The Becker-Posner Blog

Europe’s Long-Term Economic Woes—and America’s

Europe’s current economic crisis is being attributed to its having a common currency but no common fiscal authority. It’s as if the United States had no Treasury Department, and a state that had borrowed heavily from banks in other states got into serious financial trouble, like Greece. It could not reduce its debt burden by devaluing its currency (and thus repaying its debts to the banks in other states in cheaper dollars), which would have the further benefit of stimulating exports (by enabling the same amount of foreign currency to buy more U.S. products) and discouraging imports (because it would take more dollars to buy products denominated in a foreign currency). The state could not expect to receive any transfer payments from other states, and the federal government would not be authorized to transfer money to the state (remember that I’m assuming that the federal government has no Treasury Department). So the state probably would default on its bank debt (“restructure” the debt is the current euphemism), and this might bring down the banks that had made the loans that were now in default.

 

That is the current economic situation, with Greece taking the place of the defaulting state, and the European Union taking the place of the U.S. government, in my hypothetical example. And the situation will be resolved, one way or another. One way would be by a default, perhaps accompanied by a bailout of banks whose solvency is endangered by the default. Another way would be by Greece’s abandoning the euro in favor of its own currency, And a third way would be by fiscal measures (“austerity”) that would restore the government’s solvency.

 

The current European economic crisis is thus the product of an encounter between a defective institutional structure (a common currency but no common fiscal authority) and an overindebted member state of the supranational institution. These problems are solvable in a variety of ways, including by dropping the euro or creating an EU fiscal authority, comparable to our Treasury Department, as well as by a default or austerity measures. But the financial crisis is short term and tends to mask Europe’s longer-term economic problems, well discussed in a recent article in the New York Times: “Europeans Fear Crisis Threatens Liberal Benefits,” May 22, 2010, www.nytimes.com/2010/05/23/world/europe/23europe.html?pagewanted=1&hp.

 

The basic problem is often said to be the conjunction of an aging population, low birthrates, and extravagant social welfare benefits (mainly pensions, early retirement, and publicly subsidized health care). For example, these benefits consume 31 percent of the Gross Domestic Product of France—twice as much as such benefits consume of the U.S. GDP (these are 2005 figures). But I think we need to dig deeper for a satisfactory explanation.

 

It is true that improvements in health care (including nonmedical preventive measures such as diet and exercise) are increasing longevity, but they are also increasing (along with the decline in manual labor as a percentage of all work) the age at which people are no longer healthy or fit enough to work. And it is true that birthrates are very low in most of Europe, which increases the percentage of old people, but that of course is not because of some biological impairment of European fertility. Nor would low birthrates matter much if Europe were more welcoming than it is to immigration, because immigrants tend to be young.

 

The major cause of Europe’s long-run economic problems is political, though the political is in turn shaped by cultural factors, including historical memory; maybe the best way to describe the major cause of the problems is Europe’s “political culture.” Government has greater prestige in Europe than in the United States and (a related point) socialism retains substantial support in Europe; individualism, with related notions such as self-reliance, freedom to fail, entrepreneurship, the “self-made” man, and the Horatio Alger story do not grip the public imagination of many Europeans. Government in Europe employs a higher percentage of the working population and engages in more redistribution of income, resulting in high taxes to fund retirement at earlier ages than in the United States, generous pensions and family leave, unemployment benefits generous enough to discourage work, and medical care. Lavish redistribution of wealth in turn entails barriers to immigration, lest the social safety net become an immigration magnet. Unions are strong in Europe, and they push up wages and (worse) encourage featherbedding, short hours, and other inefficient practices. Unions of government workers are especially pernicious, as they reinforce the natural tendency of government to overpay its employees because they are voters as well as employees. A third of the Greek work force is government-employed, for example, and much of it appears to be both overpaid and underworked relative to employees in the private sector.

 

Because socialist policies reduce economic efficiency, European countries (with some exceptions, notably Germany) have difficulty competing in foreign markets with China, Indian, Brazil, and other rapidly growing economies, and so have difficulty maintaining a positive trade balance. And because tax rates in Europe are already very high, government deficits cannot easily be reduced by raising taxes. The aging of the population increases the demand for public spending, and the demand can be met only by increased borrowing, which is also necessary to close the gap between exports and imports.

 

European economic stagnation and public overindebtedness is in short mainly a political problem, resulting from a swollen and still rapidly expanding demand for government services. It is a political problem rooted in cultural factors summed up in the word “statism,” in contrast to American individualism, as designations of dominant political ideologies. This is an oversimplification but seems to me to get at the heart of the difference between European economies and the U.S. economy.

 

Many of the same economic pathologies that plague Europe plague us, but less seriously. We have an aging population, though it is due mainly to increasing longevity rather than to a low birthrate, for our birthrate is close to the replacement level and immigration brings us over the replacement level; there has been an ominous increase of late in hostility to immigration but this may be a byproduct of the economic crisis and so may pass when the crisis passes. Many of our public employees are overpaid and underworked, but only 8 percent of our labor force is employed by government (federal, state, and local), and this includes our military personnel (almost 1 percent of the labor force), who do not appear to be either overpaid or underworked. We have an alarming public debt, swollen by unfunded spending programs in both the Bush and Obama Administrations (the new health care reform is, realistically understood, unfunded) and by the decline in tax revenues as a result of the economic downturn. But as long as the U.S. dollar remains the dominant international reserve currency (which means that it is used in many transactions in which there is no U.S. party), the demand by foreign central banks for the dollar will remain very high and the resulting volume of U.S. money held abroad will enable us to continue borrowing abroad at low or at least moderate interest rates.

 

But if we continue running huge deficits, continue being unable politically either to cut spending significantly or raise taxes significantly, continue adding huge new spending progams, continue increasing the ratio of elderly to young, continue raising the minimum wage and promoting unionism, turn protectionist, resist immigration, and become even more deeply involved in military operations, we too may eventually go the way of Europe, even the way of Greece. Nowhere is it written that the United States can never decline.

