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

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

The issue of just how much impact changes in oil prices has on the U.S. economy is important because the fact is that fluctuations in oil prices do impact the economy. There is a high correlation between higher oil prices and recessions. They are not the only or probably the most important factor always, but it is still an issue. This is probably one more reason to diversify our energy sources further.

The Department of Energy has a good, brief bit of detail related to this here. The International Monetary Fund has also produced a very good and detailed report related to this issue.

This is a good start.

The current and future strength of the economy following the deepest recession since the Great Depression is important to businesses, policy makers, and individuals all of whom have to plan for the future. As a result people look to experts for forecasts. The Great Recession is over, but uncertainty still prevails. The National Association for Business Economics (NABE) is an excellent source of economic forecasts for the U.S. economy. The May 2010 NABE Outlook (see: http://www.nabe.com/) raised its expectations for the outlook for 2010 as growth prospects have improved despite uncertainty in Europe. NABE also indicated that concerns about the strength of the consumer and stress in the financial market have eased. The forecast represents the consensus of macroeconomic forecasts that have been prepared by a panel of 46 professional forecasters.

The dollar will hold onto its recent gains in strength due to weakness in the Euro, but the long-term trends due to persistent trade deficits is for a marginally weaker dollar beyond 2011. The one risk beyond these issues is related to uncertainty about whether or not China is experiencing a “bubble”, but the size of this and implications are really uncertain. The trend is for housing starts to significantly increase this year and next but remain well below long-term trends associated with normal economic conditions. The consensus is that inflation rate will remain low due to the relatively weak economy.

Real GDP declined at an annual rate of approximately 4.0% during the period of the second quarter of 2008 until the second quarter of 2009. Overall, real GDP increased 0.1% in 2009, and then is expected to show improved economic growth equal to 3.2% in 2010 and then 3.2% again in 2011. This is a positive development, but this rate of growth is not strong enough to produce substantial improvement in the labor market. I have to note that recoveries from severe recessions that are combined with financial crises are always difficult. The low expected inflation rates is based on the expectation that the unemployment rate will remain high by historical standards, and the Federal Reserve is not expected to start tightening until later this year.

This forecast reflects relatively weak increases consumer spending. Improvements in business investment, especially in inventories and to a lesser extent in equipment and software, are expected. The very weak housing market and the significant decline in wealth due to declining home values are important contributors to a relatively weak recovery in personal consumption expenditures. The consumer price index declined 0.3% in 2009 due to weakness in the economy and the labor market, but this deflation will not continue into 2010 as it is expected the inflation rate will equal 2.0% in both 2010 and 2011. Improved stability in the credit markets and the very robust rally in the stock market are positive indicators. Significantly below trend levels of housing starts and home prices will occur in 2010 and 2011. Only 550,000 housing starts occurred in 2009 and only 680,000 are expected for 2010, and 950,000 in 2011. The majority of analysts believe the housing market has bottomed, but a slow recovery is expected.

The absence of inflationary pressures allows the Federal Reserve to pursue very aggressive monetary policies. The consensus of the economists who were surveyed by NABE is that the Federal Reserve will slowly raise the federal funds rate target this year to nearly 0.50%, but that it will raise it to the still low rate of 2.00% by the end of 2011. The expectation is also that long-term interest rates will also remain relatively low. The yield on the 10-year Treasury note equaled 3.85% at the end of 2009, and is expected to increase to 4.18% by year-end 2010 and then 4.73% by year-end 2011, reflecting the expected improvement in the economy. These relatively low long-term interest rates, party the result of aggressive monetary policies, will contribute to low mortgage rates.

The strength of the dollar is important to those who are interested in traveling and those who import and export goods and services. The dollar strengthened when the financial markets crisis deepened during the second half of 2008. The reason is that global economic weakness and uncertainty led investors to purchase dollar denominated assets to try to hedge against risk. One Euro bought 1.58 dollars in July 2008, but bought only 1.46 dollars in 2009. Since then, improvements in the stability of the global economy led to a resumption of weakness in the dollar, until the Euro crisis too hold in 2010. The economists expect one Euro to be able to buy 1.29 dollars in 2010 and 1.29 dollars in 2011. Reflecting the expectation that the economy will continue to strengthen the S&P 500 Index is expected to end 2010 at 1235, versus 1115 in 2009, and end 2011 at 1305.

