

Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease. It's not just whom you sleep with, but also whom they are sleeping with.

Truer words have never been spoken.

Unsettling news of the day

The Dow Jones closes below 6800, its lowest level since April 1997. Lost decade, indeed.

Commodity price collapse: who wins and who loses?

One of the great back stories of the ongoing economic crisis is the collapse in commodity prices, which occurred in the second half of 2008 after a record boom period lasting at least five years. The bursting of the bubble has produced clear winners and losers. Thanks to our fantastic contributors, zzzeitgeist has had excellent coverage of these repercussions. I thought I’d try to tie things together.

The biggest winners are consumers, particularly first-world automobile drivers. In the last 7+ months, oil has fallen from $147/barrel to about $37/barrel now. Economists reckon that amounts to a ‘stimulus’ of more than $240 billion. Also, now that the world food crisis has largely subsided, developing-world consumers stand to benefit from cheaper food prices. This means a lot when you spend more than 50% of your budget on food.

The mining sector is obviously a huge loser. Mining is often a boom and bust industry, because it takes a long time to develop new mining projects. It’s hard to forecast future supply/demand fundamentals (remember when this seemed like a good idea?) and unfortunately they can change drastically and rapidly, which is exactly what has happened in the last year. As a result, a number of firms are closing mines, because prices are too low to justify operating costs. Mining firms often take on a lot debt out of necessity – digging mines ain’t cheap. But thanks to the financial crisis and the disappearance of cheap credit, heavily indebted companies are suddenly struggling to stay afloat. Case in point: Rio Tinto, the world’s second largest mining conglomerate. See Rory’s excellent treatment of Rio’s debt woes here.

Finally, commodity-dependent countries suffer perhaps the worst. When prices are high, resource-rich countries are suddenly flush with cash, which they can use to advance geopolitical aims, reward cronies, or invest in infrastructure, education and health to avoid the resource curse (don’t hold your breath). Falling commodity prices have scaled back these ambitions. See Dan’s analysis of Venezuela, Rory’s take on Russia, or this money quote about Iran.

In my mind, these are the biggest winners and losers, but this list is by no means exhaustive. Falling commodity prices also have an enormous effect on agricultural trade, international cooperation, foreign direct investment, Guinea, South Africa, Australia, several Latin American countries, etc. Who else am I missing?

(photo from jeff-o-matic’s photostream)

What do Google and Dunder Mifflin have in common?

Paper Mills. No, Google isn't making a foray into the forest products and packaging industry. The company will obviously use the defunct paper mill to house a massive data center.

This is an unremarkable story unto itself, but to me, it represents a symbolic transition of old industry to new. There's also a tinge of irony here. A company that categorizes and delivers knowledge to people electronically replaces one that profited from the delivery of information through an anachronistic channel: the printed page. (If you don't think that paper is outdated, may I remind you that your are reading a blog on a computer and that Amazon just launched the Kindle 2 this week.)

More importantly, this story illustrates the merits of creative destruction. One could draw the conclusion from Stora Enso's press release that Google itself may be partly responsible for the mill's "persistent losses in recent years and poor long-term profitability prospects". Even so, Google offers society exponentially more value in return. As our economy falters and businesses fail, I hope that our leaders (and opinionators) carefully consider actions (and words) that may impede transformative process of creative destruction.

We may never know the next great American car company if we artificially extend the life of the incumbents. So when you see an empty paper mill or idle auto manufacturing plant, think not of jobs lost, but imagine the next great product or service from a company that will take over that space.

Is it an onus?

Pundits like to act outraged when they hear Wall Streeters complain that $500,000 isn't that much money. They're right that it's a lot of money...if you don't live an upper crust lifestyle in New York. 

When a basic apartment goes for more than a million, 500k can go pretty quick. Obama and his economic team are quite right that all firms should be cutting back in this " winter of hardship" (seriously?). But capping executive pay is a pretty blunt and inefficient method of forcing companies to do this. Companies receiving federal bailout funds should certainly be subject to strict scrutiny, but if an executive can successfully employ this "bridge" money to shore up balance sheets and lead a return to profitability, shouldn't they be rewarded accordingly? 

Wall Street's "bonus" culture has been entrenched for so long that we seem to forgot exactly what one normally earns a bonus for. We shouldn't embrace it in it's current form, nor should we pay regulators the exorbitant amounts previously earned by execs. As always in times of hardship, we swing from one extreme to the other and suggest heavy handed ways to counter problems we didn't see coming and are all occasionally guilty of hyperbole.