Slow Economic Growth is a Crucial European Problem-Becker

Both Europe’s short-term and long-term economic futures do not look bright. The need to bail out Greece, and possibly also Spain, Portugal, and Italy is the immediate problem, but the fundamental problems go much deeper. Relatively rapid economic growth will cure many budgetary imbalances since the challenge is not the size of government debt per se, but its size relative to GDP. A faster growing economy can tolerate sizable growth in government spending as long as the growth rate of its debt is no faster than the rate of growth of GDP.

Unfortunately, large government spending and rigid economies, the European approach, tend to both increase the growth rate of government debt, and at the same time lower the growth rate of GDP. As a result, the prospects for rapid growth in most European economies, and for getting government debt under control, are dim unless major reforms are introduced into their welfare state, labor markets, regulatory framework, and other government policies.

Europe needs high income and other tax rates in order to finance its system of early retirements and generous pension benefits, especially among its large numbers of government employees, its liberal unemployment benefits, easy access to welfare payments to support unmarried mothers, the care of children, and many other government subsidies. Edward Prescott has shown (see e.g., his “Why do Americans Work so Much More than Europeans”, Federal Reserve Bank of Minneapolis, Quarterly Review, 28, July 2004) that higher marginal tax rates account for a significant part of the difference in employment, earnings, and hours worked between the US and the main European countries. High tax rates reduce both the level of income at any moment and the rate of growth of income over time.

 

Very low European birth rates contribute to the difficulty in financing generous support of the elderly since fewer men and women of prime working ages are available to be taxed to support the growing number of retirees, although the greater education, and hence greater productivity, of each young European partly but not fully compensates for having fewer young workers. The substantial increase in life expectancy is an enormous benefit of modern medicine and of greater knowledge about healthy personal care. However, longer expected lifetimes have greatly raised pension and health burdens in most European countries since their retirement ages have not increased in proportion to the growth in years lived of older persons.

The rigidities imposed by a single currency, the euro, will continue to cause frictions and difficulties for countries in the European Monetary Union. Part of the problem, as in the current Greek crisis, is the separate fiscal regimes of member countries.  But budgetary deficits and reckless borrowing are not the only forces that create tensions within a common currency. Some countries using the Euro will at times experience severe shocks to their economy that create unemployment and deficits in their foreign trade accounts. Economically weaker countries with own currencies usually respond to such shocks by devaluating their currency, as Greece frequently did in the past when it had the drachma.

Devaluation is not available to individual countries within the euro monetary union. They have to adjust to bad shocks to their individual economies either through increased unemployment, reduced wages, or migration of some unemployed workers to countries that are doing better. These adjustments are difficult for Greece, Italy, Spain and other weak members of the EU because their labor markets are inflexible, and because many workers in these countries are reluctant to migrate elsewhere, partly because they would give up generous benefits.

States of the US also have a common currency, and also face state-specific shocks since they specialize somewhat in different commodities and services. However, the difficulties states face in adjusting to their economic shocks are reduced by the much greater flexibility of US than European labor markets, and the willingness of many unemployed Americans to move to states that are doing well.

Apropos of comparisons between US and Europe, the US faces many of the same problems as Europe, but generally they are in a more muted form. The US has more flexible labor markets, lower marginal tax rates, fewer invasive regulations, a smaller welfare state, higher birth rates, greater immigration, more rapid incorporation of immigrants into the general economy, greater encouragement to starting new businesses, greater competition, and many other economic advantages. Nevertheless, the US has large fiscal deficits, and large health care and retirement obligations that will be growing rapidly over time.

To manage effectively a growing federal government debt, it is essential that the growth in entitlements be reduced, in part by raising the age of retirement and of access to Medicare. It is also crucial that government policies encourage more rapid economic growth of the American economy. Unfortunately, this is not true of many policies proposed or implemented during the past 18 months. These include, among many others, higher income taxes on corporations and on persons with bigger incomes, government regulation of pay, especially the pay of executives, health care “reform” that will raise, not lower, government spending on healthcare, special subsidies to various unproven green technologies, so-called job creation bills that create few jobs per dollar spent, and more aggressive anti-trust actions against successful companies, such as Google. These and other policies will reduce US economic growth at a time when faster growth is more necessary than ever.

 

Central Bank Independence-Becker

Governments that control central banks have often used their power to increase the money supply and create inflation. A growth of the money supply increases the revenue collected by the government through an inflation imposed tax on the holders of money.

These and other abuses of governmental power over central banks helped create the intellectual support for independent central banks. During the past several decades several central banks, such as the Mexico central bank, have become more independent of their government.

I have little doubt that central banks should have considerable independence Yet complete central bank independence from politicians does not seem desirable since banks also can abuse their powers. At times they can be tone deaf to what is happening in the economy, and at other times they are too much under control of the private banks that they regulate.

An analogy is often drawn between an independent judiciary and an independent central bank. Just as an independent judiciary often prevents legislatures and heads of governments from abusing their power to formulate and interpret laws, so an independent central bank is supposed to prevent governments from inflating the money supply, and in other ways creating monetary mischief. Yet the analogy between central banks and the judiciary is incomplete and not perfect. If the Supreme Court gives an unpopular opinion, such as its recent decision on the unconstitutionality of bans on spending by corporations during elections, that does not directly reflect on the governing policies of the President or Congress. Indeed, President Obama has openly criticized the opinion and clearly expressed his opposition. On the other hand, when central bank policies help create inflation or unemployment, the governing party will be blamed because the electorate cannot distinguish the effects of central bank behavior from the effects of presidential and legislative decisions.

Milton Friedman in “Should there be an Independent Monetary Authority” (1962) and elsewhere argued against complete independence of the Fed and other central banks because that would give too much power to the top bank officials. He also opposed making a central bank subservient to political leaders because that could lead these leaders to misuse the bank’s powers in order to promote their short –term political gain. His solution was a monetary rule, such as a fixed growth rate in the money supply. Such a rule would make many important central bank decisions completely automatic, and independent of the desires of both central bank heads and government officials. Taylor-type interest rate rules that have greatly influenced some central banks are generalizations of Friedman’s rule on money supply growth that are linked to inflation and the growth of GDP. Taylor-type rules also can operate automatically, and could be largely independent of both central bankers and politicians.

