Greece burns

The recent tragic forest fires in Greece got me thinking. Yes, global warming is playing a part in this. For instance, two years ago there were huge, deadly fires in Portugal, Spain and Greece.

But surely there are other, economic factors at play. This article in The Economist lays out some of them. Developers are under suspicion for starting some fires to clear forest for construction, a result of the inefficient justice systems and weak property rights in many Mediterranean nations. It even seems that "productivity pay" for firemen may not be a good idea, as some seek to "encourage" demand for their services.

There is another intriguing angle. While the word "forest" conjures images of untouched wilderness, in reality forest in many parts of the world (and certainly in the heavily populated Mediterranean basin) have been shaped by man for ages. People cleared undergrowth for pasture and fuel, which in turn greatly reduced the risk of fires. However, rural depopulation is cutting this link between man and tree (see here), increasing the risk of fires.

Of course, the European Unions policies often don't help. Its generous agricultural subsidies are oriented to large-scale intensive farming and reforestation schemes often involve non-native species that involve highly flammable trees (eucalyptus, certain pines).

In the end, what do you do? Encourage once again the traditional agricultural practices to reestablish the previous equilibrium? I doubt that many people would like to be shepherds, even if heavily subsidized. Or do you just let the fires burn and wait until a truly wild native forest slowly establishes itself?

Biofuel madness

It's amazing how the biofuels bandwagon has kept gaining strength despite the fact that it's one of the main factors behind the steep rise in food prices. (Note to The Economist: remember that oil is used to grow crops!).

People have tolerated this because biofuels have a warm, green image (not deserved in many cases). Who can possible be against the environment?

But its pretty clear that biofuels serve mostly one purpose: to benefit incumbent politicians. On production cost grounds, biofuels make no sense, with the possible exceptions of sugarcane and jatropha. Politicians love to subsidize non-viable industries with a good public image becase 1) not many objetct lest they be called anti-environment and 2) those subsidies come back as campaign contributions from agribusiness (which has no choice, given that it wouldn't exist without those politicians).

In other words, politicians subsidize themselves. Rent-seeking at its most perverse worst.

Norwegian lottery winners

Don't ask how I came across this study. But it's one of the most hilarious and memorable abstracts I've seen in a long time (yes, I do have a peculiar sense of humor). It's worth quoting in full:

Abstract The study investigated 261 lottery winners of prizes of NKR 1 million (US $150,000) or more in the years 1987–91 in a postal survey. The modal Norwegian winners were middle-aged married men of modest education, living in small communities. Emotional reactions to winning were few, aside from moderate happiness and relief. Winners emphasized caution, emotional control and unconspicuous spending, e.g. paying debts and sharing with children. There was only a slight increase in economic spending. A wish for anonymity was frequent, together with fear of envy from others. Betting was modest both before and after winning. Experiences with winning were predominantly positive. Life quality was stable or had improved. An age trend was observed, accounting for more variance than any other variable. The older winners seemed to represent a puritan subculture of caution, modesty and emotional restraint. A slightly more impatient pattern of spending was characteristic of younger winners. The results support Kaplan's 1987 and others' findings that lottery winners are not gamblers, but self-controlled realists and that tenacious, negative cultural expectations to the contrary are myths, but perhaps also deterrents of uncontrolled behavior.

Culture is everything.

Surreal headline of the day: Sun Tzu's "The Art of Spin"

"China: Recalled Toys Not Poor Quality"

In fact, you can see that the lead paint was applied flawlessly in each and every case.

Snark aside, the Chinese government really needs to apply the ancient sage's wisdom to the modern battlefield of damage control.

It's the house prices, stupid!

That, in essence, is the message of Bill Gross's latest Investment Outlook. The top fixed-income guru (a well-deserved title, I might add) and head honcho of PIMCO estimates that house prices may fall 10% over this cycle, leading 2 million household to lose the roof over their heads.

It's a theme I've also insisted upon (see here). While the current market turbulence is worth undestanding and addressing, in the grand scheme of things the real danger lies in a housing-led spending collapse.

Gross discards the idea that rate cuts are the real remedy since their effectiveness is not guaranteed in the current panicky environment. Oh, there's also the small matter of a possible run on the U.S. dollar.

Instead, he proposes that the federal government implements a massive bailout for homeowners threatened by foreclosure.

