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The Financial Accelerator, Revisited

The Financial Accelerator, Revisited

This was on the WSJ blog by Greg Ip and I though it was worth passing on.

Fed Chairman Ben Bernanke’s newfound urgency in addressing the risk of recession can be traced in part to the insights he gleaned from his pioneering research on the financial system and the Great Depression.

[Ben Bernanke]

Last June, Mr. Bernanke delivered a speech on the “financial accelerator,” which describes how weakness in the financial system can compound an economic downturn. He developed the theory in the 1980s to explain the depth and duration of the Great Depression, and later expanded on it with the collaboration of Mark Gertler at New York University.

Real Time Economics wrote last June: Mr. Bernanke has spoken on countless issues … But to understand where his economic heart truly lies, read the speech he delivered at the Atlanta Fed today, “The Financial Accelerator and the Credit Channel.” Mr. Bernanke doesn’t say it, but the current crisis in the subprime mortgage market may be a perfect illustration of the financial accelerator at work today.

Rereading that speech helps explain the new urgency in Mr. Bernanke’s assessment of economic conditions, which was manifested in Tuesday’s 0.75 percentage point cut and a likely cut next week, and his advocacy of fiscal stimulus.

Fed commentary these days contains a lot of references to “feedback loops” and self-reinforcing spirals of declining confidence and asset prices. Those are the hallmark of the financial accelerator in action. They give the current economic cycle a different cast from the typical post-war cycle which was driven largely by trends in inventories, employment and, in 2001, capital investment.

On Jan. 11, governor Frederic Mishkin said in a speech: “An economic downturn tends to generate even greater uncertainty about asset values, which could initiate an adverse feedback loop in which the financial disruption restrains economic activity; such a situation could lead to greater uncertainty and increased financial disruption, causing a further deterioration in macroeconomic activity, and so on. In the academic literature, this phenomenon is generally referred to as the financial accelerator.”

It’s worth paying close attention to Mr. Mishkin’s views because he was an occasional collaborator of Mr. Bernanke when the two were in academia together, and at the Fed they continue to consult each other on research topics of common interest that often crop up in speeches.

In a separate speech Jan. 10, Mr. Bernanke, foreshadowing this week’s action , said: “economic or financial news has the potential to increase financial strains and to lead to further constraints on the supply of credit to households and businesses.” Note the reference to “news”: it’s not just economic and financial developments but how market confidence is affected by news of those developments that can aggravate the downward spiral. The Fed, he said, was “prepared to act in a decisive and timely manner and, in particular, to counter any adverse dynamics that might threaten economic or financial stability.”

That may explain why just the threat of a steep stock decline Tuesday played a part in Mr. Bernanke’s decision to cut rates: allowing the drop to play out may have had confidence-damaging consequences beyond the lost stock market wealth. The Fed, he felt, had an obligation to try and stop those effects from propagating, even at the price of appearing too ready to respond to stock prices.

“Given the weakened state of financial institutions, a sharp asset price contraction had the potential to significantly disrupt credit flows and thus do significant harm to the real economy,” Mr. Gertler said in an email Friday. “The Fed action offset this potentially disruptive chain of events. Of course, we can’t do the counterfactual of examining what would have happened had the Fed done nothing (just as we can’t for the intervention last August.) But many would agree that a real disaster might have ensued.”

While the financial accelerator conjures up the Great Depression, that almost certainly overstates the risks today. There are many institutional differences, from federal deposit insurance and the government’s larger role in economic activity to absence of the gold standard that militate against a repeat. But the financial accelerator can still produce nasty results; Paul Krugman has argued it explains the severity of the economic pain many Asian countries felt during their financial crisis in the late 1990s.

Does their awareness of the financial accelerator today imply anything for what Fed officials do at next week’s meeting? It’s hard to say, but it would certainly reinforce the Fed’s current inclination to err on the side of doing more rather than less than it ultimately thinks necessary. –Greg Ip

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In this mornings New York Times Bruce Bartlett published a nice list of anti recession measures by Congress and makes the point that they are always too late. However, if you read the list of 14 different measures he list you find that 12 of them are for public works programs and he is completely correct that they were too late to be effective anti recession measures. He is not saying anything new. It has been widely known for years that the time needed for Washington to act meant that using counter cyclical fiscal was very hard and it was usually too late. This has been standard main stream economics for years.

But two of the programs were tax cuts or tax rebates. One in 1975 and the other in 2001. Yes, he is right that the 1975 act came at the end of the recession, but the 2001 measure was very timely and the tax cut hit before the recession ended. I lived through the 1975 recession and remember clearly that the tax cuts played a major role in the 1975 consumer spending rebound.
Interestingly, Greenspan was the individual who convinced Ford to target the tax cuts to the middle class by pointing out that if President Ford wanted to buy a new car he would buy one and the tax cut would not make much difference. But for the typical middle class and/or poorer citizens liquidity constraints meant that the tax cut could make a significant difference in the car purchase decision. Moreover, as I pointed out yesterday the 2001 stimulus also clearly paid a significant role in the consumer spending rebound just as it did in 1975. The CBO just published a report where they found that one third of the 2001 tax rebate was spent in the first three months and two-thirds within 6 months.