Yet even if a central bank followed a rigid rule to determine its interest rate and money supply policies, it would be necessary to periodically evaluate how well the rule was working. And since central banks are unlikely to continue to follow a fixed rule in the face of a financial crisis, evaluations of its discretionary decisions are also necessary. While the bank should provide its own evaluations, these would tend to be biased toward justification of what it had done.

This is why I support substantial but not complete independence of central banks from legislative and executive oversight.  Such oversight can force central banks heads to justify what they did in a public and open arena. The need to provide regular reports on its behavior to legislative committees would bring out mistakes made by the central bank. It would also induce central bankers to take more careful decisions since they would anticipate having to justify what they did in a public forum.

The US approach to the Fed makes a reasonable compromise between independence and oversight. The President appoints, subject to Senate approval, all seven members of the Board of Governors of the Federal Reserve for 14-year terms. Neither the President nor the Senate can remove any member prior to the expiration of their terms because of disagreements with bank policies. The President chooses, subject also to Senate approval, the Chairman of the Board, the most powerful position on the Board, from among the sitting Governors. The chairman serves for four years and can be reappointed. The chairman must report twice a year to Congress on the Fed’s policies, and he is asked to testify on other occasions before Congressional committees. He also collaborates with the Treasury on various occasions, as during the 2008-09 financial crisis.

Some critics believe the Fed has too much independence from Congress and the President. Following this line of criticism, Representative Ron Paul of Texas in 2009 introduced a bill that would provide for greater Congressional oversight of the Fed. Others believe that the Fed and other central banks have too cozy a relation with governments, and that political pressures excessively influence central bankers to conform to short-term political wishes.

The best way to help meet both objections is to make public all the Fed’s decisions (and that of other central banks), with no more than a short lag. Rather than being an asset, central bank secrecy is a handicap to businessmen and consumers who make investment and other decisions that are affected greatly by what the bank does.  To maximize public information, the central bank, whenever feasible, should follow known interest rate and money supply rules that are clearly related to the rate of inflation and the degree of slack in the economy.

Under these conditions, present laws on the length of the chairman’s term and that of the other members of the Fed’s Governing Board, and the laws requiring periodic reports of the chairman before Congress, would be effective. A system that has the Fed following rules that govern its policy decisions, combined with some discretionary authority in crises, and also with some congressional oversight would provide a reasonable mixture of central bank independence and control by Congress.

Should Central Banks Be Politically Independent? Posner

The case for central bank independence from the political branches of the government is simple. Central banks control the amount of money in the economy. For example, by selling short-term government securities for cash, they reduce the amount of money in the economy and this drives up short-term interest rates, while by buying such securities for cash they increase the amount of money in the economy and that drives down short-term interest rates. (Long-term interest rates are also affected, and in the same direction.) Politicians like the money supply to increase before elections, because a reduction in interest rates stimulates economic activity; consumers borrow more to consume, and businesses borrow more to invest in production. In principle, consumers and businesses should anticipate inflation (if the money supply is increasing faster than the output of goods and services), resulting in higher long-term interest rates and various distortions in economic activity, and take preventive measures that will reduce the stimulative effect of the central’s bank low-interest-rate policy. But we know from the reaction of consumers and producers to the very low interest rates of the early 2000s that the effect of very low rates on consumption and production are not fully and immediately offset by anticipation of future consequences.

 

Thus if a nation’s central bank is controlled by politicians, it can be expected to reduce short-term interest rates at particular phases in the electoral cycle, and this tendency, because unrelated to any economic reasons for low interest rates, can be expected to have an inflationary effect. Moreover, inflation can easily get out of hand. When inflation is anticipated, the amount of money in circulation increases; people hold smaller cash balances because inflation erodes the value of cash. The more rapidly money circulates, the higher the ratio of money to output and therefore the higher the rate of inflation. (Money that does not circulate—money that people keep under their mattresses, for example—are not really part of the money supply because they are not exchanged for goods or services.)

 

As inflation mounts, the cure—a sharp reduction in the money supply and concomitant increase in interest rates—becomes more painful. When Paul Volcker, the chairman of the Federal Reserve, pushed short-term interest rates to 20 percent in August 1981 to break an inflation rate that had reached 15 percent, he precipitated a very sharp recession. President Reagan was furious but Volcker stuck to his guns. A politically dependent Federal Reserve probably would not have done so.

 

In fact the Federal Reserve is not completely independent from politics. Unlike the Supreme Court, its independence is not dictated by the Constitution. The United States did not have a central bank when the Constitution was promulgated, and the Constitution didn’t require the creation of one. The Federal Reserve dates only from 1911, and before then experiments with central banking in the United States had been sporadic. The Federal Reserve’s independence—which is a function of the long terms of the members of the Federal Reserve Board (14 years, though the chairman’s term is only four years, albeit renewable), the fact that they cannot be removed before the expiration of their terms, the fact that the Federal Reserve is self-financed rather than financed by annual congressional appropriations, and the fact that the members of the Open Market Committee (the organ of the Federal Reserve that controls the money supply) include presidents of the local federal reserve banks, who are chosen by private banks rather than by the President—is a gift of Congress; and what Congress has given, Congress can take back. Hence Federal Reserve chairmen and members can’t just thumb their nose at Congress.

 

Particularly not in an economic crisis, such as hit the country and the world in September 2008. Essentially the Federal Reserve recapitalized the banking industry by buying its mortgage-backed securities (and other bank debt as well), thus pouring cash into the banking system. (As did the Treasury Department.) By greatly expanding the money supply, the Fed sowed the seeds of a future inflation—but in times of economic desperation the attitude is: let the future take care of itself.

 

The Supreme Court is the best example of a government institution that is outside political control. The Justices can as a practical matter be removed from office only if they commit crimes, and their decisions on matters of constitutional law can be nullified only by the very cumbersome process of amending the Constitution. Also, there is widespread public respect for the Supreme Court, and for courts and judges in general. The Federal Reserve has neither constitutional standing nor the enthusiastic support of the people. Its close links to the banking industry are noted and very few people have even the slightest understanding of the Fed’s role and responsibilities. It performed ineptly in the run up to the financial crisis and in refusing to bail out Lehman Brothers. Bernanke’s reappointment drew sharp opposition in the Senate, and there is some indication that Senate Majority Leader Reid extracted from Bernanke during the confirmation process a quasi-promise not to raise short-term interest rates too soon, lest by doing so the Fed choke of an economic recovery.

