Fed failed to predict 2008 recession

Fed Admitted Ignorance, Underplayed Severity Of Situation Just Ahead Of Massive Crisis, New Docs Reveal

01/18/2013

"If you want to feel confident that the Federal Reserve knows where it's going as it steers the world's biggest economy, then you probably should not read the transcripts of its 2007 policy meetings.

Those transcripts, released on Friday, show a Fed groping blindly for answers about the early market tremors preceding the financial crisis, while also blithely deciding that everything was probably going to be just fine.

In what may be the most glaring example of the Fed's forecasting failure, its economists declared at the December 2007 policy meeting that the U.S. would avoid a recession, despite a slowdown in housing and turmoil in financial markets that was getting worse all the time. As we now know, the worst recession since the Great Depression began that very same month, according to the National Bureau of Economic Research. In less than a year, the financial system would be on the brink of total collapse.

The Fed didn't see it coming."

Technno-pessimism

Techno-pessimism: When will the good times return? | The Economist

Tyler Cowen's notable e-book "The Great Stagnation" is a key piece of this literature, but the position has been reinvigorated thanks to a new paper by Robert Gordon. Mr Gordon's take on stagnation is considerably more pessimistic and forward-looking than Mr Cowen's; not only is an innovative slowdown responsible for slowing progress pre-crisis, he argues, but this trend will continue as the benefits from humanity's "one big wave" of innovation peter out amid demographic and fiscal headwinds.

...It seems clear that productivity growth dropped sharply in the early 1970s relative to the earlier industrial era. At least part of that slowdown is probably due to the exhaustion of benefits from the great innovations of the past—electrification, internal combustion engines, petrochemicals, and the "early IT" of radio and telephones among them. Discovery didn't stop, of course, but the locus of innovation—computing and information technology—was simply too small a part of the overall economy to have a big effect on growth, incomes, and welfare.

By the mid-1990s, that was no longer the case. The computing age began to show up in the productivity statistics in a big way. This occurred, first, in the technology sector itself as America captured huge gains from production of chips, computers, and similar technology. By...2005, however, something seemed to go wrong. Productivity in manufacturing slipped a bit and dropped substantially for the economy as a whole. The 2000s were also a trying period in terms of employment and wage growth. This has led some thinkers, including Mr Gordon, to conclude that the boost from IT has run its course.

Federal tax revenue versus debt: growth

Here's an exponential trend looking for a breakdown:

Now here's the chart of federal debt:

US employment by age group

Note that the 55+ workforce has been steadily increasing while the 25-54 workforce has declined. Also, the 20-24 workforce has stayed roughly constant, so it appears that college age workers aren't really avoiding the job market by staying in college for additional degrees.

Source

US income inequality increasing

based on the above chart of the GINI ratio; in fact it has spiked upward since the major recession.

Analysis of problems in banking sector

What’s Inside America’s Banks? - Frank Partnoy and Jesse Eisinger - The Atlantic

Some four years after the 2008 financial crisis, public trust in banks is as low as ever. Sophisticated investors describe big banks as “black boxes” that may still be concealing enormous risks—the sort that could again take down the economy. A close investigation of a supposedly conservative bank’s financial records uncovers the reason for these fears—and points the way toward urgent reforms.

An essay that is definitely worth the time.

Total debt comparison: US vs Japan

Here's a chart of the ratio of US total credit market debt to GDP, a classic exponential trend breakdown:

Here's a similar chart for Japan:

It's remarkable how in Japan government debt has substituted for private debt; the reason for this is the government has been cushioning the credit crunch implied by falling private debt.

US population concentrations

What is most striking about this map is the vast empty areas.

Investing in technological progress leads to increased economic growth

Paul Krugman writes, in Is Growth Over? - NYTimes.com

that

" Smart machines may make higher GDP possible, but also reduce the demand for people — including smart people. So we could be looking at a society that grows ever richer, but in which all the gains in wealth accrue to whoever owns the robots."

