Professor Paul Palley's
          Economics Seminars

This update reflects the most recent data related to the indicators of measures of risk that are evident in the financial markets and are discussed below. These measures of risk are useful for monitoring the perceptions of investors related to the stability of the economy both today and in the future. As a result, these indicators are useful for producing forecasts. The following discussion focuses on historical data related to the 3-Month Treasury bill rate, the three-month Libor rate, the 10-Year Treasury Constant Maturity rate, inflation expectations, Moody’s Seasoned Aaa Corporate Bond Yield, and the value of the dollar. What the discussion below indicates is that the markets expect the U.S. and global economy to remain weak but strengthen slowly, that the extraordinary measures used by the Federal Reserve and other central banks to stabilize the markets are still in place, and that there are also signs that the worst of the financial crisis is perceived to be behind us. It is clear that both the supply of money in the financial system has increased and that at the same time perceptions of risk have declined some. At the same time, we are some distance away from what we would normally consider to be normal levels of stable economic growth. Risks that are being focused on still include the slow recovery of the housing market, the very poor commercial real estate market, outstanding and unrecognized debt crises, and the political will to continue to facilitate economic growth.

The 3-Month Treasury bill: Secondary Market Rate is an indicator of economic stress because investors look for the safest places to invest their money during a crisis, and the safest investment is the 3-Month Treasury bill. When looking at historical data, it is clear that a 3-month Treasury bill rate in the range of 3.00% and 4.00% is associated with a healthy and stable economy with low levels of inflation. Higher rates reflect higher inflation expectations and a 3-month Treasury bill rate in the range of 2.00% and 3.00% reflects much lower inflation expectations, and slower expected economic growth. We can see in the graph below that first in March 2008, and then in September 2008, October 2008 and November 2008, there were precipitous drops in the 3-month Treasury bill rate. Seeing the 3-month Treasury bill rate approach 0.00% is a sign of extreme financial distress in the financial markets, and the extraordinary lower rates since November 2008 indicate persistent weakness and uncertainty. More recently, these very low rates are also due to very aggressive Federal Reserve policies designed to increase liquidity in the financial markets and reserves in the banking system. We should expect these rates to remain extraordinarily low as long as investors continue to perceive significant risks confronting the economy, and the financial services industry remains in a weakened state and in a risk-averse mood. At the same time, the size of excess reserves held by the banking system and low 3-month Treasury bill rates indicate a large volume of cash on the sidelines that can be employed more productively once confidence increases.

The three-month Libor is the rate that banks pay each other to borrow for three months. The graph below shows that it rose significantly in the month of October 2008, reflecting the perspective of banks that there was significantly greater risk related to lending to one another. Credit was choked off during this credit crunch, and lending between banks declined dramatically, contributing to the severity of the recent recession and a reduction in credit available to businesses and households. This decline in this rate reflects the exceptional amount of monetary stimulus undertaken by the Bank of England and other actions by the British government, and central banks around the world. In other words, the significant decline in the three-month Libor starting in late October 2008 was not a sign of a healthier economy. What this indicates was the need for extreme actions by monetary authorities to rescue the financial markets and economy. Instead, a healthy economy is one where the three-month Libor fairly reflects the risks associated with a stable economy. In recent years this reflected by the three-month Libor being in the range of 4.00% and 5.00%.

The 10-Year Treasury Constant Maturity Rate is an important indicator in that many other long-term lending rates are tied to it either explicitly or implicitly. Mortgage rates, for example move in the same direction as the 10-Year Treasury rate as they represent alternative forms of long-term investment. The difference between the two rates indicates the risk associated with mortgages. The sizeable decline in as the 10-Year Treasury rate starting in March 2008 reflected the rush to quality or risk-free investments that accompanied the decline in the financial markets. Rates increased after that point, but then a significant decline occurred at the end of 2008 as investors fled to safe investments. The 10-Year Treasury then stabilized at lower levels in the range of 3.00% to 3.75%, but more recently signs of economic weakness have led to this rate falling below 2.75%. A 10-Year Treasury rate at these low levels indicate a very weak economy as this can only be the result of exceptionally low inflation expectations or continued investment in U.S. Treasuries versus riskier investments indicative of confidence in the economy. A healthy economy with inflation expectations in the range of 2.00% to 3.00% would indicate a 10-Year Treasury rate in the range of 5.00% to 6.00%.

