MAY 21 2010

Robert J. Shiller, NYT: Fear of a Double Dip Could Cause One. World markets soared initially on the announcement of the nearly $1 trillion rescue plan, and then declined. But as the economist John Maynard Keynes cautioned long ago, such market reactions are basically a “beauty contest” — with investors trying to predict the short-term reaction that other investors think still other investors will have. In other words, don’t view these beauty contests as a heartfelt response to a fundamental change in the economy. In fact, there is still a real risk of a double-dip recession, though it can’t be quantified by the statistical models that economists use for forecasts. Instead, the danger stems from the weakness and vulnerability of confidence — whose decline could bring markets down, further stress balance sheets and cause cuts in consumption, investment and local government expenditures.

Justin Weidner, John C. Williams, San Francisco Fed: The Shape of Things to Come. Economic recoveries from the past two recessions have been much more gradual than the rapid V-shaped recoveries typical of earlier downturns. Analysis of the factors that determine economic growth rates indicates that recovery from the most recent recession is likely to be faster than from the two previous recessions, but slower than earlier V-shaped recoveries.

Paul Krugman, NYT Blog: Et Tu, Wolfgang? Perhaps the most startling and frustrating thing about the debate over the fate of the euro is the way almost everyone avoids confronting the core issue — the elephant in the euro. With a unified currency, adjustment to differential shocks requires adjustments in relative wages — and because the nations of the European periphery have gone from boom to bust, their adjustment must be downward. At this point, wages in Greece/Spain/Portugal/Latvia/Estonia etc. need to fall something like 20-30 percent relative to wages in Germany.

Edward Hugh, Fistful of Euros Blog: Much Ado About (Some Of) The Wrong Things. In this context I can either see one of two alternatives: a) either Germany (and possibly one or two other smaller economies) temporarily leaves the eurozone and revalues; or b) The peripheral economies undertake a sizeable internal devaluation (say 20%, but this is just a rule of thumb estimate). At the present time most EU policymakers remain unconvinced that we need a shift of this magnitude. Yet there is surprisingly little detailed study of how the economies concerned are going to get back to growth without this price correction. Indeed the EU Commission itself has strongly pointed out that the rates of private consumption growth being assumed for these economies by the national governments in the Stability Programme estimates are highly optimistic. What would be nice would be for someone to set up a small model to try to examine just how much ongoing growth in the combined goods and services trade surplus countries like Spain now need to achieve to get positive growth in headline GDP under a variety of different assumptions, including stagnant domestic consumption and reduced fiscal spending

Caroline Baum, Business Week: Greek Contagion Myth Masks Real Europe Crisis. I hate to pour cold water on that theory, but healthy countries aren’t susceptible to Greece’s disease. The sick ones, already plagued with high debt levels and bloated state budgets, don’t need a carrier. Capital flight from these countries “is not evidence of contagion,” said economist and author Anna Schwartz. Of course, Schwartz said that in 1998 following the Asian financial crisis. Schwartz punctured the notion that financial crises spread from the initial source to innocent victims. Nations are vulnerable because of their “home grown economic problems,” she said. Schwartz’s insights are equally valid today. Capital isn’t fleeing sovereign debt markets in Spain and Portugal because Greece can’t pay its bills. Bond yields are rising because of an increased risk those countries may find themselves in the same boat as Greece: unable meet their debt obligations.

IMF: Fiscal Monitor. Navigating the Fiscal Challenges Ahead. Even as the global economy improves, fiscal balances in the advanced economies are, on average, worsening. While World Economic Outlook projections for 2010 output growth in the advanced economies have increased by a full percentage point since the last issue of the Monitor, updated projections in Section I of the Monitor show that after discounting for reduced financial sector support operations, both headline and cyclically adjusted (CA) fiscal deficits in these countries will increase in 2010—relative both to the 2009 outturn and to projections made six months ago. Based on current likely policies, the advanced economies will continue to run sizable primary deficits over the medium term, leading the average general government gross debt ratio—which has already ballooned by close to 20 percent of GDP since the onset of the crisis—to rise by a further 20 percentage points by 2015, reaching about 110 percent of GDP. These developments are occurring amid heightened market sensitivity to variations in fiscal performance across countries. Section II shows that many countries will be facing historically high financing requirements this year, making them especially susceptible to market pressures.