Dean Baker responds, in
Capital Biased Technological Progress; It Doesn't Just Happen | Beat the Press

"Krugman discusses the case where there is an exogenous change in the nature of technology that makes capital relatively more productive than labor. This leads to more capital being used, driving up its price, and less labor being used, driving down its price (i.e. wages)."

"the fact that we may appear to be seeing capital-biased technological progress should not be viewed as just some unfortunate event in the world that we have to learn to cope with. If we are in fact seeing capital-biased technological progress it is almost certainly the case that it is at least in part the result of policy decisions that could be handled differently"

I can see innovation shrinking employment, but the owners of the innovations theoretically would get the marginal wealth. Otherwise there'd be no point to the innovation. Raising tax rates on unearned income to the same as those of labor income would help a lot with the resulting inequality of wealth distribution.. This would be a policy decision that offsets the policy decisions mentioned by Baker.

A retrospective look at Japan's banking crisis

I recently stumbled across a research paper by Richard Koo titled "Japan's disposal of bad loans: failure or success?"

The thesis of this analysis is that Japanese monetary/fiscal authorities handled their post bubble banking crisis relatively well compared to how the US has handled its banking crisis which began in 2008.  The paper contains a lot of good data so it is worth the time even if you disagree with Koo's conclusions.

However, it looks like Koo is defining "success" as a fourteen year recessionary period.

The problem I have with this Koo analysis is with its conclusion is that Japanese monetary/fiscal authorities did mostly the right things.  The paper shows that the Japanese equivalent of the FDIC's Deposit Insurance Fund was in a negative balance from 1996 to 2008. This implies that it could still be in a negative balance now.  If your deposit insurance fund is negative, that's not "success".


In Japan much of the banks' bad loans were simply shifted into government debt.


Koo posits the concept that the US is handling its banking crisis differently when in fact the US is doing the same things that Japan has done.

Unemployment much higher than expected

Notice the point that shows that the unemployment rate would be 10.7% if the participation rate hadn't gone down.  In any case, the projections were clearly not close to the actual results.

China has bailout decision

Analysis: Too big to fail? China's wealth management products stir debate
| Reuters

China International Capital Corp (CICC), a prominent Chinese investment bank, urged regulators in a December 4 note to allow such products to fail. Most are not guaranteed by banks, analysts say. "If we don't take this opportunity to let a relatively small-scale contract be broken, it will only reinforce the attitude that these products have a rigid return and a limitless guarantee," CICC said. Forcing Hua Xia to stand behind these products would cause "no end of trouble", it added.

The default of a Chinese investment plan has handed Beijing a tough choice: bail out investors and endorse moral hazard or let it fail and risk unnerving those who hold at least $1 trillion in so-called wealth management products.

US financial regulators faced a similar decision four years ago and decided on unlimited bailouts, because the alternative was in their minds an apocalyptic financial system crash.

Is that really the only alternative?

Update: What this means is that China is on the verge of a major financial panic.

Update: China Warns of Rising Financial Risks Dec 26 2012

Due to soaring bank loans, with lending to the property sector and local governments a particular concern, China's financial system is facing increasing risk, the finance ministry warned Wednesday.

Interest rate trends

Calculated Risk today said in a post on housing starts showing that starts are increasing that

 "Residential investment and housing starts are usually the best leading indicator for economy."

If housing starts are up, then that should mean that a Fed interest rate tightening cycle is close to beginning.

Except that the Fed Funds rate has been at or near zero for an extended period of time.

Here's what happened with interest rates after the Great Depression:

It's impossible to know how long it will take for interest rates to normalize this time.

Federal debt and GDP

The amount of federal debt appears to be growing exponentially

whereas real GDP seems to to show a linear growth trend(and growth may approach zero soon):

Four years of ZIRP

The Fed Funds rate has been near zero since December 2008:

See Fed cuts key rate below 1% for first time - Dec. 16, 2008

"the Federal Reserve cut its key interest rate to a range of between zero percent and 0.25%"

This is unprecedented.