Get with it Mr. President and Mr. Treasury Secretary. This is your moment to one-up Barney Frank and the Democrats. Reestablish not the RFC or the RTC, but create an RMC – Reconstruction Mortgage Corporation. If not, make some modifications in the existing FHA program, long discarded as ineffective. Write some checks, bail ‘em out, prevent a destructive housing deflation that Ben Bernanke is unable to do. After all “W”, you’re “the Decider,” aren’t you?

Sigh.

Irony aside, even if we had a better president than the current one it would not be easy to design and get a program of this nature enacted. Start with the fact that U.S. is not in a good fiscal position, so offsetting spending cuts might be needed (Any volunteers? Didn't think so). But I wouldn't be surprised if this comes the top issue in the 2008 election.

In defense of bubbles

The chic contrarian position nowadays is to argue that financial bubbles do have benefits. First, Daniel Gross defended the tech bubble (it was not only good, it was great!) as a means to encourage lots and lots of investment and innovation which provide long-term gains to society. Hardly a scientific argument, but it does make some sense.

Now, on these grounds it is much harder to defend the real estate bubble. Yes, there was some financial innovation involved, as Gross mentions. But it certainly was not of the life-changing variety (as were the Internet or railroads) and it was mostly already in place before the party got underway.

So did it provide benefits? Mystery blogger Knzn argues that it was the only way to ensure that a recovery took hold after the 2001 recession.

He's right, to an extent. The purpose of lowering rates to 1% was to get people to spend (the government could only do so much and firms were hungover). In a very anemic job growth environment, such as the one from 2002-2005, the only way to do that was through asset reflation, mainly residential real estate.

The real problem was that rates stayed too low for too long. In 2004 and 2005, a period in which the recovery had evidently taken hold, house prices (measured by the Case-Shiller composite index) rose 18.7% and 15.9%, respectively. And it was in 2005 and 2006 when subprime mortgage originations rocketed. If the Fed and other financial regulators had acted sooner, things woldn't have gotten out of hand to the degree that they did.

Sure, there's a fine line between asset reflation and a bubble. But it is clear that real estate bubbles are much more dangerous (they affect most people) and have a much more negative effects (depleted savings, high debt, excessive investment in nonproductive assets, screwing future hombe buyers, etc.) than garden variety stock market bubbles, with no long-term upside.

The Federal Reserve is flying blind

There's no question that the Federal Reserve's response to the current market turmoil has been belated, clumsy and not terrible effective. Many attribute it to rookie mistakes by Chairman Bernanke. But I think it goes beyond that. To understand the Fed's actions, its worth exploring the way some of that institutions top officers look at these issues. From what I've seen so far (read on), no wonder we're f***d.

Let's begin with Frederic Mishkin, a noted economist and member of the Federal Reserve's Board of Governors and its Open Market Committee. Last January he gave a speech where he laid out his thinking of asset prices and monetary policy.

First, Mishkin states that he doesn't believe central banks should actively seek to puncture bubbles of any kind, but other central bankers hold the opposite position. Having said that:

There is no question that asset price bubbles have potential negative effects on the economy. The departure of asset prices from fundamentals can lead to inappropriate investments that decrease the efficiency of the economy. For example, if home prices rise above what the fundamentals would justify, too many houses will be built. Moreover, at some point, bubbles burst and asset prices then return to their fundamental values. When this happens, the sharp downward correction of asset prices can lead to a sharp contraction in the economy, both directly, through effects on investment, and indirectly, through the effects of reduced household wealth on consumer spending.

This is not complacency. He knows the danger. But what should central banks do when they see frothy real estate markets?

A special role for asset prices in the conduct of monetary policy requires three key assumptions. First, one must assume that a central bank can identify a bubble in progress. I find this assumption highly dubious because it is hard to believe that the central bank has such an informational advantage over private markets. Indeed, the view that government officials know better than the markets has been proved wrong over and over again. If the central bank has no informational advantage, and if it knows that a bubble has developed, the market will know this too, and the bubble will burst. Thus, any bubble that could be identified with certainty by the central bank would be unlikely ever to develop much further.

This brings to mind the joke about the economist who refuses to pick up a dollar bill on the sidewalk (see here). A rather lame argument, if I may say so myself. But let's move on to a key section of his speech (bold type is my emphasis):

A second assumption needed to justify a special role for asset prices is that monetary policy cannot appropriately deal with the consequences of a burst bubble, and so preemptive actions against a bubble are needed. Asset price crashes can sometimes lead to severe episodes of financial instability, with the most recent notable example among industrial countries being that of Japan. In principal, in the event of such a crash, monetary policy might become less effective in restoring the economy's health. Yet there are several reasons to believe that this concern about burst bubbles may be overstated.