Pragmatic Capitalism Blog: A Deflationary Red Flag in the $ U.S. Dollar. If the chart below doesn’t grab your attention then few things will. In my opinion, the performance of the dollar is the surest evidence of the kind of environment we’re currently in. The surging dollar is a clear sign that inflation is not the concern of global investors. This is almost a sure sign that deflation is once again gripping the global economy and should be setting off red flags for equity investors around the world. The recent action in the dollar is eerily reminiscent of the peak worries in the credit crisis when deflation appeared to be taking a death grip on the global economy and demand for dollars was extremely high. The recent 16% rally in the dollar is a sign that investors are once again worried about the continuing problem of debt around the world and they’re reaching for the safety of the world’s reserve currency – the dollar. As asset prices decline and bond yields collapse this is a clear sign that inflation is not the near-term concern, but rather that the debt based deflationary trends continue to dominate global economic trends.

Narayana R. Kocherlakota, Minneapolis Fed: Modern Macroeconomic Models as Tools for Economic Policy. It is hard to compute macro models with financial frictions. It does not become easier to compute models with both labor market frictions and financial frictions. The models do not capture an intermediate messy reality in which market participants can trade multiple assets in a wide array of somewhat segmented markets. As a consequence, the models do not reveal much about the benefits of the massive amount of daily or quarterly reallocations of wealth within financial markets. The difficulty in macroeconomics is that virtually every variable is endogenous, but the macroeconomy has to be hit by some kind of exogenously specified shocks if the endogenous variables are to move.

CBO: How Policies to Reduce Greenhouse Gas Emissions Could Affect Employment. The Congressional Budget Office (CBO) has analyzed the research on the effects that policies to reduce green house gases would have on employment and concluded that total employment during the next few decades would be slightly lower than would be the case in the absence of such policies. In particular, job losses in the industries that shrink would lower employment more than job gains in other industries would increase employment, thereby raising the overall unemployment rate. Eventually, however, most workers who lost jobs would find new ones. In the absence of policies to reduce emissions of greenhouse gases, changes to the climate also might affect employment; however, this brief does not address such changes because that effect would probably arise after the next few decades, and it has not been studied as carefully by researchers.

Sewell Chan, Washington Post: Is Ben Bernanke Having Fun Yet? Nine days ago, Ben S. Bernanke, the Federal Reserve chairman, caught a Friday-night flight from here so he could address 1,100 graduates at the University of South Carolina the next morning about “The Economics of Happiness.” After the speech, he took a call in his hotel room from Jean-Claude Trichet, head of the European Central Bank, and the next day pledged billions of dollars to help Europe stave off a financial crisis — a flashback to the huge lending programs the Fed put together in 2008 to forestall economic collapse at home. Mr. Bernanke, 56, hasn’t had much time to reflect on whether history’s verdict on his extraordinary actions of recent years will be harsh or forgiving. Nor has he had time to read the spate of new books about how he and two Treasury secretaries, Henry M. Paulson Jr. and Timothy F. Geithner, navigated a maelstrom that left millions of Americans jobless, homeless or broke.

Arne Feddersen, Wolfgang Maennig, University of Hamburg: Mega-Events and Sectoral Employment: The Case of the 1996 Olympic Games. This paper extends earlier studies in several ways. First, monthly rather than quarterly data will be employed. Second, the impact of the 1996 Olympics will be analyzed for 16 different sectors or subsectors. Third, in addition to standard DD models, we use a non-parametric approach to flexibly isolate employment effects. Regarding the Olympic effect, hardly any evidence for a persistent shift in the aftermath of or the preparation for the Olympic Games is supported. We find a significant positive employment effect in the monthly employment statistics exclusively during the staging of the Olympic Games (July 1996). These short-term effects are concentrated in the sectors of “retail trade”, “accommodation and food services”, and “arts, entertainment, and recreation”, while other sectors showed no such effects.