There are other very good resources on the internet for forecasts related to the economy and specific economic indicators. Among the good resources include websites for the Congressional Budget Office (http://www.cbo.gov/), and the Federal Reserve Bank of Philadelphia’s Livingston Survey (http://www.philadelphiafed.org/research-and-data/real-time-center/livingston-survey/).

Paul

.New industries may emerge for a number of reasons, but often it is the combination of necessity (whether perceived by the consumer or due to other real needs) and the emergence or utilization of new technologies. In many ways the energy industry has been and will continue to be an example of this. Now, as any reasonable projection indicates rising oil prices in the future, and due to limits in the supply of existing energy resources, new investments in energy development are necessary. Due to environmental risks related to the continuing use of oil and coal, and national security risks alternative energy sources are being sought. This includes clean or green energy resources and will in all probability mean additional investments in nuclear power. It is a problem that many existing oil reserves are in countries with unstable governments or have governments hostile to the security of western industrial countries including the United States. Whatever the case, new industries will emerge and other existing industries will evolve.

First, before pursuing a discussion of the role of government, it is important to understand how businesses and consumers determine which energy resources they will utilize. Businesses will determine which energy resources they will use based on the productivity of the alternative resources relative to the cost of these resources. Households engage in the same calculations. The decision install solar panels depends on the costs associated with this relative to the expected savings evident on a households energy bills. Given this, technological advancements are important because technology tends to lead to increases in productivity and then lower associated costs. At the same time, the cost or price of the energy resource is important too. The feasibility of investing in new energy resources depends this. As a result, government efforts to promote alternative or new energy resources and industries focus on technology and productivity, and also the cost associated with acquiring the new energy resources. This implies subsidies and also carbon or other taxes or fees.

Countries around the world are aggressively encouraging the development of alternative energy industries, companies, and markets. At the same time, it is not clear what the effort will by the United States government in encouraging these industries, companies, and markets. Companies are aware of the differences. This very detailed article in the New York Times Magazine discusses issues related to building a green economy, including the role of public policy and efforts by foreign governments and companies. China, for example is making significant investments. This column By Thomas Friedman expresses the frustration of some companies and advocates for investment. The same author answers questions related to uncertainty about climate change in this column; even if scientists are wrong, and the vast majority do agree on this issue, isn’t it still better to develop one of the most important new industries for the future? After all, the long-term trajectory for oil prices is that they will increase and energy efficiency will always be important to businesses. This article discusses one current example of an initiative in the U.S. to invest in wind farms. Further updates are always ongoing and should be fun to monitor.

What role did fraud play in the financial crisis associated with the last recession? This is an interesting column that poses this question.

The National Bureau of Economic Research is an excellent resource for the dating and understanding economic recessions in the U.S., and other economic issues as well. The U.S. economy has experiences a number of recessions since the early 1970s. These recessions (a complete list is detailed on the National Bureau of Economic Research website) occurred during the following years; December 1969 to November 1970; November 1973 to March 1975; January 1980 to July 1980; July 1981 to November 1982; July 1990 to March 1991; March 2001 to November 2001; and the most recent one that started in December 2007 and ended during the fourth quarter of 2009. This link to the Federal Reserve Bank of St. Louis depicts trends related to the Consumer Price Index (CPI) for all urban consumers for energy related prices since the mid-1950s. The recessions are indicated by the shaded areas. It does appear as if higher energy prices correlate with recessions. However, remember that correlation does not imply causation, and also a number of factors affect oil and energy prices.

First, it is important to consider the factors that lead to changes in oil prices. On the demand side these factors would primarily include changes in income or economic growth, and changes in demand for energy using products. On the other hand, the factors that affect supply will include changes in the cost of energy production, and political decisions related to the aggregate level of oil produced by state owned or controlled oil producers. In addition, financial or portfolio related investment decisions are important. Low interest rates can encourage speculation in oil and other commodities due to lower opportunity costs associated with these investments. A weaker dollar will also contribute to higher oil prices for two reasons; one is that oil is priced in dollars and a weaker dollar will lead to higher oil prices to compensate for this. Secondly, a weaker dollar may also cause investors to shift their portfolio from dollar denominated financial assets to oil as a way to realize a higher return on investment.

