Keynes Quotes for the 2007 FOMC Meetings

What J.M. Keynes might have said had he been at the 2007 FOMC meetings:

• It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. --General Theory (1935) Book 4, Chapter 12, Section 2, p. 148
• The decadent international but individualistic capitalism in the hands of which we found ourselves… is not a success. It is not intelligent. It is not beautiful. It is not just. It is not virtuous. And it doesn't deliver the goods. In short we dislike it, and we are beginning to despise it. But when we wonder what to put in its place, we are extremely perplexed. --National self-sufficiency (1933) Section 3, republished in Collected Writings Vol. 11 (1982).
• This is a nightmare, which will pass away with the morning. For the resources of nature and men's devices are just as fertile and productive as they were. The rate of our progress towards solving the material problems of life is not less rapid. We are as capable as before of affording for everyone a high standard of life ... and will soon learn to afford a standard higher still. We were not previously deceived. But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time — perhaps for a long time. --The Great Slump of 1930 (1930), in Essays in Persuasion
• The old saying holds. Owe your banker £1000 and you are at his mercy; owe him £1 million and the position is reversed. --Overseas Financial Policy in Stage III (1945), Collected Writings 24:258.

What Keynes might have said today in response to the transcripts:

• There were endless possibilities, not out of reach. --Essays in Bibliography (1933)
• Logic, like lyrical poetry, is no employment for the middle-aged. --Essays in Bibliography (1933)
• Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally. --General Theory (1935) Book 4, Chapter 12, Section 5, p. 158
• The disruptive powers of excessive national fecundity may have played a greater part in bursting the bonds of convention than either the power of ideas or the errors of autocracy. --The Economic Consequences of Peace (1919).
• Words ought to be a little wild for they are the assault of thoughts on the unthinking. --New Statesman and Nation (London, July 15, 1933).
• It is ideas, not vested interests, which are dangerous for good or evil. --Concluding Notes, ch. 24, The General Theory of Employment, Interest and Money (1936).
• I do not know which makes a man more conservative—to know nothing but the present, or nothing but the past. --The End of Laissez-Faire, ch. 1 (1926).

FOMC Transcripts: Housing Edition

The transcripts from the 2007 Federal Open Market Committee (FOMC) have just been released. These transcripts are released with a five-year lag. Naturally, economists and pundits are excited to see what people at the Fed did or did not know back then about the state of the economy and impending financial crisis.

The transcript from the January 30-31 meeting includes multiple discussions of the housing sector that suggest awareness of problems, but underestimation of their depth and duration. I've pasted some interesting housing remarks from the transcript at the end of this post. To accompany those, I took a look at what was actually forecast about housing, both at the Fed and by professional forecasters.

Fed forecasts in the Greenbook are also only available with a five-year lag, but the Survey of Professional Forecasters forecasts are available with hardly any lag. In the graph below, the thick navy line is actual housing starts (in millions of units) per quarter. The green line is the Fed's Greenbook forecast made one year earlier for housing starts in that quarter. The dashed line is the same forecast, made by professional forecasters (the median SPF forecast).

You can see that throughout the housing boom, both Fed and professional forecasters consistently underestimated housing starts. Housing starts started to fall in the second quarter of 2006 and have yet to recover to anywhere near their 2006 peak. Look at 2007 in the graph. The blue line is below the red line and far below the green line, which were the forecasts made in 2006 about 2007. I'll update the graph with Greenbook forecasts made in 2007 about 2008 when those are put online.

Here is another graph that shows Greenbook forecasts for housing starts made at multiple horizons. If you draw a vertical line up from a particular date, you will see forecasts made 1 quarter, 1 year, and 7 quarters earlier about housing starts at that date.

Quotes about housing starts in the January 30-31 transcripts:

Mr. Slifman: As I noted earlier, the leveling-off of home sales, the uptrend in mortgage applications, and the improvement in homebuying attitudes suggest that housing demand may be leveling off... cyclical recoveries in sales and starts have generally been fairly coincident historically...Accordingly, we think that the recent stabilization of sales should be accompanied soon by a stabilization of starts.