 

So the Fed is best described as quasi-independent rather than independent. A constitutionally independent Fed—an institution parallel to the Supreme Court—would create something close to a dictatorship over the business cycle, and this is too much power for a democratic society (perhaps any society) to cede to a bevy of economists and financiers. But the quasi-independence of the Fed, by giving it a great deal of discretion over monetary policy (even if the discretion is not complete), worries some economists, who think the Fed apt to misuse it, whether because of unsound economic theories or in an effort to mollify the political branches. But occasional proposals, as by Milton Friedman, to tie the Fed to a precise formula for increasing or decreasing short-term interest rates seem too rigid, because a formula cannot prescribe the correct response to unpredictable shocks to the economy, as we experienced in the financial collapse of 2008.

Asset-Price Bubbles—Posner

Eugene Fama, a brilliant economist at the University of Chicago, is one of the principal founders of modern finance theory, and is an especially strong proponent of the “efficient markets” theory of asset pricing, whereby the prices of common stocks or other traded assets are assumed to impound the best available information about their value, including future value discounted to the present. Fama is not a dogmatic proponent of the theory; some of his pioneering research has identified anomalies in stock pricing that seem to contradict the theory. But he supports the theory in the main and one consequence is that he is extremely skeptical of the existence of asset-price “bubbles.”

 

A bubble is an increase in the price of an asset that cannot be explained by changes in conditions of demand or supply that could be expected to alter the value of the asset relative to the value of other goods or services. (More precisely, a bubble can be defined as a disequilibrium event involving a steep increase in price that persists for a significant time, cannot be explained by fundamentals, and, after peaking, quickly gives way to a steep decrease in price.) We experienced what is widely believed (and what I believe) to be a bubble in housing prices between 1996 and May 2006, when average housing prices plateaued and immediately began to decline. Between 2002 and May 2006 the median price of a house rose by almost 50 percent. Between then and 2010 it fell by a third, and it has since risen slightly.

 

One can imagine factors that would explain a steep rise and later a steep fall in the price of housing. They might include a sharp increase in incomes or wealth, or in population, or big changes in construction costs, zoning and building codes, commuting costs, family size, and so on, but such changes cannot account for the pattern of housing prices. What seems to have happened was that the prosperity of the second half of the 1990s increased the demand for and hence (because the housing stock is very durable, so that increases in demand are not immediately reflected in increases in supply) the price of houses, and that the upward trend continued into the early 2000s because of the mistaken decision of the Federal Reserve to push short-term interest rates way down in 2001, to keep them down, to raise them only gradually, and to lower them again if necessary to prevent the market from dropping (the “Greenspan put”). Because houses are bought mainly with debt (a mortgage), and because short-term interest rates influence long-term rates, such as mortgage interest rates—and in fact those rates fell in the wake of the Fed’s pushing down short-term rates—people found it cheaper to finance a house purchase and so demand continued to increase, driving up price.

 

So far, no bubble. But even after the Fed started raising short-term interest rates, albeit very gradually, in 2004, and mortgage interest rates began to rise as well, house prices continued their rapid climb. At this point, rising house prices became a bubble phenomenon. Prices continued rising because prices were rising. People who did not own a house watched prices rise and inferred that other people knew or thought that houses were underpriced—were a good value, a good investment. Observing such behavior, and inferring that therefore prices might well continue rising, people who didn’t own a house began to think it was a good time to buy a house; indeed some people began buying houses as a speculation. The buying frenzy was facilitated by the adjustable-rate mortgage, which enabled people to buy houses with little or no down payment and very low (“teaser”) interest rates for the first couple of years followed by a much higher “reset” rate. If during that period house prices continued to rise, the buyer would have substantial equity in the house and would be able to refinance his house with a conventional 30-year mortgage at a low rate, and so would never have to pay the reset rate on his original, adjustable-rate mortgage. If prices didn’t rise, he could abandon the house at the end of the two years, ordinarily at no cost except a moving cost.

 

Buying a house or other asset because other people are doing so may seem an example of irrational “herd” behavior. But herd behavior is not irrational. If you are an antelope, and you see your fellow antelopes begin to stampede, you are well advised to join them, because they may be fleeing from a lion. We commonly take our cues from people who we believe have desires and aversions similar to our own.

 

Fama believes that the housing “bubble” was not a bubble—that, rather, people rationally if mistakenly believed until May 2006 that houses were underpriced, and beginning then believed that they were overpriced. But he acknowledges that he has not been able to identify the demand or supply factors that would have given rise to such beliefs. Nothing much about the housing industry seems to have changed over the period of a few years in which housing prices rose by almost 50 percent and then plunged to nearly their previous level.

 

If rational (or at least not demonstrably irrational) herd behavior explains the bubble, what explains its bursting? Obviously the price climb must end well short of the point at which the entire Gross Domestic Product is being spent on housing. Eventually everybody who wants a house and can afford it at the existing price level has bought it. But why don’t prices level off when that happens, rather than fall? The reason is that the satiation point is not an equilibrium. When prices stop rising, people who counted on continued price increases to enable them to refinance their mortgage, or who had bought houses as speculative investments, begin to abandon or sell the houses, and with the supply of housing rising but demand not rising, prices fall. Now reverse bubble thinking sets in. People infer from declining house prices that other people think houses are not a good investment after all. They begin to worry that as more people abandon their houses or put them up for sale, prices will continue falling, so they decide to get out while the getting is good, and as more people do that prices fall faster and farther.

 

The run that brought down Lehman Brothers in September 2008 and threatened to bring down much of the rest of the banking industry was a similar phenomenon. Most of Lehman’s capital was short term, and unlike deposits in commercial banks its capital was not federally insured. When it was realized that Lehman was heavily invested in mortgage-backed securities, whose value was plummeting in the wake of the bursting of the housing bubble, the suppliers of Lehman’s short-term capital began withdrawing their capital from Lehman—less because they thought that Lehman’s assets no longer exceeded its liabilities than because they feared that other suppliers of Lehman’s capital thought Lehman was broke and therefore would withdraw their capital as fast as possible and that—a classic bank run—would break Lehman. It was another example of rational herd behavior.