The difference between the 10-Year Treasury Constant Maturity rate and the 10-Year Treasury Inflation-Indexed Security is a very good measure of inflation expectations. Inflation is not necessarily a bad thing at all because it is associated with growing economies. On the other hand, the exceptionally high rates of inflation seen in the 1970s significantly stressed the economy. Very low rates of inflation can also be a real problem because this indicates lower rates of economic growth which limits the ability of businesses to raise the prices of their products, and this reduces the profits they then earn. Deflation is a far more significant risk as declining prices lead to lower profits and potentially losses due to serious declines in all forms of spending. The reason is that buyers wait for even lower prices. Deflation is associated with severe economic recessions and depressions. The sporadic increases in inflation expectations between the middle of 2006 and the middle of 2008 depicted in the graph below reflected higher commodities prices and other inflation pressures. The decline in inflation expectations to nearly 0.00% after that point as shown in the graph below indicates severe economic distress and the expectation that the economy will continue to be very weak, and that deflation is a threat. Then the increase in inflation expectations to just over 2.00% was a moderately positive sign because it indicates that deflation is less of a risk, and that some economic growth is expected in the future. However, now that the bond market is anticipating inflation rates in the range of 1.60% and 1.90% we see continued concern about the underlying strength of the economy.

Moody’s Seasoned Aaa Corporate Bond Yield is an indicator that tells us something about the availability of funds for businesses seeking to raise money, and as a result perceptions of risk facing corporations. Notice in the graph presented below that the real, inflation adjusted, Moody’s Seasoned Aaa Corporate Yield rose sharply between September and November 2008. This is the same period in which, as noted above, the 3-month Treasury bill rate approached 0%. As I also indicated above, this indicates a flight to risk free assets, and even away from even the safest corporate bonds. This is a sign that financial markets perceived significant risks to the real economy, and suggests that if these conditions persisted then the most credit worthy borrowers would face real issues related to their financing efforts. Bond issuers that are associated with higher levels of risk saw even more significant increases in the yield on their bonds. The decline in the real, inflation adjusted, Moody’s Seasoned Aaa Corporate Yield since January 2009 is a positive sign because it indicates an increase in the supply of funds for the least risky borrowers and also indicates the perception that economic conditions are improving.

The Trade Weighted Exchange Index for the value of the dollar versus major currencies is another important indicator related to the perceived risk associated with the global economy. The dollar is generally considered to be a safe haven currency, and as a result in times of global economic stress we will see investors buying dollars that they can use to purchase U.S. Treasury bills and other dollar denominated investments. The long-term trend for the dollar is that it is declining in value. The reason for this is the sizeable trade deficit carried by the U.S. What we can see in the graph below is that the dollar increased in value during the last half of 2008, followed by a brief decline, and then once again a sizeable increase between January and March 2009. Following this, the dollar resumed its decline in value. These increases in value were directly the result of the financial crisis which had become a global financial crisis. What we see though, is that the dollar is resuming the long-term trend that has been in place since the early 1980s. Contributing to the decline in value is also increases in demand for oil and gold, commodities that are alternatives for those worried about inflation or risk. These increases in the value of these commodities are also the result of the exceptionally low interest rates today as this facilitates investing in commodities on margin. As the economy stabilizes further interest rates will increase and the prices of these commodities will correct and the decline in the value of the dollar will be more gradual.

See the link below for a column published in the New York Times September 1, 2010 written by Karl Case, co-developer of the important Standard & Poor’s Case-Shiller housing price index. The column explains the ramifications of the collapse in home prices, including the very negative impact on wealth and the economy. The column also discusses the benefits associated with buying and owning a home, and the factors contributing to a slow recovery of the housing market.

The link: http://www.nytimes.com/2010/09/02/opinion/02case.html?pagewanted=2&ref=opinion

Here is an interesting column about the structural problems facing the economy: http://www.nytimes.com/2010/08/18/opinion/18friedman.html?ref=opinion

See this interesting report written by the economists Alan Blinder and Mark Zandi, advisers to Bill Clinton and John McCain respectively. The article is about the positive impact of efforts by the federal government and Federal Reserve on the national economy in efforts to fight the recent recession and financial crisis.

The link is: http://www.economy.com/mark-zandi/documents/End-of-Great-Recession.pdf

Group,

Here is an interesting perspective on the problems facing our economy written by David Stockman, a director of the Office of Management and Budget under President Ronald Reagan

Paul

I was asked to suggest some book or other resources for those who want to continue learning about economics. Here is a list of books and resources I like;

Books about Economics

1. Freakonomics by Steven Levitt and Stephen Dubner. This is a very good book about unusual applications of economics.
   
2. On The Wealth of Nations
   - By P. J. O’Rourke. This is a good and irreverent look at The Wealth of Nations by Adam Smith.
   
3. The Economic Naturalist: In Search of Explanations for Everyday Enigmas – by Robert H. Frank. This is another interesting book about applications of economics.
   