Mr. Stockton: As Larry said, even given the overall dimensions of the housing shock, we've been encouraged about our story of stabilization.  But I remember that, as we went into the investment shock earlier in this decade, we just didn't have enough imagination about how bad things could get, and we kept thinking that we were seeing signs of slowing or stabilization, that the new technology was still great, and that there should be reasons or underlying motivation for investment.  Perhaps what we've seen recently as stabilization are the beneficial effects of the drop in long-term interest rates that occurred from last summer into the fall and pulled some people forward, but really we may not have fully made the adjustment yet.  The overhang of unsold homes out there is very large, and we could be underestimating the size and duration of that.     

Mr. Stern: The housing sector is subdued, but the District data on sales and starts suggest stabilization, as do the national data.  The data on the inventory of unsold homes perhaps are contradictory to that statement because there are still a lot of unsold properties; at least those data suggest that it will be some time before there is any pickup in housing activity.  In any event, as Bill Dudley mentioned, mortgage delinquencies and foreclosures are rising, albeit starting from a fairly low level, and though that probably won’t have a significant effect on economic performance, it could be a political issue in Minnesota and elsewhere in the District.

Mr. Fisher: I did talk to two of the top five housing CEOs and a third one, a smaller company.  They seem to confirm the sense of the staff in that they feel that the housing situation is bottoming out, but they continue to caution that any reading of the housing industry between Thanksgiving and the Super Bowl is of questionable value.

Coffee Houses and Blogs

Now that I'm blogging regularly again, I am reminded of the coffee houses in late seventeenth and early eighteenth century London, which, much like the blogosphere, revolutionized the way the public consumes and interacts with information. For the small price of a cup of coffee, coffee house patrons could participate in the great social interactions of information exchange. Here's part of a delightful old broadside song from 1667 about the coffee houses. As you read it, think a bit about the blogging world.

You that delight in wit and mirth,
And long to hear such news
As come from all parts of the earth,
Dutch, Danes, and Turks, and Jews,
I'll send you to a rendezvous,
Where it is smoking new;
Go hear it at a coffee-house,
It cannot but be true. 

There's nothing done in all the world,
From monarch to the mouse,
But every day or night 'tis hurled
Into the coffee-house.
What Lily, or what Booker can
By art not bring about,
At coffee-house you'll find a man
Can quickly find it out. 

They know all that is good or hurt,
To bless ye, or to save ye;
There is the college, and the court,
The country, camp, and navy;
So great a university,
I think there ne'er was any,
In which you may a scholar be
For spending of a penny. 

A merchant's prentice there shall show
You all and everything
What hath been done, and is to do,
'Twixt Holland and the King;
What articles of peace will be
He can precisely shew;
What will be good for them or we
He perfectly doth know.

I wrote on my old blog: 

The coffee house revolution and the Internet revolution both changed the was we socially interact with information. In 1674, "The Women's Petition Against Coffee" argued that coffee made men idle and impotent, much as many women today feel about mainly-male online "vices" like online gaming, or the way we all wonder what we're doing spending so much time interacting through a screen. Individual coffee houses came to be associated with particular types of clientele: houses for literary wits, for learned scientists, for lawyers, etc. So people socialized and shared and interacted over the news with other people like themselves-- much like we tend to read the news stories that our own social groups share with us or read blogs by people who think more or less like we think. The fact that we can custom tailor our news exposure to our own interests is a source of both excitement and criticism; it helps us in the necessary task of filtering information, but limits the breadth of our exposure. 

The coffee houses, like the Internet, changed the way finance was conducted. Financial markets are markets in information. So it is important to realize that information exists in a social, political, and cultural context. It is how we interact with it; it is inseparable from its transmission. 

Just for Fun.