 

What brought down Lehman and threatened to bring down much of the rest of the banking industry was the bursting of another bubble—the housing-credit bubble. The firms that finance the purchase of housing, whether they are mortgage lenders or purchasers of securitized mortgage debt, are essentially joint venturers in the housing market. If they are financing a housing bubble and it bursts, they are losers along with the house owners. The bursting of the housing bubble will precipitate defaults and reduce the value of the house as the collateral for the mortgage.

 

So why did the sophisticated finance industry finance a housing bubble whose bursting was bound to hurt the industry? There were plenty of warnings that there was a housing bubble; why did the industry ignore them? I think it was another though somewhat more complex example of rational herd behavior. The major assets of a modern financial institution are short-term capital and talented staff, and both are highly mobile assets that the institution will lose if it is less profitable than its competitors, and it will be less profitable if it refuses to make risky mortgage loans. Just as the adjustable-rate mortgagee’s downside risk is truncated by his ability to abandon the home if house prices don’t rise, so the financial institution’s downside risk is truncated by limited liability, which protects shareholders and managers from having to pay their company’s debts out of their own pockets.

 

Thus I don’t think bubble behavior is necessarily or even characteristically irrational. Often, including in the case of the housing and housing-credit bubbles, it is a rational adaptation to uncertainty. It is not efficient behavior in an overall social sense, and so efforts at detection and prevention of bubbles are probably worthwhile. Given the abundant warning signs and explicit warnings of a housing bubble and a housing-credit bubble, the failure of the Federal Reserve under Greenspan and Bernanke, the federal housing authorities, other economic organs of government, and almost the entire economics profession to detect these bubbles cries out for an explanation.

 

 

Social Interactions and Bubbles-Becker

Bubbles in prices of stocks, houses, or other assets are usually defined to mean sizable and somewhat prolonged deviations in these prices from the fundamental determinants of the prices. These price deviations are supposed to get larger and larger until the bubble bursts, and then price rather abruptly go back close to the levels expected from fundamentals. Do bubbles so defined exist? I believe they do, although I applaud economists who work hard to find explanations of such price movements in more subtle changes in fundamentals. But we do not have good explanations for when bubbles arise and when they end.

Bubbles depend on expectations that get out of whack and become self-fulfilling for a while. In recent years, one of the most glaring examples of what appears to be a bubble is the pricing of young Internet and biotech companies during the period 1995-2000. Many companies in these fields that had no earnings or even any sales, and objectively had little prospects of earning anything in the reasonable future, were deluged with money from venture capitalists and others. Their stocks if they went public had enormous market values relative to any likely discounted earnings. After a few years the market realized the folly of what had been happening, the bubble burst, values came back to earth, and most of these companies went out of business.

The boom in housing prices in the United States that started in the late 1990s, and peaked in 2006, is another example of what looks like a bubble. According to data that Karl Case and Robert Shiller compiled, real housing prices in the United States went up on average by about 10% a year for six or seven years, and then crashed after 2006 to erase much of the previous gain. Neither increases in construction costs nor in overall population levels, two major fundamental determinants of housing prices, appear capable of explaining these price movements. Some of the price rise is surely explained by low interest rates on mortgages and low down payment requirements, but part of the bubble mentality was the willingness of lenders to give ridiculously generous terms to many buyers who had little ability to withstand any even moderate shocks to their economic circumstances.

The most plausible view of asset price bubbles is that the price increases of an asset are supported by expectations of even further price increases that makes it worthwhile to buy and hold the asset at prices that far exceed the prices determined by the fundamentals. A sophisticated and attractive version of this argument is that social interactions produce large and cumulative changes in prices from modest initiating forces. It is well known in social interaction theory (see, for example, the book Social Economics by Gary Becker and Kevin Murphy) that a “social multiplier” can magnify small initial changes in demand for a good or asset into large changes in prices or consumption.

According to this argument, suppose a “few” participants in say the housing market begin to expect significant price appreciation, perhaps due to low interest rates. Their expectations then influence the expectations of others through a “contagion” or social interaction, process. As more and more persons expect housing prices to rise, this leads to expectations of even greater housing price increases, and a bubble in housing prices starts. The bubble would end when expectations about price increases become even a little pessimistic since then price levels would seem much too high, and price decline expectations could spread through the populations. Prices may then fall abruptly to earth.

Although I find a social interaction approach to bubbles appealing, it does run into several difficulties. Why do not enough savvy investors see through what is going on, and build up large short positions. These short holdings would prevent a bubble from getting out of hand because they in effect increases the supply of the asset to help offset much of the unrealistic increase in demand? Some investors like John Paulson did take short positions in the residential housing market and made fortunes, as this theory would predict, although Paulson did it very indirectly through mortgage-backed securities and swaps. However, papers in finance point out that in many asset markets it is difficult to take large short positions on the future prices of these assets. Such difficulties would limit how much short arbitrage occurs (see the classic paper by Andrei Shleifer and Robert Vishny “the Limits of Arbitrage”, Journal of Finance, 1997).

However, if only small initial shocks are required because of the magnification produced by social interactions, why do not bubbles occur even more frequently in markets like housing? The national housing indexes that Case and Shiller compiled show only a few episodes over the past century when major deviations from fundamentals occurred at the national level-the Florida land boom of the 1920s was a local, or at most a regional, phenomena.

Moreover, if the social interactions explanation is right, bubbles should also happen in a downward direction, so that prices could continue to fall below levels justified by fundamentals. National housing prices have basically never been significantly below levels expected from construction costs and other fundamentals. Prices below fundamentals have persisted for years in declining cities, as Edward Glaeser of Harvard has shown, but these are not examples of bubbles. Rather, they reflect the slowness in the rate of depreciation in the excess housing found in declining cities. Perhaps downward bubbles are generally less common because it is easier to take long rather than short positions, so that arbitragers can more easily buy assets in sufficient quantities to keep prices from falling too much below the fundamental determinants.