Workers aged 55-69

Here's a trend looking for a breakdown:

Given that the youngest baby boomers are 48, there is a limit to how much more this number can grow.

Why China failed to progress technologically

Explaining why Chinese scientific discoveries didn't flower into a scientific revolution, Levenson wrote, "It is not because their forebears were constitutionally unable to nurture a growing tradition of science, but because they did not care to."

Science had no social prestige, he says, and it would never have occurred to traditional Chinese scholars that kudos was to be gained from claiming discoveries or inventions.  The ancients didn't turn such inventions into world-changing technologies, so why should we?

China Road page 105
Seems plausible to me

Trend breakdown: foreign ownership of Treasury debt

Notice that the proportion of US Treasury debt held by foreign governments has peaked

This begs the question, what will happen when the Federal Reserve reduces it's purchases of this debt?

Book review: China Road

I just finished a very good book Amazon.com: China Road: A Journey into the Future of a Rising Power (9780812975246): Rob Gifford: Books.

It's written by an English journalist who worked in China for many years. It was published in 2007 so it's reasonably contemporary and it addresses most of the big issues that China faces. The author thoughtfully analyzes the concept of whether China is capable of ever turning to democracy for example. The book focuses more on the domestic effects of the economic boom rather than the trade issues.

One interesting thing that the book addresses is the idea that China doesn't have social values anymore since Confucian ideals were obliterated by Maoism and now Marxism has no traction either. So the mentality is just do whatever you want since it's a "man eat man" world.

Another point that the author makes is that Confucian thought is hostile to populist, democratic ideas. And that the weight of Confucian tradition makes it unlikely that democracy will happen in China anytime soon. Of course that's debatable but it's a point of view that I had been unaware of.

Here's the book description from Amazon:

Route 312 is the Chinese Route 66. It flows three thousand miles from east to west, passing through the factory towns of the coastal areas, through the rural heart of China, then up into the Gobi Desert, where it merges with the Old Silk Road. The highway witnesses every part of the social and economic revolution that is turning China upside down.
In this utterly surprising and deeply personal book, acclaimed National Public Radio reporter Rob Gifford, a fluent Mandarin speaker, takes the dramatic journey along Route 312 from its start in the boomtown of Shanghai to its end on the border with Kazakhstan. Gifford reveals the rich mosaic of modern Chinese life in all its contradictions, as he poses the crucial questions that all of us are asking about China: Will it really be the next global superpower? Is it as solid and as powerful as it looks from the outside? And who are the ordinary Chinese people, to whom the twenty-first century is supposed to belong? 

This book is well worth your time.

FDIC leader says banking system still poses significant risks

FIRST LOOK: FDIC’S HOENIG SAYS PUBLIC REMAINS AT RISK — FDIC Director Tom Hoenig will deliver a broad policy speech this morning at the AICPA-SIFMA conference in NYC.  Hoenig’s speech “says that the public remains at risk of having to pick up the pieces when the next financial setback occurs. The safety net continues to expand to cover activities and enterprises it was not intended to protect, resulting in subsidized risk taking by the largest financial firms and fueling their leverage. At the same time, the tolerance for leverage remains essentially unchanged, leaving us in a situation that is little different than before the recent crisis.  ...
“We can be confident that as time passes, this leverage again will be a problem and the public again will be left holding the bag. … Hoenig offers three recommendations to change this outcome by changing the framework and related incentives. They are: Changing the structure of the industry to ensure that the coverage of the safety net is narrowed to where it is needed … Simplifying and strengthening capital standards … Reestablishing a more rigorous examination program for the largest banks and bank holding companies to best understand the risk profile of both individual firms and financial markets.”

Essentially none of the problems that led to the 2008 banking crisis have been resolved.