Interestingly, the argument against tax cut being used by many bloggers is Milton Freedman’s
permanent income hypothesis. But even he recognized that this only applied to individuals that were not facing liquidity constraints — a very small segment of the population.


Do tax rebates work?

I love the articles we are now seeing that the 2001 tax cut did not work.

But look at what happened to real retail sales right after the 2001 tax rebates were implemented. The US experienced a very large surge in real retail sales that were
not adequately explained by the usual factors. ( see the jump above the arrow in the chart)

This looks a lot more convincing to me about the impact of the stimulous then some survey asking people to remember how they spent the money. This is especially true when the biggest use of the rebate was to pay off debt, and this free up resources that would have been used for debt servicing to spend on other things. The retail sales data implies that is what happened.

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I spent the weekend babysitting a grandchild.

But I was reminded that at the end Goldilocks
was run out of the forest by the three bears.

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7 years of the stock market

Earlier today Cactus posted on the real Dow over the past seven years.

Another comparison is to look at the alternative strategy, investing in cash or 3 month T bill.

If in January, 2001 you had placed your investments in 3 month T bills and reinvested the income in 3 month T bills, at the end of December, 2007 your total returns would have been
almost exactly the same as if you had invested in the S&P 500 with daily dividend reinvestment.
Way to go team Bush.

P.S. In looking at the current stock market and listening to strategist this chart is an important lesson to think about. You will hear from Wall Street analysts that if you do not go back into the market and miss the first leg off the bottom you are missing a great opportunity. Of course they are right. But if you miss that first bounce off the bottom and wait to go back into the market as long as you return while the market is below the cash line you are still better off than if you rode the market down and back up.

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The Fed and Elections

We are already starting to hear discussion about the point that this is an election year will influence Fed policy –either to ease or tighten more then it should because of the election.

The historic record is clearly that in election year the Fed does what economic fundamentals call for it to do and that the fact that it is an election year has no significant impact on Fed policy.

The chart compares actual fed funds with my version of the Taylor rule that gives inflation and unemployment equal weight. The vertical grey lines are Presidential elections. It shows that there is no significant difference between actual fed funds and the policy index in the period leading up to elections — if rising inflation calls for higher rates the Fed tightens or if economic weakness or a rising unemployment rate calls for lower rates it eases.

The historic record clearly demonstrates that Fed policy has not been influenced by elections beyond the standard belief that the Fed tried to avoid reversing policy in the last few weeks before presidential elections. Even under Volcker when actual fed funds were substantially above the policy index the direction of changes in actual fed funds was what the policy index implied it should be.

Yes, the recent jump in headline inflation implies that the Fed should not be easing now.

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In the previous OldVet comments I talked about the relationship between interest rates and the stock market. I just though I would but up one example of what I was talking about. Note how the fitted value has started rising in recent months but the market Pe has not moved up yet.



We’re starting to see a new campaign by the Republicans about a cut in the corporate tax rates.

There is a good case to be made for corporate tax cuts. This is especially true if the objective is to increase business fixed investment. After all corporations account for over 80% of business fixed investment as compared to only about 11% by partnerships, S-corps, etc that are subject to the individual tax code. ( non-profits account for the remainder) If you want to stimulate capital spending you should give the money to the economic sector that actually does the investments. But this is also the problem with the standard supply side argument that cutting taxes at the individual level really does not give you much bang for the buck.

In todays world of international competition there is also the problem of international competition to consider. For example KPMG did a big study of this last year that is getting a lot of attention. That study had this chart that compared US corporate tax rates to comparable tax rates in other countries.

You can find the study at:

The study shows that other countries have been lowering rates while the US rate has remained at 40%. They argue that the US needs to lower corporate rates to offset other countries cutting taxes to below the US rate.

But the problem with this comparison is that the US corporate tax rate is not really 40%. The
effective US corporate tax rate is really only 25%.

The US has a long record of cutting the effective tax rate and it is now only half of what it was in 1950.

My question is why do they have to be so dishonest about it? There is a valid argument for lower corporate taxes. Why do they feel they have to publish studies that are so fundamentally biased that if people knew the facts it would undercut their argument. I guess they have such a low opinion of the business press and other newspaper reporters that they are confident that reporters will never fact check the study.

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Some quick comments on the employment report.

Does not look good. I’m starting to have doubts about my forecast that we are just sliding into a stagnation, not a recession scenario. The household survey look especially worrisome.

But the hours worked data is not as weak. December hours worked were unchanged. The 4th quarter hours worked data is up at a 1.1% rate, about the same as the third quarter. It still implies that the second and third quarter rebound in productivity growth is probably continuing.

The new factor is weakness in finance. Employment growth in that sector just turned negative
and it will almost certainly remain negative for some time.

Finance employment is now about 6% of payroll employment as compared to about 10% for
manufacturing employment. But finance is a high wage area — average hourly earnings in fiance is $19.89 as compared to $17.66 for total private average hourly earnings. This has negative consequences for income and spending growth.

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5% unemployment rate

WOW — in seven year team Bush managed to raise the unemployment rate from under 4% when they took office to 5%.

Way to go team Bush!!

P.S. Note that in modern times only one Republican President managed to leave office with a lower unemployment rate then they inherited. Every Democratic President achieved this feat.

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