If only small initiating and terminating forces are needed for bubbles to start and end, then it is easy to understand why bubbles occur, and why the start and end of bubbles are so difficult to predict, either by market participants or government officials. Some economists have suggested recently- discussed in the May 8 issue of The Economist- that governments try to take actions, such as countercyclical taxes on real estate, that prevent bubbles, in particular housing bubbles, from getting out of hand. The papers The Economist cited appear to misuse the “externality” argument for government actions in the housing market, but in addition I am highly skeptical that government officials can succeed where profit-seeking market participants fail. At least in the US, the vast majority of government officials involved encouraged rather than tried to moderate the housing bubble. I believe the best contribution public policy can make to the control of bubbles is to follow steady well-defined rules of behavior, such as Taylor-type rules, or capital requirement rules, that at least prevent political pressures from exacerbating any bubbles that do develop in housing and other markets.

Slow Recovery in US Employment? Becker

Sorry for this late post

Gary Becker

The April US employment report gave mixed signals. The good news is that employment grew by 300,000, and the employment gain in March was revised upwards from 160,00 to 230,000. But in seeming contradiction, the unemployment rate also rose by two percentage points, from 9.7% to 9.9%. Which of these figures gives a better indication of the speed and breadth of the American recovery from a deep recession?

The employment figures are consistent with the solid growth of 3.2% in real GDP during the first quarter of 2010. Economists trust employment data more than unemployment datat since the latter is subjective, as unemployment figures depend on how many persons are actively looking for work. The unemployment rate excludes men and women who lost their jobs but have given up finding new ones. It also excludes potential new entrants to the labor market who would like to be employed, but are not actively looking for work since they do not expect to find anything. Such an explanation of the difference in the change in employment and the change in unemployment would suggest that the underemployment rate fell since the measure of underemployment includes people whose hours have been reduced, or who are working part-time because they cannot find full time work. Yet contrary to these expectations, the reported underemployment rate also increased, from 16.9% to 17.1%.

In most other respects, the anatomy of unemployment has been no different during this recession than other severe recessions. Most of the unemployed are young and have limited education and other skills. Long term unemployment-those unemployed more than 6 months- now accounts for almost half the unemployed, up from 40% in February of this year, and from 22% in February of 2009. As is typical during serious recessions, long-term unemployment grew a lot as the recession became more severe and prolonged. The fraction of the unemployed who are long term unemployed usually rises even after a recovery begins since the unemployed who have not been able to find jobs for many months are among the least likely to find employment during the early stages of a recovery.

Employment has been growing more slowly than is typical during this recovery. Usually, an economy recovers faster after severe recessions than after mild recessions because greater pent up demand by consumers and investors accumulates during severe recessions. For example, the recovery was very strong in 1983 after a prolonged recession when unemployment peaked at 10.8% in December of 1982, higher than the peak unemployment rate of 10.2 in October 2009. The recovery was even sharp during the Great Depression years of 1934-36 until a second severe dip began in 1937.

GDP grew sharply not only during the first quarter of this year, but even more rapid at 5.6% during the last quarter of 2009, and decently at 2.2% during the third quarter of 2009. So GDP is growing at reasonably good rates, although it is not booming. GDP grew, for example, considerably faster during the all the quarters of 1983 after the severe recession that peaked in December 1982. The difference between the much faster rates of growth in GDP than in employment during much of the Great Recession, and so far during the recovery period, is the result of the continuing improvement in labor productivity, measured by output per employee or per hour worked.

The typical pattern during most recessions is for measured labor productivity to fall as good employees are kept on even though they do not have much to do, and as fixed capital is underutilized. Yet productivity continued to grow during most of this past recession. A common explanation for this improvement in productivity is that businesses tried to squeeze more out of their employees and capital because times were bad. However, times are bad during all serious recessions, yet measured productivity usually falls. The EU has had a more serious recession in GDP than did the US, yet EU countries followed the typical patter with reductions in labor productivity during the recession.

This growth in labor productivity during the recession of 2007-09 suggests that unemployment may fall more slowly than is typical after a severe recession because growth in GDP will be achieved in good part through further improvements in labor productivity. Why the recovery in employment and in unemployment has been relatively slow, given the severity of the recession, is not completely clear, but I believe one factor is the uncertainty about the policies that Congress and President Obama are impatient to implement.

Among the issues of concern to businessare how severe will be the new regulations of the financial sector? Will taxes be raised on individuals with higher incomes and corporations? Will a stiff carbon tax be introduced? Will trade unions be encouraged? Will the Justice Department adopt a new approach to anti-trust policy that is less pro consumer and more pro competitors of successful businesses? Will caps and other restrictions on the pay of top executives be continued and expanded? Members of Congress and persons close to President Obama have discussed these and other possible policies that may have discouraged many businesses from rapidly increasing employment and investments in capital.

To be sure, other uncertainties are likely also affecting business hiring, such as whether the EU will experience a double dip because of its sovereign debt crisis, or whether China will have to cut back because of excessive inflation and structural defects. But the US government does not control most of these other uncertainties. It does control its own policies, and they should be pro a private enterprise competitive economy rather than anti big and small business, and pro big unions.

 

 

                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

Stubbornly High Unemployment—Posner

I agree with Becker that the underemployment rate is a more meaningful measure of the health of the labor market than the unemployment rate, but they are closely correlated, and both have changed little since last fall. Thus the recovery has been slow. I would emphasize the economic as distinct from the political reasons why it has been slow, though the latter have played a role as well.

 

Producers responded to the economic crisis that crested with the collapse of Lehman Brothers in mid-September 2008 by slashing prices and costs. Slashing prices tends to keep output up while slashing costs increases labor productivity (output per unit of labor) because it involves layoffs and (what has the same effect) outsourcing to foreign countries. If all the recent productivity gains had taken the form of outsourcing production, there would be no reason to expect that lower prices would have reduced unemployment even though they would have tended to maintain output and therefore consumption. If higher productivity were achieved by technological advances rather than by layoffs or outsourcing, we would expect it to herald rapid economic growth. If it’s just the result of layoffs and outsourcing, however, it will fall when, faced with increased demand, producers do more hiring.

