The Fed vs. the Financiers

The Fed vs. the Financiers

By : Kenneth Rogoff

Republish : Zulfikar

In his August 31 address to the world’s most influential annual monetary policy conference in Jackson Hole, Wyoming, United States Federal Reserve Chairman Ben Bernanke coolly explained why the Fed is determined to resist pressure to stabilize swooning equity and housing prices. Bernanke’s principled position – echoed by European Central Bank head Jean Claude Trichet and Bank of England head Mervyn King – has set off a storm in markets, accustomed to the attentive pampering lavished on them by Bernanke’s predecessor, Alan Greenspan.
This is certainly high-stakes poker, with huge sums hanging in the balance in the $170 trillion global financial market. Investors, who viewed Greenspan as a warm security blanket, now lavish him with fat six-figure speaking fees. But who is right, Bernanke or Greenspan? Central bankers or markets?
A bit of intellectual history is helpful in putting today’s debate in context. Bernanke, who took over at the Fed in 2006, launched his policy career in 1999 with a brilliant paper presented to the same Jackson Hole conference. As an academic, Bernanke argued that central banks should be wary of second-guessing massive global securities markets. They should ignore fluctuations in equity and housing prices, unless there is clear and compelling evidence of dangerous feedback into output and inflation.
Greenspan listened patiently and quietly to Bernanke’s logic. But Greenspan’s memoirs, to be published later this month, will no doubt strongly defend his famous decisions to bail out financial markets with sharp interest rate cuts in 1987, 1998, and 2001, arguing that the world might have fallen apart otherwise.
On the surface, Bernanke’s view seems intellectually unassailable. Central bankers cannot explain equity or housing prices and their movements any better than investors can. And Bernanke knows as well as anyone that none of the vast academic literature suggests a large role for asset prices in setting monetary policy, except in the face of extraordinary shocks that influence output and inflation, such as the Great Depression of the 1930’s.
In short, no central banker can be the Oracle of Delphi. Indeed, many academic economists believe that central bankers could perfectly well be replaced with a computer programmed to implement a simple rule that adjusts interest rates mechanically in response to output and inflation.
But, while Bernanke’s view is theoretically rigorous, reality is not. One problem is that academic models assume that central banks actually know what output and inflation are in real time. In fact, central banks typically only have very fuzzy measures. Just a month ago, for example, the US statistical authorities significantly downgraded their estimate of national output for 2004!
The problem is worse in most other countries. Brazil, for example, uses visits to doctors to measure health-sector output, regardless of what happens to the patient. China’s statistical agency is still mired in communist input-output accounting.
Even inflation can be very hard to measure precisely. What can price stability possibly mean in an era when new goods and services are constantly being introduced, and at a faster rate than ever before? US statisticians have tried to “fix” the consumer price index to account for new products, but many experts believe that measured US inflation is still at least one percentage point too high, and the margin of error can be more volatile than conventional CPI inflation itself.
So, while monetary policy can in theory be automated, as computer programmers say, “garbage in, garbage out.” Stock and housing prices may be volatile, but the data are much cleaner and timelier than anything available for output and inflation. This is why central bankers must think about the information embedded in asset prices.
In fact, this summer’s asset price correction reinforced a view many of us already had that the US economy was slowing, led by sagging productivity and a deteriorating housing market. I foresee a series of interest rate cuts by the Fed, which should not be viewed as a concession to asset markets, but rather as recognition that the real economy needs help.
In a sense, a central bank’s relationship with asset markets is like that of a man who claims he is going to the ballet to make himself happy, not to make his wife happy. But then he sheepishly adds that if his wife is not happy, he cannot be happy. Perhaps Bernanke will soon come to feel the same way, now that his honeymoon as Fed chairman is over.

The Federal Reserve makes a bold cut in interest rates

The Federal Reserve makes a bold cut in interest rates

By : economist.com

Republish : Zulfikar, ST

IS THE Federal Reserve running scared of the financial markets—or the housing market? On Tuesday September 18th America’s central bank cut its target for the federal funds rate by half a point, to 4.75%, the first reduction for more than four years. Financial markets had thought a quarter-point cut a shade more likely, but prayed fervently for a half. Rejoicing, the S&P 500 jumped by nearly 3% after the Fed’s announcement and the Dow Jones index closed more than 300 points up.
Once the cheering stops, it may be worth reflecting on what the Fed’s action—and words—say about the state of the economy, especially the housing market. The “tightening of credit conditions”, said the Fed, “has the potential to intensify the housing correction and to restrain economic growth.” The Fed seems to be trying to act before things get worse: the cut, it said, “is intended to help forestall some of the adverse effects on the broader economy”.

This argument is close to that laid out by Frederic Mishkin, a Fed governor, at the Jackson Hole central bankers’ symposium a fortnight ago. If a central bank cuts rates swiftly, Mr Mishkin argued there, it can soften the effects of even a sharp drop in house prices—not least because falling house prices translate only slowly into lower spending. The arguments of Janet Yellen, head of the San Francisco Fed, also seem to have been persuasive, says Adam Posen of the Peterson Institute of International Economics in Washington, DC: “the San Francisco Fed is one of the only regional Feds to have independent full-scale forecasts”. She gave warning this week that “financial market turmoil seems likely to intensify the downturn in housing”.

