An overview of the fall of 2010- for the Fed and China

The recent history of monetary policy in the U.S. and China were reviewed in two WSJ articles today.  These articles basically gave the answers to two questions on my fall final exam.

Starting with the article on the U.S.:

WSJ 12-27-2010 "For Tough Fed Call, Even Hindsight Is Not 20-20" by JonHilsenrath

Summary: In November, the Fed went on another buying spree known as QE2 (quantitive easing 2).  This time around the Fed is buying more long term U.S.securities. The Fed's goal is to bring down long term interest rates to spur investing and spending.

However, 10 year Treasury yields reached their current 52 week low in Oct 2010 (at 2.33%) in expectation of the program, and have been trending up ever since. The 10 year Treasury opened at 3.4% today (12-27-2010).

Why did rates go up - exactly opposite of the Fed's goal? One possible explanation is that people think there will be much more inflation in the future, so they will pay less today for an IOU for a future amount (i.e. rate goes up). Another possible explanation is that fewer people want to buy U.S. long term securities right now - other investments are starting to look better (fewer buyers leads to lower price of bond, i.e. rate goes up).

It is easy to read too much into the recent movement in long term rate; rates are still at historically low levels, and would probably be higher had the Fed not acted.

So what did the Fed accomplish? According to the article, fears of deflation are falling - but some now fear inflation.  Evidence does not suggest inflation will be a problem any time soon, but perception matters. The Fed is paying a heavy price politically - and not just to domestic doubters.

Which leads us to international doubters:

WSJ 12-27-2010 "China Says It Can Subdue Prices" by Jason Dean

Summary: China is struggling with rising prices, particularly for food and housing. As a result they are raising interest rates and banks' ratio of reserves to deposits (reserves = cash which can't be lent out). China's goal is to slow down borrowing and growth - and hence prices.

An extra challenge for China is that they are raising rates while the U.S. is trying to lower them. This draws more investment funds or "hot money" into China. All those investors buying yuan to invest in China puts upward pressure on the yuan.  However, China is reluctant to let the yuan strengthen because its goods would then cost more in the U.S., and its exports would decline.

From Dean, "Chinese officials have openly criticized the Fed's quantitative easing, in part because they say it burdens emerging economies with potentially excessive capital inflows that could fuel inflation."

China may impose capital controls to keep "hot money" out and to make it easier for China to maintain the current yuan exchange rate. The article does not delve into which capital controls China is likely to impose but possibilities include: transaction taxes, exchange controls (limits on quantity of currency that can be exchanged), and controls on purchases of various financial assets.

Capital controls used to be frowned on by mainstream economists, but after the Asian crisis there is a begrudging consensus that capital controls may be a valid policy tool in some situations.

From Dean, the official inflation target rate in China has been raised from 3% for 2010 to 4% for 2011.

The Economist and "Life Begins at46"

The cover story of this week's Economist magazine is about happiness. Numerous surveys of happiness all over the world show that happiness depends on age - but not in the way you might guess.  My quick sketch below tells the story.

If you can just hang in there until your teenagers leave - life gets better. Alternative theories exist but that is my favorite (don't tell my kids). Other theories focus more on letting go of hopes and dreams and appreciating life as it is.

For more go to

Age and happiness: The U bend of life

If you don't have a subscription you might not be able to follow that link.

The Economist magazine is offering a free trial of four issues - I warn you, you might get hooked. Despite its name, The Economist is not an academic journal - it is more of a beefed up Time or Newsweek with a dose of humor. I often flip first to its sections on science and recommended books.


full subscriptions (not for students)

student subscriptions

The causes of the financial crisis and the documentary "The Inside Job"

A good start to understanding the causes of the financial crises:

Katie Couric Interview of "The Inside Job" director Charles Ferguson 11-9-2010
(36 minute interview)

Charles Ferguson has the credentials to be taken seriously.  According to Steve Dollar (10-1-2010 WSJ article - see link below),

 "[Charles Ferguson] The 55-year-old software millionaire-turned-filmmaker, whose 2007 Iraq War documentary, "No End in Sight," earned an Oscar nomination, is no gimmick-prone Michael Moore. He's a former policy wonk with a doctorate in political science from M.I.T."

Even if you saw the movie, this interview provides perspective and answers a few nagging questions.