 

But how fast will demand increase? There is pent-up demand from postponement of purchases (especially of durable goods, where postponing replacing is feasible) and selling from inventory rather than from new production. These probably are the most important factors in the recent increases in GDP. But unless there are other factors pushing demand, GDP will plateau when the pent-up demand is satisfied and inventories are restocked to a normal level. Such plateauing is possible because no fewer than six factors are weighing on the economy. One is the continued tightness of credit. Interest rates are low but credit standards have risen, partly under pressure from federal bank examiners trying to prevent further bank failures, and partly from the new credit card law. The tighter credit is, the less production and consumption there is, because both producers and consumers depend heavily on credit to maintain their desired level of current production and consumption. And just as outsourcing has been used to achieve cost reductions, speculating in foreign currencies (the “carry trade”) and other high-risk lending and investing have been the source of the enormous recent bank profits. Federal Reserve policy has enabled the banks to borrow at very low rates, and they find it more profitable to invest the foreign funds abroad (or in trading) than to lend into a depressed consumer and small-business market with high expected default rates.

 

A second factor in the sluggishness of the economic recovery is the housing market. Housing prices remain very depressed, and because houses are the major component of consumer wealth, depressed housing prices spell reduced wealth for much of the population. A reduction in personal wealth tends to lead to a reallocation between spending and savings, in favor of the latter, and this slows current economic activity.

 

Third is the European financial crisis sparked by the insolvency of Greece (no mere liquidity crisis in that country—it’s broke), which has driven down the value of the Euro relative to the dollar. The consequence is to make U.S. exports more costly, which retards production in the United States. And Greek (or Portuguese, or Spanish, etc.) bond defaults will hurt U.S. banks that have large investments in those countries.

 

Fourth is the dreadful finances of U.S. states and cities (California, New York, and Illinois are close to being bankrupt), which will require Greece-like austerity measures, which will slow economic activity.

 

Fifth is the huge and mounting public debt of the United States, which creates a likelihood of either tax increases and spending cuts, both of which measures would reduce economic activity in the short run, or of inflation designed to reduce the debt burden—a danger rendered more acute by the increase in the money supply engineered by the Federal Reserve.

 

And sixth are the uncertainties created by the Obama Administration’s economic policies. In fact the Administration has not pursued a radical leftwing course, as some have feared. Its policies have been, in general, continuous with those of the Bush Administration. But the health care law has created enormous uncertainty for business, which cannot calculate the effects of the law on its costs, and for many individuals as well. (There is also uncertainty concerning taxes and spending, as I said, but the federal debt cannot be blamed primarily on this Administration. It is largely the result of the Bush Administration’s fiscal incontinence combined with the unavoidable effects of a very severe economic crisis.)

 

I agree with Becker that the Administration’s pro-union policy is no help, but it’s not clear that it will amount to much. The long-term decline in unionization seems irreversible. The exception of course is public employees’ unions, but the fiscal distress of state and local governments is likely to weaken the public employee unions, just as in Greece.

 

Uncertainty is an enormous retardant to economic recovery, and the Administration could do more to allay it by, for example, giving up on banker bashing. For in the face of uncertainty—in the sense of risk that cannot be quantified and thus embedded in a cost-benefit analysis—both producers and consumers tend to freeze. That is a rational response to uncertainty: one freezes both to protect oneself against unknown dangers and to gain time for learning more about them. But the effect of such freezing is to depress economic activity by channeling investing and spending into inert savings, such as government securities (which does however tend to alleviate the deficit). Political turmoil in the United States, two unresolved wars abroad, dangerous political instability in nuclear-armed countries such as Pakistan and North Korea (and soon perhaps Iran), the European economic crisis—all are sources of uncertainty that have economic effects just by virtue of their uncertainty, apart from any direct effects on the government, business, or consumers.

Did Speculation Make the Economic Crisis Deeper or Shallower? Posner

Speculators have never been popular, and they have never been as unpopular as they are in the United States today. Increasingly they are blamed for the economic crisis. Probably they should be rewarded for making the crisis less grave than it would otherwise have been.

 

There is a wide range of speculative activities, but my focus will be on financial speculation, which I’ll define as a bet on the future price of some commodity or asset, which could be a house or a bond—to pick the two speculative assets centrally involved in the crisis. (Mortgage-backed securities and collateralized debt obligations, the specific financial instruments at the center of the crisis, are essentially bonds or bond clusters—debt obligations or packages of debt obligations that pay a contractually fixed interest rate or rates.) In the 2000s, until the crash, there was a great deal of speculation in housing prices, including by people who bought a house with a mortgage that they could afford only if the value of the house increased. They would buy the house with no down payment and very low (sometimes zero) interest rates usually for two years, after which the interest rate would be “reset” at a higher level—a level they could not afford unless their house appreciated significantly in value, in which event they would have equity in the house and could use it to refinance the house with a normal mortgage at a normal interest rate. So they wouldn’t have to pay the reset rate.

 

At the other end of the market from the speculating home buyer was the speculating investor. Buying MBSs (mortgage-backed securities) and CDOs (collateralized debt obligations, often an assemblage of the riskier slices of mortgage-backed securities) entailed speculating on future housing prices, because the direction of those prices—up or down—would affect the default rate on the mortgages in which the buyers of the securities were investing indirectly. If the default rate rose because housing prices cratered, the securities might not pay the agreed-on interest rate, and so their value would fall.

 

Some very smart, very unconventional people, though they were only a tiny minority of the financial community, began thinking, some as early as 2005, that housing prices might well crash, that the housing boom was a bubble—house prices were rising because house prices were rising, convincing people that they would keep on rising. The “contrarians”—the subject of Michael Lewis’s new book, The Big Short—wanted to put their money where their mouth was. But while it is easy to bet on a rise in the future price of some asset, simply by buying the asset, it is not so easy to bet on a fall in that price. If it is a stock (or other security, including a bond), you can borrow it and agree to sell the stock to someone at some specified date in the future at a specified price. If as you expect the price falls, you can buy the stock that you’ve agreed to sell at a price lower than the sale price, deliver the stock you borrowed to the buyer and be paid the agreed-on price, pocket the difference, and deliver the cheap stock you just bought to the person you borrowed the stock from for the speculation, thus completing the transaction. The process I have just described is selling short.

