The clueless Fed

The release of Federal Open Market Committee (FOMC) meeting transcripts from 2006 show how little America's top economic minds understand how leveraged asset bubbles harm the economy:

As the housing bubble entered its waning hours in 2006, top Federal Reserve officials marveled at the desperate antics of home builders seeking to lure buyers.

The officials laughed about the cars that builders were offering as signing bonuses, and about efforts to make empty homes look occupied. They joked about one builder who said that inventory was “rising through the roof.”

But the officials, meeting every six weeks to discuss the health of the nation’s economy, gave little credence to the possibility that the faltering housing market would weigh on the broader economy, according to transcripts that the Fed released Thursday. Instead they continued to tell one another throughout 2006 that the greatest danger was inflation — the possibility that the economy would grow too fast.

“We think the fundamentals of the expansion going forward still look good,” Timothy F. Geithner, then president of the Federal Reserve Bank of New York, told his colleagues when they gathered in Washington in December 2006. ...

The transcripts of the 2006 meetings, released after a standard five-year delay, clearly show some of the nation’s pre-eminent economic minds did not fully understand the basic mechanics of the economy that they were charged with shepherding. The problem was not a lack of information; it was a lack of comprehension, born in part of their deep confidence in economic forecasting models that turned out to be broken.

“It’s embarrassing for the Fed,” said Justin Wolfers, an economics professor at the University of Pennsylvania. “You see an awareness that the housing market is starting to crumble, and you see a lack of awareness of the connection between the housing market and financial markets.”

“It’s also embarrassing for economics,” he continued. “My strong guess is that if we had a transcript of any other economist, there would be at least as much fodder.” ...

The committee consists of the governors of the Federal Reserve and the presidents of the 12 regional banks.

“The speed of the falloff in housing activity and the deceleration in house prices continue to surprise us,” Janet Yellen, then president of the Federal Reserve Bank of San Francisco, said in September.

One builder she spoke with, she said, “toured some new subdivisions on the outskirts of Boise and discovered that the houses, most of which are unoccupied, are now being dressed up to look occupied — with curtains, things in the driveway, and so forth — so as not to discourage potential buyers.” ...

But the Fed’s chairman, Ben S. Bernanke, appears as the most consistent voice of warning that problems in the housing market could have broader consequences.

The general consensus on the board, summarized by Mr. Geithner, was that problems in the housing market had few broader ramifications. “We just don’t see troubling signs yet of collateral damage, and we are not expecting much,” he said at the September meeting.

Mr. Bernanke initially agreed, telling colleagues at his first meeting as chairman, in March, “I think we are unlikely to see growth being derailed by the housing market.”

As the year rolled along, however, Mr. Bernanke increasingly took the view that his colleagues were too sanguine.

”I don’t have quite as much confidence as some people around the table that there will be no spillover effect,” he said. ...

One fundamental reason for this blindness was that Fed officials did not understand how deeply intertwined the housing sector and financial markets had become. They also were convinced that financial innovations, by distributing the risk of losses more broadly, had increased the strength and resilience of the system as a whole.

So, for all the criticism you might give Ben Bernanke, apparently he's the least incompetent of the bunch.

I'll admit I didn't know that the housing bubble would cause a financial crisis. The best I can say for myself is that I expected a failure of Fannie Mae and Freddie Mac, but also expected more diversified financial institutions to be OK.

However, I expect people with Ph.D.s in economics to know a lot more about this stuff than I do. (After all, I'm a software developer, not an economist.) I especially expect it of economists who are supposedly so good at what they do that they get appointed to a post at the U.S. Federal Reserve.

Occupy Wall Street comes to your neighborhood

The OWS movement is now protesting foreclosures:

In more than two dozen cities across the nation Tuesday, an offshoot of the Occupy Wall Street movement took on the housing crisis by re-occupying foreclosed homes, disrupting bank auctions and blocking evictions.

Occupy Our Homes said it's embarking on a "national day of action" to protest the mistreatment of homeowners by big banks, who they say made billions of dollars off of the housing bubble by offering predatory loans and indulging in practices that took advantage of consumers.