The Fed will have been helped towards its half-point cut by benign data on both consumer and producer prices: the latter, released on the day of the Fed’s decision, showed a 1.4% fall in August. More bad news from the housing market, published the same day, will have added weight to the argument for a bigger cut. An index of homebuilders’ confidence fell to match the lowest level reached since its inception in 1991. And the rate of foreclosures has more than doubled in the past year.
To some, it will seem as if the Fed has caved in to Wall Street. The emphasis on the housing market may help to dispel that impression. So might the Fed’s insistence that “some inflation risks remain” and that it will “continue to monitor inflation developments carefully.” So too, notes Mr Posen, will recent data on inflation, housing and jobs. Even so, the Fed will have to keep choosing its words carefully in the months ahead.

FEAR OF FINANCE

FEAR Of Finance

By :J.Bradford D.Long

Re-publish : Zulfikar

Fear of finance is on the march. Distrust of highly paid people who work behind computer screens doing something that doesn’t look like productive work is everywhere. Paper shufflers are doing better than producers; speculators are doing better than managers; traders are doing better than entrepreneurs; arbitrageurs are doing better than accumulators; the clever are doing better than the solid; and behind all of it, the financial market is more powerful than the state.
Common opinion suggests that this state of affairs is unjust. As Franklin D. Roosevelt put it, we must cast down the “money changers” from their “high seats in the temple of our civilization.” We must “restore the ancient truths” that growing, making, managing, and inventing things should have higher status, more honor, and greater rewards than whatever it is that financiers do.
Of course, there is a lot to fear in modern global finance. Its scale is staggering: more than $4 trillion of mergers and acquisitions this year, with tradable and (theoretically) liquid financial assets reaching perhaps $160 trillion by the end of this year, all in a world where annual global GDP is perhaps $50 trillion.
The McKinsey Global Institute recently estimated that world financial assets today are more than three times world GDP – triple the ratio in 1980 (and up from only two-thirds of world GDP after World War II). And then there are the numbers that sound very large and are hard to interpret: $300 trillion in “derivative” securities; $3 trillion managed by 12,000 global “hedge funds”; $1.2 trillion a year in “private equity.”
But important things are created in our modern global financial system, both positive and negative. Consider the $4 trillion of mergers and acquisitions this year, as companies acquire and spin off branches and divisions in the hope of gaining synergies or market power or better management.
Owners who sell these assets will gain roughly $800 billion relative to the pre-merger value of their assets. The shareholders of the companies that buy will lose roughly $300 billion in market value, as markets interpret the acquisition as a signal that managers are exuberant and uncontrolled empire-builders rather than flinty-eyed trustees maximizing payouts to investors. This $300 billion is a tax that shareholders of growing companies think is worth paying (or perhaps cannot find a way to avoid paying) for energetic corporate executives.
Where does the net gain of roughly $500 billion in global market value come from? We don’t know. Some of it is a destructive transfer from consumers to shareholders as corporations gain more monopoly power, some of it is an improvement in efficiency from better management and more appropriately scaled operations, and some of it is overpayment by those who become irrationally exuberant when companies get their names in the news.
If each of these factors accounts for one-third of the net gain, several conclusions follow. First, once we look outside transfers within the financial sector, the total global effects of this chunk of finance is a gain of perhaps $340 billion in increased real shareholder value from higher expected future profits. A loss of $170 billion can be attributed to future real wages, for households will find themselves paying higher margins to companies with more market power. The net gain is thus $170 billion of added social value in 2007, which is 0.3% of world GDP, equal to the average product of seven million workers.
In one sense, we should be grateful for our hard-working M&A technicians, well-paid as they are: it is important that businesses with lousy managements or that operate inefficiently be under pressure from those who may do better, and can raise the money to attempt to do so. We cannot rely on shareholder democracy as our only system of corporate control.
The second conclusion is that the gross gains – fees, trading profits, and capital gains to the winners (perhaps $800 billion from this year’s M&A’s) – greatly exceed the perhaps $170 billion in net gains. Governments have a very important educational, admonitory, and regulatory role to play: people should know the risks and probabilities, for they may wind up among losers of the other $630 billion. So far there is little sign that they do.
Finally, finance has long had an interest in stable monopolies and oligopolies with high profit margins, while the public has an interest in competitive markets with low margins. The more skeptical you are of the ability of government-run antitrust policy to offset the monopoly power-increasing effects of M&A’s, the more you should seek other sources of countervailing power – which means progressive income taxation – to offset any upward leap in income inequality.
Eighteenth-century physiocrats believed that only the farmer was productive, and that everyone else was somehow cheating the farmers out of their fair share. Twentieth-century Marxists thought the same thing about factory workers.
Both were wrong. Let us regulate our financial markets so that outsiders who invest are not sheared. But let us not make the mistake of fearing finance too much.