The economy experienced a long and sustained period of economic growth during the 1960s. This was due to both strong levels of private consumption and investment, and increases in government spending and monetary policies that did not understand the inflation pressures building. The recession December 1969 to November 1970 was a result of a long period of economic growth ending. This is not unusual. Long periods of growth lead to economic imbalances that are not addressed, inventories grow, households accumulate debt, and the economy grows tired. In addition, the Federal Government took steps to reduce budget deficits during the late 1960s, a contractionary fiscal policy. Oil prices did not contribute to this recession.

The recessions of November 1973 to March 1975 and January 1980 to July 1980 were primarily a direct result of the oil shocks (severe supply constraints) during the early and late 1970s, the one in 1973 being most significant. The 1979 oil crisis was the result of the Iranian revolution. These oil shocks led to significantly higher oil prices that then reduced spending by both businesses and households. A significant decline in stock market values also occurred during the 1973 to 1974 period. There were other contributing factors that further clarify the reasons for the January 1980 to July 1980 recession. Inflation pressures building in the late 1960s and early 1970s resulted from the long period of economic growth during the 1960s, poor monetary policies, and ineffective fiscal policies. The wage and price controls implemented during the Nixon administrative were very counterproductive. Other policy mistakes were also made. These inflation pressures combined with higher oil and energy prices led to very high inflation rates (see this graph for an historical perspective). This led to very high interest rates leading to significant weakness in consumption and investment. The Federal Reserve, now under the leadership of Paul Volcker, engaged in very contractionary monetary policies that led to higher interest rates in order to greatly reduce demand, and ultimately lowers inflation rates both in the near and longer term. Other central engaged in the same policies. This was ultimately successful for longer term growth, but also this contributed to the January 1980 to July 1980 recession.

The very severe July 1981 to November 1982 was the result of the after affects of the 1979 oil crisis triggered by the Iranian revolution, and continued tight monetary policies. These monetary policies, undertaken here and in other western industrialized countries, were designed to reduce inflation pressures which they did do successfully, but this does contribute to near-term economic weaknesses Furthermore, the fiscal policies of President Reagan were designed to be expansionary, and this offset the Federal Reserve’s effort to control inflation, and there was uncertainty related to the outcome of these policies. The recession of July 1981 to November 1982 was serious, and the oil shocks of 1973 and 1979 did contribute to this recession.

Inflation reemerged as a minor concern in the late 1980s due to the period of economic growth that started in 1983, and this led to higher interest rates. In addition, the Savings and Loan Crisis in the late 1980s led to serious banking problems and downturns in some real estate markets. These factors, and higher oil prices in 1990 due to the first Gulf War led to the mild recession of July 1990 to March 1991. This recession was relatively short in duration, and oil prices contributed to this, but were not the only primary factor. The economy at this time, after years of inflation fighting by the Federal Reserve was much less susceptible to oil price shocks that could potentially trigger greater long-term inflation risks.

The primary stimulus for the March 2001 to November 2001 recession was the collapse of the stock market bubble, particularly the decline of the prices of stocks issued by dot-com companies and related firms. The important issues here was excess financial speculation raising stock prices to levels that were well above those supported by economic fundamentals. The collapse of this bubble led to a significant decline in wealth, reducing consumption. It also led to a decline in business investment as excess capacity existed in technology related productive capacity and infrastructure. Notice the end date for this recession, November 2001. This indicates that the events of September 11, 2001 extended rather than caused this recession. In addition, oil prices were not clearly a factor in this case.

The most recent recession started in December 2007 and will probably be determined to have ended during the fourth quarter of 2009. As we know, this recession was triggered by the bursting of the housing market bubble coupled with a severe financial crisis that compromised the banking and financial system globally. The crisis led to the failure or collapse of many of the largest financial institutions in the U.S., including AIG, Bear Stearns, Fannie Mae and Freddie Mac, and Lehman Brothers. It also weakened other major banks, led to a significant decline in the financial viability of automakers and other firms involved in the financial markets. As the speculative demand that triggered the housing and financial bubble built the bubble expanded, but when the speculative demand dried up, the bubbles burst. There are a lot of excellent resources available to be read about these events. Oil prices did play some role in this but it was relatively small. There was a surge in oil prices in 2008 that resulted in prices exceeding $140 per barrel during the summer of 2008. This speculation resulted or was caused by funds leaving other assets, and weakened an already very poor economy.

What do you think?

Here is a good, brief column (http://www.nytimes.com/2010/04/04/opinion/04friedman.html?ref=opinion), discussing the importance of immigration, education, and risk taking in promoting economic growth.