My favorite album of 2012 was Some Nights by Fun. I'm not sure how I didn't notice this before, but the song titles and lyrics describe graduate school to an almost spooky degree. Here's a track name and some lyrics for the major phases of grad school.

Start of grad school: We Are Young

So let's set the world on fire, we can shine brighter than the sun.

Middle of first year: It Gets Better

What have we done, oh my god. This is really happening.
You never looked so bored. Can you feel my fingernails? They've never been so short...
Yes, I know it hurts at first but it gets better.
It gets better, it gets better. It gets better, we'll get better.

Second year: One Foot

To my left there's a window.Where did I go?...
And bad ideas, but ideas nonetheless and so
I put one foot in front of the other one. (Oh oh oh!)
I don't need a new love or a new life just a better place to die.

Field exams: All Alright

And it's all alright.
I guess it's all alright.
I got nothing left inside of my chest,
But it's all alright.

Third year: Some Nights

What do I stand for? What do I stand for?
Most nights I don't know.

Fourth Year: Carry On

If you're lost and alone, or you're sinking like a stone
Carry on.

Fifth Year: Why am I the One

I think I kinda like it but I might of had too much.

(If this is your kind of humor, also see Shakira Teaches Economics.) 

Loving the Long Shot

The latest recipient of the 2012 Carolyn Shaw Bell Award is Professor Catherine Eckel of Texas A&M. This award is given annually by the American Economic Association Committee on the Status of Women in the Economics Profession (CSWEP) to recognize an individual who has furthered the status of women in economics. Eckel is an experimental economist who has studied the role of a wide range of social and psychological factors in economic exchange-- attitudes toward risk, gender differences, beauty, trust, corruption, and charitable giving, to name a few.

One of her recent papers is particularly interesting from a macroeconomics and finance perspective: "Loving the Long Shot: Risk Taking with Skewed Lotteries" (2012, with coauthor Philip Grossman). The study addresses a widely noted conundrum, that risk-averse individuals voluntarily play the lottery. The expected payoff of a lottery ticket is less than the price of the ticket. Lotteries are positively skewed, since the vast majority of tickets have low payoff but there is a very small probability of a very large prize. Eckel and Grossman use a laboratory protocol to elicit the skewness preferences of 93 test subjects. They can isolate the effect of positive skewness on subjects' willingness to take risky gambles. If you haven't read an experimental economics paper before, I highly recommend reading Section 3 (pages 7-9) of their paper for an idea of how experimental design works in this field. From the conclusions:

We find that, controlling for risk preferences, individuals are overwhelmingly skewness-seeking in their lottery choices; lotteries with skewed payoffs are more attractive than lotteries with the same expected earnings and risk (variance) but lacking skewness.  Given equal expected earnings and risk, 84.9 percent of our subjects select a lottery with skewness = 1 over a lottery with skewness = 0 and 88.2 percent also prefer a lottery with skewness = 1 or 2 to a lottery with skewness = 0... More importantly, we find that increased skewness in the payoff structure entices a sizeable share of our sample (37.6 percent) to take on greater risk in their choice of lotteries. The change in lottery choices resulting from the skewing of payoffs increases the risk subjects face more than three times as much as it increases their expected payoffs.

The first thing that came to mind when I read this paper was the remarkable lottery loan governemnt fundraising scheme in England in the late 17th and early 18th century, shortly before the South Sea Bubble. An unprecedentedly large lottery was called the "Two Million Adventure." Tickets cost £100 and guaranteed a 6% yield annuity. In addition, tickets won prizes. The maximum prize was £20,000 and every ticket won a prize of at least £10. Prizes were paid in the form of a fixed sum annuity over a period of years, meaning the government held the prize money as a loan until it was paid out to the winners. Investors went crazy for tickets, and all tickets were sold within 9 days. Lottery payoffs were positively skewed. Including the prizes, the great mass of investors earned around a 6.5% yield, but a few lucky winners won much larger amounts, including one grand prize winner. Overall, the average yield was 8%, but the vast majority earned less and a few earned much more. Standard risk preferences suggest that investors would have preferred to buy annuities that simply guaranteed 8% yield, but Eckel's findings explain why investors so loved the lottery tickets. Richard Dale's book "The First Crash: Lessons from the South Sea Bubble" explains how the lottery loans were related to the notorious South Sea Bubble.