Markus Brückner, Hans Peter Grüner, VoxEU: The OECD’s growth prospects and political extremism. Will the global crisis lead to a rise in political extremism just as during the Great Depression? This column examines the vote share for extreme parties in a sample of 16 OECD countries over three decades. A one-percentage-point decline in growth leads to a one-percentage-point increase in the vote share for right-wing or nationalist parties.

Paul Frijters, Juan D. Barón, IZA: The Cult of Theoi: Economic Uncertainty and Religion. Sacrifices to deities occur in nearly all known religions. In this paper, we report on our attempts to elicit this type of religious behaviour towards “Theoi” in the laboratory. The theory we test is that, when faced with uncertainty, individuals attempt to engage in a reciprocal contract with the source of uncertainty by sacrificing towards it. In our experiments, we create the situation whereby individuals face an uncertain economic payback due to “Theoi” and we allow participants to sacrifice towards this entity. Aggregate sacrifices amongst participants are over 30% of all takings, increase with the level of humanistic labelling of Theoi and decrease when participants share information or when the level of uncertainty is lower. The findings imply that under circumstances of high uncertainty people are willing to sacrifice large portions of their income even when this has no discernable effect on outcomes.

MAY 14 2010

Carmen M. Reinhart, Vincent R. Reinhart, Washington Post: 5 Myths about the European debt crisis. 1. This is a new type of crisis. 2. Small economies such as Greece can't launch major financial turmoil. 3. Fiscal austerity will solve Europe's debt difficulties. 4. The euro is to blame for Greece's financial woes. 5. It can't happen here.

Martin Wolf, Wolfexchange: Must large capital inflows always end in crisis? Why is running current account deficits so dangerous? There are four reasons: first, it often means unsustainable asset price bubbles in the capital-importing country; second, it means unsustainable build-ups of debt in the private and public sectors of the capital-importing economy; third, it often means an unsustainable expansion of the financial system, characterized by excessive leverage and excessive build-ups of risky assets financed by supposedly risk-free liabilities; finally, it also often means a build-up of currency mismatches within the economy, particularly in the financial system, which makes the economy extremely vulnerable to currency collapses.

Carlos Caceres, Vincenzo Guzzo, Miguel Segoviano: IMF: Sovereign Spreads: Global Risk Aversion, Contagion or Fundamentals? Over the past year, euro area sovereign spreads have exhibited an unprecedented degree of volatility. This paper explores how much of these large movements reflected shifts in (i) global risk aversion (ii) country-specific risks, directly from worsening fundamentals, or indirectly from spillovers originating in other sovereigns. The analysis shows that earlier in the crisis, the surge in global risk aversion was a significant factor influencing sovereign spreads, while recently country-specific factors have started playing a more important role. The perceived source of contagion itself has changed: previously, it could be found among those sovereigns hit hard by the financial crisis, such as Austria, the Netherlands, and Ireland, whereas lately the countries putting pressure on euro area government bonds have been primarily Greece, Portugal, and Spain, as the emphasis has shifted towards short-term refinancing risk and long-term fiscal sustainability. The paper concludes that debt sustainability and appropriate management of sovereign balance sheets are necessary conditions for preventing sovereign risk from feeding back into broader financial stability concerns.

Robert Samuelson, Real Clear Politics: The Welfare State's Death Spiral. The welfare state's death spiral is this: Almost anything governments might do with their budgets threatens to make matters worse by slowing the economy or triggering a recession. By allowing deficits to balloon, they risk a financial crisis as investors one day -- no one knows when -- doubt governments' ability to service their debts and, as with Greece, refuse to lend except at exorbitant rates. Cutting welfare benefits or raising taxes all would, at least temporarily, weaken the economy. Perversely, that would make paying the remaining benefits harder. If only a few countries faced these problems, the solution would be easy. Unlucky countries would trim budgets and resume growth by exporting to healthier nations. But developed countries represent about half the world economy; most have overcommitted welfare states. What happens if all these countries are thrust into Greece's situation? One answer -- another worldwide economic collapse -- explains why dawdling is so risky.