Let's let government service remain just that and reinstitute the true meaning of bonus.

(Photo via c-weiss)

Recession fun: spot the inferior good!

In economics, an inferior good is a one which is consumed less as income rises. This is an easy concept to understand: as you get older and make more money, you’re probably going to eat less Ramen Noodles. However, consumption of inferior goods is also broadly counter-cyclical, meaning that as the economy slows, consumption is likely to rise.

We're in the midst of a bad recession, which means that many people have less money to spend on leisure. Instead, here’s a game you can play for free. I call it: SPOT THE INFERIOR GOOD! The rules are simple: whoever identifies the most goods for which consumption has increased during the last year, wins. Post lists and debate whether goods are actually inferior in the comments; winner gets a free cup of Ramen Noodles!

Here’s my list:

1. Natural Light Beer
2. Subway Veggie Delite Subs
3. Pornography
4. Spam
5. Boxed wine
6. Tuxedo t-shirts
7. Rob Schneider movies

Hey, I said it was a bad recession...

China: cooperation or competition?

It seems clear that combating a global recession will require a good deal of international cooperation. There are a number of policy arenas where coordinated government action makes sense, such as monetary, fiscal and trade policy. So far, world leaders have said the right things in regards to working together, and they’ve explicitly acknowledged the dangers of protectionism. So what do you do when a rising economic power decides that it will do whatever it takes to avoid recession, even if it means harming other economies?

From the Asia Times:

As for the beggar thy neighbor, it has become clear over the past week that
Chinese government officials intend to export their way out of the global
economic crisis. This is all too readily apparent in the recent downward
movements of the Chinese yuan relative to the dollar. Stripped of any rhetoric,
this movement represents a "competitive devaluation" designed to boost Chinese
exports to the US at the expense of both domestic US manufacturers and competing
countries such as South Korea and Japan.

Such a move, if deliberate and sustained, is potentially disturbing for three reasons. One, as Martin Wolf has argued, in order for the root causes of this recession to be addressed, the world’s massive surplus countries (ahem… China) must expand domestic demand to mitigate imbalances. China is neglecting its systemic responsibilities to satisfy domestic concerns, which brings me to my second point. I tend to think that when a government’s legitimacy and mandate to rule are predicated on delivering sustained rapid economic growth, such a government will be more tempted by “beggar-thy-neighbor” strategies.

Finally, in this particular economic climate, we really do need to be wary of the ghosts of Smoot-Hawley. I’m not fear-mongering, nor am I suggesting that we’re entering a new period of trade-destroying protectionism; in fact, I’ve argued the opposite. But there is a lot of damage to trade that could be done legally, without violating existing WTO commitments, mainly due to the gap between applied and bound tariff rates. This sort of posturing by China merely provides fodder for the Lou Dobbs crowd and makes international cooperation all the more difficult to sustain politically.

The G20 and SWFs

The G20 is scheduled to meet this Saturday to outline a set of guidelines for the world's 20 largest economies to coordinate action in light of the worsening global economic milieu. An illustrious crew of economists at VoxEU have written the book (literally) on what government officials need to say and do to deliver the world from catastrophe. The prescriptions are as banally predictable as all the doomsday yarns and the fact that government officials will inevitably do the wrong thing. Beyond the obvious calls for increased cooperation and coordination, one piece of advice struck me as quite odd. Guillermo Calvo, via Dani Rodrik:

The new Bretton Woods institutions should be more tolerant of controls on capital mobility, especially as those controls centre on limiting the actions of the banking sector.

True, these new capital controls may certainly help developing countries stall capital flight; but there are a number of complications. The dollar is still seen as the safest asset in the world. For that reason, SWFs (from China to Dubai) have been sinking ever more money into dollar denominated assets - at least one piece of anecdotal evidence to explain the recent rise of the dollar. This has, at least in part, kept the US out of the worst of the crisis. There is no way the US will allow new restrictions on capital outflows to be the bulwark of any new "Bretton Woods". Not only are such controls notoriously hard to enforce, they would probably bring the dollar back down, and I have a feeling that's something we would be loathe to support.

To be sure, global capital flows were somehow involved in the current financial troubles. But to reiterate, our current situation is far too complicated and opaque to be blamed on any single silver bullet: whether they are swaps, the housing bubble, or capital outflows. The underlying root was a mispricing and misunderstanding of risk throughout the financial model.

Capital outflows allow investors to put their money where they see fit. SWFs represent, by far, the largest outflows of capital. They are intended to mitigate risk and exist to safely invest currency reserves in the way that will most diversify national wealth. For their sake, and ours, let's keep letting them.