If you didn't see the movie (which I recommend) watching this interview might allow you to fake expertise at cocktail parties. No one is spared. Academic economists take a big hit too.

 A partial list of causes of the financial crises stressed by Ferguson include:

1. regulators' conflict of interest (high incomes once return to private sector)

2. economists' conflict of interest (large consulting fees and paid-for-papers - which go undisclosed)

3. politicians' conflict of interest (hard to write tough regulations for your sponsors)

4. poorly designed compensation packages - that reward earnings regardless of risk

5. board of trustees' lack of independence and motivation to protect shareholders - friends of CEO rubber stamp compensation packages. 

6. investment banks are NOT required to consider clients' interests -  an investment bank can sell financial instruments that they think will fall in value to clients, and then bet against those financial instruments without disclosing anything to their clients.

7. Congress promoting proliferation of mortgages ("homeownership for all" may sound good  as a political slogan but there are consequences).

8. adoption of free market philosophy without full consideration of implications

Some other places to look:

(WSJ) No Straight Answers in Sight by Steve Dollar (10-1-2010)

(WSJ) Hiding, Harboring, Hoarding at Harvard by David Weidner (9-23-2010)

In today's New York Times

NYT (12-10-2010) A Secretive Banking Elite Rules Derivatives Trading

McKinsey and David Wessel

Video: Why trends matter

McKinsey director Peter Bisson explains the value of tracking global forces and how to build them into corporate strategy.

McKinsey audio podcast on increasing investment in emerging markets:
http://www.mckinsey.com/mgi/publications/assets/farewell_cheap_capital/index.asp

David Wessel's column in the WSJ is always a good read. He writes clearly and focuses on topics related to macroeconomics. Today, Wessel discusses a McKinsey report on global savings (Farewell to Cheap Capital, Dec. 2010). McKinsey is the "google" of think tanks - they attract the cream of the crop and do everything. The report's conclusion is not surprising - it is just handy to have numbers. Basically,  real interest rates are headed higher as China and emerging markets stop flooding the world with saving and start investing in their own infrastructure. While rich world households and governments are saving more, they are probably not saving enough to plug the gap. According to Wessel, McKinsey estimates that real long term rates may increase by 1.5%.

If you believe this will happen within 10 years then: 1. refinance that mortgage while rates are low if you can,  2. maybe wait to buy an annuity (higher rates are good for savers), and 3. count on slower world growth eventually.

Wessel's  article (Dec 9, 2010):
http://online.wsj.com/article/SB10001424052748704250704576005364008384394.html

McKinsey written report on Farewell to Cheap Capitol (Dec 2010):
http://www.mckinsey.com/mgi/publications/farewell_cheap_capital/index.asp

Bernanke on 60 Minutes, and Daily Show Response

link: http://www.youtube.com/watch?v=LxSv2rnBGA8

An interview with Ben Bernanke, the Chairman of the Fed, aired this Sunday December 5th, 2010 on 60 Minutes. Bernanke endorsed making plans now to rein in the deficit in the long term, but not to start implementing those plans until the recovery is more secure. Bernanke discusses how an immediate drop in government expenditure or increase in taxes would further dampen the economy (from class: shift AD left) leading to more unemployment.

Bernanke estimated it could take 4 or 5 years until unemployment returns to 5 to 6%. He did not use the term natural rate of unemployment, but that is what he appeared to mean.  Bernanke expressed concerns about the ability of the long term unemployed to find jobs again.  Perhaps concerns about the long term unemployed explain why he suggests our new natural rate of unemployment is higher than it was before the "Great Recession" (previous consensus was about  4.5 to 5%).





http://www.comedycentral.com/colbertreport/full-episodes/index.jhtml?episodeId=368141


The Daily Show (Jon Stewart) has fun with a Bernanke verbal fumble in this interview. The credit for this link goes to a commenter (thank you). Bernanke appears to contradict his earlier explanation of quantitative easing (QE). QE is the name for the Fed policy of buying financial assets with electronically created money to stimulate the economy and/or support key financial institutions.

Growth of Wealth and Health

Thanks to Corby Drone, I can suggest a wonderful new video clip. Not only does is it reveal world history in the last two hundred years in two minutes, it stunningly demonstrates the power of a good graph. I have added it my list of favorite serious videos (on left).



http://www.youtube.com/watch?v=jbkSRLYSojo

It was recently posted on Mankiw's blog.