Go oooon!

To begin with, the bursting of asset price bubbles often does not lead to financial instability. In research that I conducted with Eugene White on fifteen stock market crashes in the twentieth century, we found that most of the crashes were not associated with any evidence of distress in financial institutions or the widening of credit spreads that would indicate heightened concerns about default.5 The bursting of the recent stock market bubble in the United States provides one example. The stock market drop in 2000-01 did not substantially damage the balance sheets of financial institutions, which were quite healthy before the crash, nor did it lead to wider credit spreads. At least partly as a result, the recession that followed the stock market drop was very mild despite some severely negative shocks to the U.S. economy, including the September 11, 2001, terrorist attacks and the corporate accounting scandals in Enron and other U.S. companies; the scandals raised doubts about the quality of information in financial markets and ultimately did indeed widen credit spreads.

Most, Mr. Mishkin, is not good enough. And this argument is misleading. First, we're talking about real estate, not stocks. Second, credit spreads did jump dramatically in 2001-2002, as a lot of the excessive tech and telecom investments --which were made due to the wildly optimistic assumptions that were also reflected in stock prices---went bust. Things did not get very ugly because rates were quickly cut.

There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability. House prices are far less volatile than stock prices, outright declines after a run-up are not the norm, and declines that do occur are typically relatively small. The loan-to-value ratio for residential mortgages is usually substantially below 1, both because the initial loan is less than the value of the house and because, in conventional mortgages, loan-to-value ratios decline over the life of the loan. Hence, declines in home prices are far less likely to cause losses to financial institutions, default rates on residential mortgages typically are low, and recovery rates on foreclosures are high. Not surprisingly, declines in home prices generally have not led to financial instability. The financial instability that many countries experienced in the 1990s, including Japan, was caused by bad loans that resulted from declines in commercial property prices and not declines in home prices. In the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble.

Yes, residential bubbles are not common. That's precisely why the Fed should've been much more worried! But what really shocks is that time has stood still for Mr. Mishkin. He still sees a world of bank-originated plain vanilla mortgages taken out by solid, creditworthy citizens which are then are sold to prudent investors through bonds packaged by Freddie Mac and Fannie Mae. It's as if the whole subprime/Alt-A thingy never happend.

Clearly, even Mr. Mishkin grants that bubbles can exist and burst. So what happens then?

Instead of trying to preemptively deal with the bubble--which I have argued is almost impossible to do--a central bank can minimize financial instability by being ready to react quickly to an asset price collapse if it occurs. One way a central bank can prepare itself to react quickly is to explore different scenarios to assess how it should respond to an asset price collapse. This is something that we do at the Federal Reserve.

Indeed, examinations of different scenarios can be thought of as stress tests similar to the ones that commercial financial institutions and banking supervisors conduct all the time. They see how financial institutions will be affected by particular scenarios and then propose plans to ensure that the banks can withstand the negative effects. By conducting similar exercises, in this case for monetary policy, a central bank can minimize the damage from a collapse of an asset price bubble without having to judge that a bubble is in progress or predict that it will burst in the near future

I have a word for this: GIGO. Yes, the universal law of garbage in, garbage out has proven itself once again. Is it any wonder that the Fed's response has been slow and not very effective when it has ignored the changes in the mortgage market? Evidently, their "stress tests" were based on unrealistic/deficient/naive assumptions.

This is very, very worrisome. The Federal Reserve is flying blind through a raging storm. Better buckle-up.

Surreal economics headline of the day: BBC edition

Iraqi growth 'unexpectedly slow'

Nothing else needs to be said.

The vulture of Omaha

It didn't take long for Warren Buffet's name to come up in relation to the current market crisis. It turns out, according to rumors cited by the Wall Street Journal, that Mr. Buffet might buy parts of Countrywide Financial Corp., one of the nation's leading mortgage lenders (and now stuck in the subprime quicksand).

While he's not regarded as a vulture investor, Buffet is no stranger to the fine art of purchasing distressed securities. During the Long Term Capital Management Crisis in 1998, he offered to purchase its assets, an offer that was apparently rejected (this very relevant study by the Federal Reserve summarizes the episode)

Judging the Fed

Naked Capitalism provides an excellent, in-depth summary of the debate on whether the Federal Reserve did the right thing by intervening in the markets (hat tip: Mark Thoma).