(Image: New Yorker)

I was elected to lead, not to read!

Well we are at crisis levels. The bailout, which plenty of people say won't work anyway, has stalled in an incredible fashion today. I won't try to give a run down of the issues at hand, but let's be clear that neither I, the President, nor both candidates fully understood the subtleties of our current pickle, despite the stellar briefings I'm sure they have all received. Apparently neither do any of our elected representatives because despite all of the calls for immediate action we are being greeted with limp and tepid responses carrying no weight. For clear explanation read these concise and lucid treatments of what's happening and why.

As Brad Setser points out, the balance sheet of the Fed reveals the huge nature of the deal. It's sad, and in this situation downright scary, that an election season filled with promises of bipartisan compromise has devolved into another typical session of Washington malaise. To be perfectly frank I'm ready for some good 'ole unilateral, unchecked decision making rather than this current handwringing and indecision. And besides, Paulson isn't nearly as bad as Russ Cargill.

Recession obsession

News is trickling in on the backs of quarterly reports that suggests Asian and European economies are not nearly as decoupled from American economic conditions as previously thought. The contagion of the American "credit crunch" is spreading and though these markets may be technically independent from the US economy (i.e. they have not bought securitized loan packages from American banks) they still face a number of problems.

The instruments of financial (not monetary - the ECB is notoriously opaque) work in Europe are close to ours. The loan bubble that caused the "credit crunch" here exists in Europe as well; it simply manifests in a slightly different form. Look at the housing markets in Spain and Britain, unemployment pretty much anywhere but Germany, and contracting export margins throughout Europe and Asia (especially China and Japan). Unlike the quick action of the Fed, the sclerotic pace of EU regulation and the inflation-bent of the ECB won't do anything to counter these effects anytime soon.

There are a number of other significant problems in what is increasingly looking like a global recession, which Larry Summers ties up nicely. But the problems now seem beyond the scope of interventionist policy. Even if they were not, I am not convinced the Fed could responsibly round up enough liquid cash to implement any type of further "injection" to buoy the economy. With more and more banks facing huge writedowns and even insolvency, the Fed cannot feasibly expand its own balance sheet. The one thing policy wonks should not be adding to the cacophony is a cry for another stimulus. The term "credit crunch" conjures up ideas that the situation would be resolved if there was simply more money around to lend out. This simply isn't the case.

The Fed "injects" money into the economy (whether it's a tax stimulus or a bail-out) by controlling the reserve supply of cash to banks. To ease short term interest rates (and thus push money) the Fed buys securities by crediting the account of their primary dealer (who is free then to lend out these reserves) thus expanding its own balance sheet. This practice, if ensconced permanently in policy, will yield disastrous results: essentially, an even greater expansion of GSEs (and not just ones dabbling in mortgages either) with bills passed to the taxpayer and profits distributed to managers and shareholders. This encourages reckless and risky investment policies which will even further undermine the financial system.

The crunch needs to be felt by those who helped cause it, not passed indefinitely down the line. Free markets need to be free in the good times and the bad. If only Paulson had seen it coming.

Monetary policy: Between a rock and a hard place

Blog note: sorry for being off the radar for a few days - the next few weeks are crunch time for my Master's dissertation. Fortunately, I see my illustrious coauthor has kept you entertained with stories about kites, voicemail, and Schlitz. I'll do my absolute best to keep posting at least once a day.

Anyways, right now is a good time to thank your lucky stars that your name isn't Ben Bernanke and that your business cards don't read "Chairman of the Federal Reserve." Mr. Bernanke is facing a daunting combination of high inflation (year-to-year inflation in June was 4.1%, the largest annual increase since May 1991), anemic growth (1.9% in the 2Q, largely on the back of fiscal stimulus checks), and stubbornly high food and energy prices.

Going into the Fed's August meeting on Tuesday, it's an impossible position to be in. Raise interest rates and you risk aggravating a delicate situation where credit remains tight, energy prices remain volatile, and the housing market may not have quite bottomed out yet. Lower interest rates and you risk stoking the fires of inflation.

What to do? Realistically, probably nothing. In June, the last time the Fed met, they left interest rates unchanged at 2%. Wall Street is betting that they'll do the same thing this time, and I think they've got it right. When interest rates are this low, realistically it's hard to lower them much further, and Mr. Bernanke is still more concerned about pumping liquidity into the system than inflation. The real question becomes: how much inflation is Mr. Bernanke willing to tolerate? If he wants to keep rates this low, it will have to be a lot.