Alina Carare, Ashoka Mody, IMF: Spillovers of Domestic Shocks: Will They Counteract the “Great Moderation”? The paper has three main findings. First, the reduction in output volatility apparently ceased in some advanced industrialized countries by the mid-1990s, and a mild tendency towards increased volatility was evident in some countries. Besides Japan (documented by Bernanke, 2004), one large country experiencing an increase in output growth volatility is Germany. Second, and of greater significance for interpreting recent events, the bottoming out of the decline in volatility and its possible reversal was associated with an increased role for spillovers, starting sometime in the mid-1990s. Third, it was not the size of the spillover "shocks" but rather the sensitivity of countries to these shocks that increased over time.

Greg Mankiew: Does a common currency area need a centralized fiscal authority? Paul Krugman has a thoughtful and thought-provoking column on Greece today. A large part of his argument is that Europe is not an optimal currency area because it lacks a large central government enacting transfer payments among the various regions. I am not so sure. The United States in the 19th century had a common currency, but it did not have a large, centralized fiscal authority. The federal government was much smaller than it is today. In some ways, the U.S. then looks like Europe today. Yet the common currency among the states worked out fine.

Pierre Monnin and Terhi Jokipii, SnB: The Impact of Banking Sector Stability on the Real Economy. This article studies the relationship between the degree of banking sector stability and the subsequent evolution of real output growth and inflation. Adopting a panel VAR methodology for a sample of 18 OECD countries, we find a positive link between banking sector stability and real output growth. This finding is predominantly driven by periods of instability rather than by very stable periods. In addition, we show that an unstable banking sector increases uncertainty about future output growth. No clear link between banking sector stability and inflation seems to exist. We then argue that the link between banking stability and real output growth can be used to improve output growth forecasts. Using Fed forecast errors, we show that banking sector stability (instability) results in a significant underestimation (overestimation) of GDP growth in the subsequent quarters.

Edward L. Glaeser, Joshua Gottlieb, Joseph Gyourko, Harvard: Did Credit Market Policies Cause the Housing Bubble? Theoretical and empirical analyses suggest that neither interest rates, nor downpayment requirements, nor approval rates moved enough over the past decade to generate the magnitude of price changes that parts of the United States experienced. Moreover, other standard explanations for rising housing prices, like rising incomes, also fail to explain much of the price volatility. Using the standard toolkit of the empirical economist, we are unable to offer much of an explanation for what happened. We do believe that faulty expectations played some role in what happened. If economists are going to better understand housing bubbles, we will surely need to accept that home buyers often have very exuberant beliefs about housing prices.

Eric A. Hanushek, Ludger Woessmann, NBER: The Economics of International Differences in Educational Achievement. This chapter reviews the economic literature on international differences in educational achievement, restricting itself to comparative analyses that are not possible within single countries and placing particular emphasis on studies trying to address key issues of empirical identification. While quantitative input measures show little impact, several measures of institutional structures and of the quality of the teaching force can account for significant portions of the immense international differences in the level and equity of student achievement. Variations in skills measured by the international achievement tests are in turn strongly related to individual labor-market outcomes and, perhaps more importantly, to cross-country variations in economic growth.

Nicola D. Coniglio, Giuseppe Celi, Cosimo Scagliusi, University of Bari: Organized Crime, Migration and Human Capital Formation: Evidence from the South of Italy. The presence of organized crime is a pervasive feature of many developed and developing countries. Even if ‘mafia’ organizations have greatly enlarged the geographical scope of their activities, as in the past they are still deeply rooted in specific territories where their presence generates a host of influences on socio-economic performances (perverse social capital). We identify municipalities where the presence of organized crime is particularly pervasive in an Italian region, Calabria, where is based one of the most powerful international criminal organization, 'Ndrangheta. Our results suggest that the presence of organized crime inhibits the accumulation of human capital both directly (reducing the incentive to invest in formal education) and indirectly by increasing migration outflows.