4. The Economic Naturalist’s Field Guide: Common Sense Principles for Troubled Times – by Robert H. Frank. This is also another interesting book about applications of economics by the same author.
   

Books Related To Economic History

1. Lords of Finance: The Bankers Who Broke the World
   - by Liaquat Ahamed. This is a very good book about the events that led to the Great Depression.
   
2. The House of Morgan: An American Banking Dynasty and the Rise of Modern Finance - by Ron Chernow
   
3. The Ascent of Money: A Financial History of the World - by Niall Ferguson
   
4. The Cash Nexus: Economics And Politics From The Age Of Warfare Through The Age Of Welfare, 1700-2000
   - by Niall Ferguson
   
5. This Time is Different – by Carmen Reinhart and Kenneth Rogoff
   

Interesting Biographies

1. Titan: The Life of John D. Rockefeller, Sr. - by Ron Chernow
   
2. Alexander Hamilton (the first Sectretary of the treasury)
   - by Ron Chernow
   
3. Andrew Carnegie – by David Nasaw
   

Newspapers, Business News Sites, Blogs

1. The Wall Street Journal: http://online.wsj.com/home-page. This has a more conservative editorial page.
   

Interesting Blog: Real Time Economics (http://blogs.wsj.com/economics/)

Interesting Blog: MarketBeat (http://blogs.wsj.com/marketbeat/)

1. The New York Times: http://www.nytimes.com/. This has a more liberal editorial page.
   

Interesting Blog: Paul Krugman (http://krugman.blogs.nytimes.com/)

Interesting Blog: Freakonomics (http://freakonomics.blogs.nytimes.com/))

1. CNN Money: http://money.cnn.com/
   
2. CBS Market Watch: http://www.marketwatch.com/
   
3. MSN.Money: http://moneycentral.msn.com/home.asp
   
4. Yahoo!Finance: http://finance.yahoo.com/
   
5. Bllomberg.com: http://www.bloomberg.com/
   

Websites Related to Economic Thought

The History of Economic Thought Website: http://homepage.newschool.edu/het/

Encyclopedia of Law and Economics: http://users.ugent.be/~gdegeest/

Paul

Here is an interesting column to read about the limits of behavioral economics as the sole explanatory approach to many problems.

We would expect that higher gasoline prices lead people to want to live closer to work. This fact would have a real impact on the housing market. If you are interested, see this link for a paper produced by the Federal Reserve about this topic and result: http://www.federalreserve.gov/pubs/feds/2010/201036/201036pap.pdf

In an effort to better understand decision-making by both businesses and consumers, especially in the wake of the recession and economic crisis that started in 2007-08, economists have increasingly sought to better understand just how rational we are. The evidence increasingly shows that people can behave in ways that contrast with rational decision-making. This paper produced by economists and the Federal Reserve focuses on consumer decision-making: http://www.federalreserve.gov/pubs/feds/2010/201025/201025pap.pdf

Paul

The building of the housing market bubble and then the bursting of this bubble, and the financial crisis that blew up in 2008, exposed significant failures in decision-making on the part of both the private and public sectors. The fact is that there has been a series of financial crises since the deregulation of the financial markets started in the 1980’s, indicating that while the current crisis is far worse than what has been observed in recent years it was part of a pattern. Starting with the saving and loan crisis of the late 1980’s, to the bursting of the NASDAQ stock market bubble in the late 1990’s to 2000, and the more recent crisis among others, economists and behavior scientist have learned a lot about how these events happen. These lessons explain why those countries with tighter regulations on their financial markets and banking system (like Canada) did not experience a significant recession and financial crisis.

What has historically led to financial crises? In many ways the answer revolves around perceptions of greed and fear. Specifically, many have wrote that too much greed and too little fear leads to financial crises, and the too much fear and too little greed sustains financial crises. What precipitates financial crises and feeds into the greed is the poor evaluation of risk leading to irrational evaluations of risk versus reward. This poor evaluation of risk could be due to greed clouding the perception of reality or due to not investing the time necessary to evaluate the risk associated with an investment. An example would be those who bought complex financial derivatives that ultimately failed because they did not unravel and expose the risk exposure of the investments whose value supported the price of the financial derivatives. Specifically, the poor evaluation of risk leads to poor credit evaluation. Often, as we have seen, the probability of extreme events is higher than anticipated or accepted by investors, but repeatedly investors have contributed to the development of investment bubbles and then crises. In addition, Wall Street firms and other banks did not hold enough strong secondary reserves to secure capital adequacy.