The multiplier for fiscal stimulus

Boskin makes a  strong case against using fiscal policy to end recession:.
Prognosis: Congress should just focus on getting its long term accounts in order.


Michael Boskin WSJ 12-1-2010 on the multiplier and fiscal stimulus

Remittances

In the U.S. we don't focus much on remittances -  many people don't even know what they are. Worker remittances are money payments sent by immigrant individuals (not businesses) back to their home countries.  The World Bank also counts as remittances the compensation of employees who are migrant or border workers who live for less than a year in the host country. (*see note at end for World Bank's official definition).  In 2009, U.S. inflow remittances (from U.S. residents crossing the border to work in Mexico and Canada) were neglibile (2,947 million). The outflow remittances from the U.S. in 2009 were very small compared to the U.S. GDP (48,304 million) - only about .3% of GDP - but still made the U.S. the top source for remittances in the world. Source: the World Bank 2011 report on remittances cited below and U.S. BEA's published GDP estimates.  


For some countries, remittances from the U.S. count for a major portion of their income. Remittances from the U.S. were equal to 17% of El Salvador's GDP in 2008, and almost a quarter of El Salvador's families received remittances from the U.S. (Source: the U.S. Department of State report on El Salvador (http://www.state.gov/r/pa/ei/bgn/2033.htm).   The World Bank 2011 report on remittances finds that global remittances are more than two times greater than official aid.


Below highlighted in blue is a summary from the World Bank's Migration and Remittances Factbook 2011:  Published November 4, 2010 by World Bank, ISBN: 978-0-8213-8218-9; SKU: 18218. Access with graphs and maps online at

http://go.worldbank.org/QGUCPJTOR0


Worldwide remittance flows are estimated to have exceeded $414 billion in 2009, of which developing countries received $307 billion (This represents a small decline of 6 percent from the level in 2008). The true size, including unrecorded flows through formal and informal channels, is believed to be significantly larger. Recorded remittances are more than twice as large as official aid and nearly two-thirds of foreign direct investment (FDI) flows to developing countries.


In 2009, the top recipient countries of recorded remittances were India, China, Mexico, the Philippines, and Poland. As a share of GDP, however, smaller countries such as Tajikistan (50 percent), Tonga (38 percent), Moldova (31 percent), the Kyrgyz Republic (28 percent), and Lesotho (27 percent) were the largest recipients in 2008.


Rich countries are the main source of remittances. The United States is by far the largest, with $46 billion in recorded outward flows in 2008. Russia ranks as the second largest, followed by Switzerland and Saudi Arabia.

An excerpt (highlighted in blue) from another World Bank report from Remittances and Development: Lessons from Latin America, April 2008 Pablo Fajnzylber and Humberto Lopez al discusses the economic impact 
of remittances. (http://go.worldbank.org/MYSC3YO560 )

  

One of the main conclusions of Remittances and Development is that remittances do tend to reduce poverty and inequality and they have several positive growth-enhancing effects – e.g. higher savings, human capital investments, entrepreneurship, and bank deposits. However, these positive effects tend to be relatively modest compared to the development challenges faced by most countries in the region. Moreover, remittances can also reduce labor supply and lead to real exchange rate over-valuations. Overall, it appears that a healthy policy stance is that of combining measures to minimize negative effects on competitiveness and maximize the impact of remittances on access to financial services among the poor, while making improvements in the regulatory environment aimed at promoting secure and low cost remittances services and maintaining the focus on complementary growth-enhancing policies.

In terms of the simple AD & AS graph, remittances can be viewed as alternative to lending as an extra source to boost C & I. Thus assuming all else equal (including labor effort and nominal exchange rates), an increase in remittances should shift the AD curve right, increasing output and prices.


link to video clip above (2.5 minutes) 
http://www.youtube.com/watch?v=YHKbG7Js-64

World Bank Official Definition of remittances: Workers' remittances and compensation of employees comprise current transfers by migrant workers and wages and salaries earned by nonresident workers. Data are the sum of three items defined in the fifth edition of the IMF's Balance of Payments Manual: workers' remittances, compensation of employees, and migrants' transfers. Remittances are classified as current private transfers from migrant workers resident in the host country for more than a year, irrespective of their immigration status, to recipients in their country of origin. Migrants' transfers are defined as the net worth of migrants who are expected to remain in the host country for more than one year that is transferred from one country to another at the time of migration. Compensation of employees is the income of migrants who have lived in the host country for less than a year. Data are in current U.S. dollars.