Ian Ayres, Barry Nalebuff: Lifecycle Investing: A New, Safe, and Audacious Way to Improve the Performance of Your Retirement Portfolio. Of course, to more evenly expose yourself to the market, you have to buy more stock when you’re young. The problem is that most people haven’t saved much for retirement in their 20s and 30s. It would be nice to buy more stock when you’re starting off. But a reasonable initial reaction is that you can’t invest what you don’t have. That’s just wrong. If you’ve saved $4,000 for retirement, you can borrow another $4,000 and invest $8,000 in stock index funds. The idea of mortgaging your retirement savings seems to go against everything we’ve been taught about prudence. I hope to convince you that modest amounts of leverage when you’re young can pay big diversification benefits.

Ben S. Bernanke, Fed: The Economics of Happiness. Notwithstanding that income contributes to well-being, the economics of happiness is also a useful antidote to the tendency of economists to focus exclusively on material determinants of social welfare, such as the GDP. GDP is not itself the final objective of policy, just as an increase in income may not be a good enough reason for you to change jobs. Obtaining broader measures of human welfare is challenging, but not impossible. Indeed, the United Nations has produced its human development reports for 20 years, and the Organisation for Economic Co-operation and Development has been engaged in a comprehensive project to examine the progress of societies in order to ensure that economic policymaking focuses on improving human welfare, broadly construed

MAY 7 2010

Gara Afonso, Anna Kovner, Antoinette Schoar. VoxEU: What happened to US interbank lending in the financial crisis? Many commentators have argued that interbank lending froze following the collapse of Lehman Brothers. This column presents evidence from the fed funds market that, while rates spiked and loan terms became more sensitive to borrower risk, mean borrowing amounts remained stable on aggregate. It seems likely that the market did not expand to meet additional demand for funds.

Stephen LeRoy, San Fransisco Fed: Is the “Invisible Hand” Still Relevant?

The single most important proposition in economic theory, first stated by Adam Smith, is that competitive markets do a good job allocating resources. Vilfredo Pareto’s later formulation was more precise than Smith’s, and also highlighted the dependence of Smith’s proposition on assumptions that may not be satisfied in the real world. The financial crisis has spurred a debate about the proper balance between markets and government and prompted some scholars to question whether the conditions assumed by Smith and Pareto are accurate for modern economies.

Susann Rohwedder, Robert Willis, RAND: Mental retirement. Some studies suggest that people can maintain their cognitive abilities through “mental exercise.” This has not been unequivocally proven. Retirement is associated with a large change in a person’s daily routine and environment. In this paper, we propose two mechanisms how retirement may lead to cognitive decline. For many people retirement leads to a less stimulating daily environment. In addition, the prospect of retirement reduces the incentive to engage in mentally stimulating activities on the job. We investigate the effect of retirement on cognition empirically using cross-nationally comparable surveys of older persons in the United States, England, and 11 European countries in 2004. We find that early retirement has a significant negative impact on the cognitive ability of people in their early 60s that is both quantitatively important and causal. Identification is achieved using national pension policies as instruments for endogenous retirement.

John Robertson, Atlanta Fed: The young and the restless. The contribution of opening small firms to net job growth is very large (averaging about 1 million jobs a quarter). In fact, when opening firms are netted out of the data, existing firms on average destroy more jobs than they create. Job creation at new firms has been relatively stable over time. During the recessionary period from the end of 2007 through the second quarter of 2009, the decline in jobs created at opening firms was surprisingly small. Job losses at closing firms did not surge in the most recent recession. In fact, job destruction caused by closing firms is relatively stable over time (research suggests that, in addition to the fact that many firms get smaller before they finally close, there is a significant "up or out" phenomenon in that many firms that closed were recently opened firms that failed). Most of the cyclical action is at surviving firms, and larger surviving firms tend to account for most of the variation in net employment change. During the recessionary period from the end of 2007 through the second quarter of 2009, surviving firms with at least 50 employees lost about twice as many jobs as firms with fewer than 50 employees (see for example, the study by Moscarrini and Postel-Vinay on the relative cyclical sensitivity of large and small firms).