 

Selling short is risky, because the price of the stock may rise over the price specified in the short sale when you expected it to fall (which means you’ll have to buy at a price higher than the price specified in the sale contract the stock that you need in order to return stock equivalent to what you borrowed), and costly, because you have to pay interest to the person you borrowed the stock from.

 

As an alternative to short selling, you can buy a credit default swap, which is a form of insurance on debt—not necessarily your own debt. If there is a bond that you expect to go into default (it might be a bond backed by a collection of mortgages), you can buy insurance against the resulting loss in the bond’s value. So if there is a default, the issuer of the credit default swap pays you, and so you gain just as the short seller gains when the price of the stock or bond that he’s shorted falls.

 

Like other speculators, short sellers and buyers of credit default swaps that insure strangers’ debt are unpopular because they are trading on and therefore hoping for a future calamity. When the price of an asset falls as a result of speculative activity, the speculators are blamed. That’s like blaming a thermometer for a fall in temperature. Provided the speculators do not spread false rumors about the assets they’re hoping to see fall in price, or engage in other fraud, their activity is socially beneficial. It adds to the information in the market and by doing so tends to bring about a more rapid and complete alignment between prices and underlying values.

 

It’s hard to sell houses short, but one can speculate that housing prices will fall by selling mortgage-based bonds short, since as I said a housing crash will increase the mortgage default rate and thus reduce the value of bonds that are based on mortgages. Had there been rampant short selling of such bonds in the early 2000s, the price of those bonds would have fallen because a high level of short selling would have been a signal of widespread doubt that housing prices would continue to rise. When bond prices fall, yield rises, because the interest rate of a bond is a fixed percentage of the bond’s face value. (So if the value of a bond that pays 2 percent interest falls in half, the interest rate to buyers of the bond rises to 4 percent.) With interest rates on mortgage bonds higher and housing prices therefore lower (because mortgage interest is a major cost of buying a house), we might have been spared the housing bubble whose bursting triggered the economic crisis that the nation and the world are still struggling to climb out of.

The Value of Profitable Speculation-Becker

Throughout history people who make good profits during economic crises have been condemned as “speculators”, and used as scapegoats, often by the very governments whose policies caused a crisis. These speculators have been imprisoned, and sometimes even put to death Successful speculators, however, usually dampen fluctuations in outputs and prices, and help provide markets where companies can hedge risks that accompany their business activities.

Posner’s definition of speculation as bets placed on future prices of assets or commodities is good enough for my purpose. A speculator in the oil market, for example, would buy some quantity of oil contracts at a given price with the expectation that he will sell these contracts in the future at a sufficiently higher prices than he paid to justify interest carrying costs, and other costs of holding these contracts. If successful he makes a profit. At the same time, however, he would serve two socially useful functions. He would raise the demand for oil now, and thereby raise present oil prices. When he sells his long contracts in the future he would raise the supply of future oil, and hence lower future oil prices. In this way, he would contribute to greater stability of oil prices over time.

Speculators also provide futures, or hedging, markets for oil and other producers of commodities and assets. These producers may not want to bear the risk of what future spot prices will be, so they may contract in futures markets to sell their future outputs at market-determined prices. They sell in part to speculators who hope to profit from any difference between the prices in futures markets and actual future prices.

When prices of oil, natural gas, copper, food, and other commodities rose sharply during the period 2004-08-oil reached a peak of over $145 a barrel in 2008- politicians, the media, and many others blamed speculators in these markets for the severe price increases. Of course, no one credited speculators with the sharp fall in these prices during the past couple of years, for it has been obvious that the worldwide recession was the main cause of this steep fall in commodity prices. It should have been equally obvious that booming world demand by China, the US, and other countries mainly explained the run up in commodity prices during the boom years prior to the world recession. As the world economy continues its recovery from the crisis, commodity prices will continue to rise again, with or without speculators. Oil has already recovered from its bottom of about $45 a barrel in 2009 to reach over $80 a barrel in recent months.

Speculators who made money on the run up in oil and other commodity prices went long; that is, they bought oil and other commodities- commonly through financial assets in futures markets- and they sold their assets in the future at higher prices. They profited by buying at lower prices and selling at higher future higher prices, but their purchases and sales helped to even out commodity prices over time. That is, successful speculators tended to help commodity markets by leveling somewhat the movement of commodity prices over time. Speculators who went short say in the oil market during the long period of run up in its price tended to lose money because they raised the effective supply of oil at an earlier time in order to buy oil back at higher prices at a later time. Their short sales and subsequent purchases increased rather than decreased the magnitude of price increases over time.

To be sure, speculators who shorted oil not long before it reached its peak price in 2008 made money if they continued their short positions until the sharp fall in oil prices after the world economy crashed. Yet these short speculators also helped stabilize oil prices by lowering them before they peaked through their shorting activities, and then helping to raise oil prices somewhat after prices collapsed by covering their short positions. Similarly, speculators who went long on oil shortly before the peak in oil prices lost money because they bought at higher prices than they were able to sell at after the crash. These speculators exacerbated the fluctuations in prices since they helped bid up oil prices further when they were high, and helped lower them further when these prices were low.

As a good rule of thumb-there are some exceptions to this rule- speculators in competitive speculation markets, whether long or short, contribute to a more efficient functioning of the economy when they make money, and they help make the economy less efficient when they lose money. Yet it is precisely the speculators who make money who are attacked by political leaders and others, not those who make bets that steer an economy in inefficient directions and also lose money for themselves.

Applied to the financial crisis, if when housing prices were rising so rapidly, more speculators had been shorting the housing market, or shorted mortgage-backed securities whose value depended on what happened in the housing market, their actions would have reduced the sharp increase in housing prices, and reduced the subsequent steep fall in these prices. Therefore, it was the absence of sufficient short speculators when commodity and asset prices were rising sharply that helped widen the run up and eventual collapse in these prices.

No amount of writing by economists will eliminate the hostility to individuals who make lots of money when times are bad. Still, in designing policies to reduce the future severity of financial and other economic difficulties, it is important to continue to emphasize that speculation serves a useful social purpose, especially when the speculators are making profits.