Source World Bank staff estimates based on IMF balance of payments data.

Catalog Sources World Development Indicators

Efficient Cities

Too big to work - This article suggests that congestion issues are leading business to choose smaller - more manageable sized cities all over the world. Mumbai gets special attention - and not the good kind.

WSJ Efficient Cities 11-25-2010

India's Prime Minister Singh

                                             

                    

In today's WSJ (Friday 11-19-2010), there is an interesting article by Tom Wright and Vibhuti Agarwal about India's Prime Minister  Manmohan Singh. As stated in the WSJ, "Although Singh is a noted economist famous for introducing India's market-led reforms in 1991, much of Mr. Singh's political support rests on the perception that he is above reproach." His administration is now threatened with a scandal which is discussed in the article. As usual, it is the cover up that causes more trouble than the original transgression.

http://online.wsj.com/article/SB10001424052748704104104575622163077934440.html?mod=ITP_pageone_2

I started a companion blog for my EMBA students going to India this spring. It will be updated about once a week.

Go to http://econfanindia.blogspot.com/ to check it out.

Investment Strategy

In today's WSJ, Burton Malkiel rolls out some timeless investment advise (just before the release of the 10th edition of his book). As I list his book as one of my top five, I won't begrudge him the publicity.

Malkiel is professor of economics at Princeton and is one of many who advise investors to buy and hold. Market timing doesn't have a good track record.  Malkiel points out that missing out on the best 30 days of the market (because you did not time the market perfectly) can be the difference between profit and loss over a 14 year period.

Malkiel also makes a plug for low-cost investment. The fees paid for managed investment eat into returns, and few managed investments beat the market consistently for long.  Buffett is the hero in this category. Most investors should stick with index funds (of foreign and domestic stocks and bonds) from low-fee financial institutions like Vanguard.

'Buy and Hold is Still a Winner' by Burton Malkiel (need WSJ subscription)

A similar  2007 article from the Motley Fool

'Timing the Market' by The Motley Fool 1-23-2007

To summarize mainstream advice:
1. invest constant amount regularly (don't time market)
2. invest primarily in low-fee index funds
      for example 25% global stock fund, 35% domestic stock fund 40% bond fund
      rule of thumb - If investing for retirement, the percentage in bond funds should equal your age.
3. periodically adjust your portfolio to maintain desired allocation
4. save a lot
    If you are fully funding your own retirement at 65, saving 15-20% from the time you start working    would be ideal.
5. be smart about tax implications - max out your 401k
    

Review: Why the West Rules For Now - By Ian Morris

35 minute lecture (followed by Q&A)



Nothing jumped out at me in the paper today, so I am taking the opportunity to plug for my new favorite book. Why the West Rules - For Now by Ian Morris. It is one of those rare books that has changed the way I view the world.

Morris's book builds on my previous favorite book, Guns, Germs and Steel by Jared Diamond.  Diamond used archaeological evidence, historical record, and other scientific evidence to demonstrate that Western Civilization got an early head start due to geographical luck.

The hilly plains (slightly north of the fertile crescent, the land between the rivers) were blessed with more plants and animals suitable for domestication than anywhere else in the world. There were no pack animals capable of plowing or hauling in the Americas (llamas don't cut it) . Without easily stored high protein crops or  animals suitable for domestication, it is difficult to muster the surplus labor needed to philosophize or invent things. Furthermore, innovations in agriculture were much harder to spread across the extreme climate variation in vertical land masses (like the Americas and Africa) than horizontal land masses (like Eurasia). Finally, centuries of exposure to the diseases of domesticated animals gave early European conquistadors a potent invisible weapon that decimated the native populations of Central and South America.