Daniel Aaronson, Bhashkar Mazumder, Shani Schechter, Chicago Fed: What is behind the rise in long-term unemployment? In particular, we attribute the sharp increase in unemployment duration in 2009 to especially weak labor demand, as reflected in a low rate of transition out of unemployment into employment, and a smaller portion of this increase (perhaps 10 percent to 25 percent) to extensions in unemployment insurance benefits. We show that, in any given month, individuals with longer unemployment spells are less likely to be employed the following month. This suggests that the average ongoing spell of unemployment is likely to remain longer than usual well into the economic recovery and expansion, plausibly keeping the unemployment rate above levels observed in past recoveries.

Mirko Abbritti, Sebastian Weber, ECB: Labor market institutions and the business cycle Unemployment rigidities vs. real wage rigidities. This paper investigates the importance of labor market institutions for inflation and unemployment dynamics. Using the New Keynesian framework we argue that labor market institutions should be divided into those institutions that cause Unemployment Rigidities (UR) and those that cause Real Wage Rigidities (RWR). The two types of institutions have opposite effects and their interaction is crucial for the dynamics of inflation and unemployment. We estimate a panel VAR with deterministically varying coefficients and find that there is a profound difference in the responses of unemployment and inflation to shocks under different constellations of the labor market.

Bernt Bratsberg, Elisabeth Fevang, Knut Roed, IZA: Disability in the Welfare State: An Unemployment Problem in Disguise? Economies with low unemployment often have high disability rates. In Norway, the permanent disability insurance rolls outnumber registered unemployment by four to one. Based on administrative register data matched with firms' financial statements and closure data collected from bankruptcy proceedings, we show that a large fraction of Norwegian disability insurance claims can be directly attributed to job displacement and other adverse shocks to employment opportunities. For men, we estimate that job loss more than doubles the risk of entry to permanent disability and that displacements account for fully 28 percent of all new disability insurance claims. We conclude that unemployment and disability insurance are close substitutes.

Gabriel Felbermayr, Mario Larch, Wolfgang Lechthaler, VoxEU: The beneficial international spillovers of labour market reforms. How do labour market reforms in one country affect its trading partners? Politicians often appear to assume detrimental spillover effects from labour market reforms abroad. This column argues that recent models of trade and unemployment highlight beneficial linkages, and this is confirmed by empirical work.

Kym Anderson, John Cockburn, Will Martin, VoxEU: Would freeing up world farm trade reduce or increase poverty? Many economists argue that removing trade barriers such as the EU’s Common Agricultural Policy will be globally welfare-improving. This column presents findings from simulations that estimate the welfare effects depending on the extent of trade reform and possible policy responses. It suggests that removing the world’s price and trade distortions would reduce the number of poor people worldwide by 3%.

Erik Snowberg, Justin Wolfers, IZA: Explaining the Favorite-Longshot Bias: Is it Risk-Love or Misperceptions? The favorite-longshot bias describes the longstanding empirical regularity that betting odds provide biased estimates of the probability of a horse winning – longshots are overbet, while favorites are underbet. Neoclassical explanations of this phenomenon focus on rational gamblers who overbet longshots due to risk-love. The competing behavioral explanations emphasize the role of misperceptions of probabilities. We provide novel empirical tests that can discriminate between these competing theories by assessing whether the models that explain gamblers' choices in one part of their choice set (betting to win) can also rationalize decisions over a wider choice set, including compound bets in the exacta, quinella or trifecta pools. Using a new, large-scale dataset ideally suited to implement these tests we find evidence in favor of the view that misperceptions of probability drive the favorite-longshot bias, as suggested by Prospect Theory.

Philip Bethge, Spiegel: The Best Translation Program Yet. Google Delivers Foreign Tongues at the Press of a Button. A German scientist Franz Och has developed one of the first translation programs suitable for everyday use. Sheer computing power gives the Google software surprisingly good results -- perhaps the best yet seen created by a machine.