Lottery loans were hugely popular in other countries too. The New York Times in 1889 noted that "The new lottery loan has caused a perfect mania among the public of St. Petersburg... At least one hundred times the amount of the 172,000,000 rubles required have already been offered."

Today in the U.S., 42 states and the District of Colombia have lotteries, but positively-skewed payoffs in finance are much more pervasive than explicit lotteries. Most data on stock prices or asset returns has positive or negative skew (unlike normally-distributed data which has zero skew.) For large banks, an implicit or explicit bailout guarantee can put a lower bound on the payoff of risky investments without imposing an upper bound, a widely recognized source of moral hazard which has frequently been blamed for the financial crisis. Prevalent and strong skewness-seeking preferences could make the moral hazard problem stronger than standard models would predict. 

I am glad that CSWEP recognized Eckel's contributions to women in economics and hope the wider economic community will spend some time reviewing and discussing her very interesting research.

Monetary Policy and Inequality

Technical statistical details don't usually make headlines, but in Britain they have, and for good reason. The Office for National Statistics (ONS) announced that they would not change the way they calculate the Retail Prices Index (RPI), the country's oldest measure of inflation. A change to the RPI was expected because the formula used to calculate it is widely recognized as flawed.

The Consumer Price Index (CPI) is the price index used for inflation targeting and other macroeconomic purposes. It was introduced in the 1990s and is calculated in a similar fashion across countries. Compared to the CPI, the RPI tends to be higher by around 1.3 percentage points. Why does this upward bias matter? The RPI is used as the price index for inflation-linked government bonds and for many company pension payments. If the ONS had changed the formula, pensioners and holders of these bonds would have received lower future payments. Pensioners tend to be older, so some groups representing older people lobbied against the change. Of course, other people would have benefited from the change, namely some companies and taxpayers who are financing these pensions and bonds.

This actually brings up a broader point about monetary policy. Protection against inflation varies significantly across the population, so monetary policy is redistributive. People don't all experience inflation in the same way. It depends on the share of their income that comes from labor income versus financial income and also on the proportion of their assets indexed to inflation. Moreover, some people's wages are indexed to inflation or at least respond quickly to inflation, while other wages are "stickier." And as illustrated by the RPI situation, even inflation-linked assets may not perfectly track inflation dynamics. Age, income, employment status, and asset holdings all play a role in determining how monetary policy affects a person.

My adviser Yuriy Gorodnichenko and several coauthors have a recent paper called "Innocent Bystanders? Monetary Policy and Inequality in the U.S." They note that there are several theoretical channels through which monetary policy can affect income inequality. For example, if low-income households tend to hold relatively more currency than high-income households, then increased inflation would create a transfer from low-income households toward high-income households. Some of the channels predict that monetary policy will increase inequality, while other channels predict that monetary policy will decrease inequality. So a priori, the effect of monetary policy on inequality is ambiguous. Through careful empirical work, they are able to determine which channels are strongest. They find that monetary policy accounts for about 10-20% of the increase in inequality since the 1980s. In particular, contractionary monetary policy shocks "have effects on labor earnings which vary systematically across the income distribution: labor income rises at the upper end of the distribution and falls at the lower end." (Their empirical results apply to the United States, not to Britain, where the relative strength of the various channels could be different.)  Considering the redistributive impacts of monetary policy, not just its overall impact on GDP, is an important challenge.

Things I Think of When I Can't Sleep

Commodity Money

Fiat Money

                

                                        

                       Commodity Bunny

Fiat Bunny