After reading Diamond, I was left with a nagging question. I was convinced Eurasia had a big leg up, but it was still unclear to me why Europe industrialized before China or India.  China developed agriculture and domestication of animals independently very early (about 6800 B.C., about 3000 years after hilly plains) and had similar advantages of crops and animals suitable for domestication. China and India also share a horizontal land mass with Europe, and had traded with Europe for centuries.

Ian Morris was able to fill in this gap for me.  Morris organized his book to answer the question: Did Western Civilization's head start give it a long term lock on industrializing first? He started early in history (with the big bang!) and provided genetic evidence over the evolution of man to show that people across the planet are pretty much the same.  Explanations for economic differences do not have a racial foundation. Morris then plunged into a long, exhaustive (and a bit exhausting) chronicle of human history. I admit I may have skimmed some in the middle, but he grabbed me again by the end.

Many have argued against the long term lock idea, especially since China was more technologically advanced and wealthier from roughly 500 A.D. until about 1800 A.D. As I understand it, Morris argues that the main reason Western Civilization ended up industrializing first was the discovery of the new world. Europe had more motive to get there first - Europeans were trying to reach the wealth of India and China. Geography also helped again. Europeans were much closer to the Americas - crossing the Atlantic from Europe is much easier than crossing the Pacific from China. China had the technology to make the crossing before the Europeans, but had burned its fleets and turned inwards. Instead of crossing long seas for no clear reason,  China instead expanded into their northern steppes.

Spoiler alert: Morris concludes history was likely to play out like it has, even if key players were changed. He argues that modern times are different; with world destruction at risk, key players matter.
Morris concludes that the distinction between West and East will become irrelevant. Once the full potential of technological progress reaches its culmination, human society may become so different as to be unrecognizable today. As a science fiction fan, I enjoyed his multiple references to Isaac Asimov and  the speculations of futurists about where technology will take us.

I am still left with a few questions. Morris focuses on the dichotomy between China and the West with scant mention of other societies, in particular India. While I would be loathe to ask for an extra 100 pages of historical details, I am curious about other possible "cores" of civilization in Eurasia. I  am also curious why the Eastern Core did not bounce around, as opposed to the Western Core (from Egypt to Rome to England etc.)

After finishing Morris, I watched a few interviews with Ray Kurzweil, a leading guru on the future of technology. Kurzweil's talk at Google in 2009 is linked under top 5 videos (see right). For the more conservative skeptics among you, you may prefer to watch Kurzweil's  interview on the Glenn Beck show (on YouTube in four parts).  For me, it doesn't get much more interesting than "Rapture for Nerds".

The Fed and QE 2

Here are links two great articles about the Fed's QE 2 (not the cruise ship). QE 2, short for quantitative easing round 2, is the label that has stuck to the Fed's current spree of buying assets they don't usually buy. When the Fed buys things (with newly electronically created money) it injects new money into the economy to stimulate it. In QE 2, the Fed is buying longer term U.S. treasuries. In the first round of QE (starting in 2008), the Fed bought all kind of assets including private company debt and mortgage backed securities. Before 2008, the Fed primarily traded in short term U.S. treasuries, and in much lower quantities.

I agree with Alan Blinder that the Fed's newest purchases are not big enough to do very much to lower unemployment. However the Fed (as Yellen points outs) is charged by Congress to try to lower unemployment, so long as prices are stable.

QE 2 has faced tremendous international political heat because it might drive down the dollar (helping U.S. exports but hurting other export driven economies). Oddly, the dollar has strengthened significantly in the last few days. Apparently, concern about the safety of the Euro has driven traders back into the arms of the dollar. It just goes to show you that exchange rates are not very predictable.

1. WSJ Alan Blinder op ed 11-15-2010 in WSJ (WSJ subscription required)

http://online.wsj.com/article/SB10001424052748704658204575611052418939656.html?KEYWORDS=Alan+blinder

With lessons from Econ 101 - this is article is a great primer on the Fed and monetary policy. Alan Blinder was vice Chair of the Board of Governors from June 1994 to June 1996.

2. WSJ Janet Yellen interview 11-16-2010 in WSJ (WSJ subscription required)

http://online.wsj.com/article/SB10001424052748703670004575617000774399856.html?mod=ITP_pageone_0

Note: The first woman served on FOMC (Fed's committee for formulating monetary policy) in 1978. Janet Yellen is currently the vice-chair of the Board of Governors of the Fed.