A contributing factor to the most recent crisis is that the pressure to profit in the short-run trumped long-term perspectives by many individuals and firms. An example is related to Moody’s and Standard and Poors. These firms were paid by the same firms whose credit products they were rating, a conflict of interest. Moody’s and Standard and Poors did not downgrade the debt issued by firms like AIG, Fannie Mae, and other firms who assumed additional debt as they issued the credit products Moody’s and Standard and Poors were rating. Moody’s and Standard and Poors did not expose financial risk; instead they understated risk. Paul Krugman in the New York Times recently noted that of the AAA – rated subprime-mortgage-backed-securities issued in 2006, 93 percent have been downgraded to junk status. Risk was significantly under-estimated and as a result interest rates were too low. Similar irresponsible and risky behavior was evident in the decisions made by Merrill Lynch, AIG, and Lehman Brothers, and many others.

The behavior of all of those who precipitated the financial crisis now appears to have been irrational and short-sighted. This raises a question; do people behave rationally? Current research has answers for this question. For example, we know that people are more likely to see data that supports their preconceived points of view rather than data that contradicts their preconceived points of view. In addition, people overvalue current events when developing expectations. Another fact is that people prefer a single explanation for events rather than a nuanced explanation for facts. This is an interesting point because all too often the popular media exploits this fact by presenting overly simplified answers to difficult and divisive questions, and they also avoid nuance to further an agenda whether be political or other goal. Complicating this further, we overvalue our talents when decisions prove to be profitable rather than considering the impact of factors completely outside of our control.

Businesses and individuals will often combat these issues by establishing complex analytical models, risk analysis strategies, and hedging programs. The problem can be that complexity will outstrip our ability to understand the process we are dealing with. The complexity of financial modeling and synthetic securities has now been shown to be one of the sources of the financial crisis itself. We know that it is hard to connect the impact of a series of potential errors. These points, combined with the fact that people can become too acclimated to risk help explain how a series of financial crises can occur, especially since it is easy to have too much faith in risk management systems. Complex governing structures are also not necessarily the solution for mitigating complex systems that increase risk because complexity can negate judgment and makes assessment difficult. Furthermore, it is all too easy for group-think to develop among individuals in the same field of work. These points suggest that checks and balances in the investment decision-making by firms that encourage and reward the free input of ideas and points of view would enhance the risk management process.

Many economists also got things wrong in the run-up to the financial crises and recession. One of a group of prominent exceptions is Robert Shiller who identified the housing bubble and warned about its consequences. Another was Paul Krugman. There were many others, but most did not express real concern. Many economists believed that markets always tended to be stable (rational expectations). This led to support for the efficient market hypothesis - the idea that financial markets price assets at exactly equal to a value supported by all known fundamentals. The problem is this undervalues the role of bubbles or destructive speculation. Some economists forgot the lessons learned from the Great Depression and undervalued lessons learned from more recent financial crises. In effect, macroeconomists have been separated into two mutually exclusive camps – those who believe markets are inherently rational (and as a result economic growth depends on the advent of new technology combined with changes in the supply of labor) versus those who were Keynesian economists who sought to combine the possibility of demand-side reasons for recessions with models assuming rational expectations. This resulted in something close to group think that discounted the possibility of bubbles and irrational behavior. The argument that bubbles don’t happen gained prominence. For example, the influential economist, Eugene Fama argued, “housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.” The Federal Reserve, including Alan Greenspan and Ben Bernanke, also discounted the possibility of a housing bubble

Another important contributor to these misperceptions was the over-reliance on elegant mathematic models and not accounting for the behavioral aspects of decision-masking that can lead to irrational or unpredictable decision-making. This has led to greater acceptance of new movements in economics, including behavioral economics and finance. We know that real-world investors are subject to herd behavior, speculative excess and irrational exuberance. Investors who seek to base their investment decisions based on economic and financial fundaments lack complete credible information, and have limited collateral leading to following the herd. People tend to over-value small losses and under-value small gains and are too likely to extrapolate from small samples. A severe decline in asset prices that is not supported by fundaments will lead under-capitalized investors to quickly see their capital be depleted forcing even the “smart” money to sell and feed a downward spiral

Interesting, the great American writer Philip Roth captured the above points in the following quotes, “Fear tends to manifest itself much more quickly than greed, so volatile markets tend to be on the downside. In up markets, volatility tends to gradually decline “and “Obviously the facts are never just coming at you but are incorporated by an imagination that is formed by your previous experience. Memories of the past are not memories of facts but memories of your imaginings of the facts.”

Paul Palley

This column considers the possibility that policy-makers may make decisions leading to conditions that will make this period a portion of what will be a long-depression.