Hopefully the OWS protesters used the occupation of homes as an opportunity to take a shower. I've heard from several sources that these people, unshowered for months, smell like rotten eggs.

FT: QE2 is about pushing up asset prices

Economist Gavyn Davies, writing for The Financial Times, says this second round of quantitative easing is about pushing up asset prices:

Clearly, the fuss is mostly about asset prices. ... which may encourage the markets to believe that there is a “Bernanke put” underlying the equity market. Almost certainly, the Fed is happy to see rises in equity prices and declines in the dollar, despite warnings that this stance may induce bubbles to develop in the US and overseas.

It is interesting to review market behaviour since Mr Bernanke’s speech at Jackson Hole on 27 August, which indicated that QE2 might be around the corner. Bond yields have hardly moved since that speech, but inflation expectations within the TIPS market have risen by over 0.5 per cent. And commodity and equity prices have risen sharply, by 16 per cent and 11 per cent respectively. These developments are all consistent with a belief that the Fed is intent on reflating the US economy, and that it will succeed in doing so.

Probably the oldest piece of advice in asset management is “don’t fight the Fed”. It usually works. If the economy grows moderately in coming months, while the Fed steadily injects money into the financial system, risk assets could benefit further.

Is the Fed blowing new bubbles?

The Federal Reserve is beginning a new round of quantitative easing, printing money to buy intermediate- and long-term bonds, thus increasing the money supply and lowering intermediate- and long-term interest rates.

This is different from what the Fed normally does to stimulate the economy. Normally it prints money to buy short-term bonds. But, since short-term interest rates are already near zero, the Fed has to take the riskier action of buying longer-term bonds if it wants to stimulate the economy.

Harvard economics professor Martin Feldstein, President Emeritus of the National Bureau of Economic Research, warns that this is dangerous and may blow new bubbles:

The Federal Reserve’s proposed policy of quantitative easing is a dangerous gamble with only a small potential upside benefit and substantial risks of creating asset bubbles that could destabilise the global economy. Although the US economy is weak and the outlook uncertain, QE is not the right remedy.

Under the label of QE, the Fed will buy long-term government bonds, perhaps one trillion dollars or more, adding an equal amount of cash to the economy and to banks’ excess reserves. Expectation of this has lowered long-term interest rates, depressed the dollar’s international value, bid up the price of commodities and farm land and raised share prices.

Like all bubbles, these exaggerated increases can rapidly reverse when interest rates return to normal levels. The greatest danger will then be to leveraged investors, including individuals who bought these assets with borrowed money and banks that hold long-term securities. These risks should be clear after the recent crisis driven by the bursting of asset price bubbles. Although the specific asset prices that are now rising are different from last time, the possibility of damaging declines when bubbles burst is worryingly similar. ...

The truth is there is little more that the Fed can do to raise economic activity. What is required is action by the president and Congress...

It sounds to me like Feldstein is saying The Onion was right.

As for other notable economists' thoughts on the Fed's actions, John Taylor is opposed and Paul Krugman is ambivalent.

The fed funds rate: Too low for too long?

Here's an interesting graph. It shows the fraction of the time in each decade that the real fed funds rate was negative, i.e. the nominal fed funds rate was below the inflation rate. In the 1970s, we had significant consumer price inflation. In the 2000s, we had a credit bubble.

How the crisis could change economic theory

Here's an interesting look at how the housing bubble may change macroeconomic theory.

The crisis exposed the inadequacy of economists' traditional tool kit, forcing them to revisit questions many had long thought answered, such as how to tame disruptive boom-and-bust cycles. ...

"We could be looking at a paradigm shift," says Frederic Mishkin, a former Federal Reserve governor now at Columbia University.

That shift could change the way central bankers do their job, possibly leading them to wade more deeply into markets. They could, for example, place greater emphasis on the amount of borrowing in the economy, rather than just the interest rates at which borrowing is done. In boom times, that could lead them to restrict how much money various players, ranging from hedge funds to home buyers, can borrow.

How to create better financial regulation

Lots of people like to blame stuff like the current financial crisis on the opposing political party. For example, note how Republicans like to blame the housing bubble, which caused our current troubles, on the Community Reinvestment Act and Democrats like to blame it on lax Bush administration regulation.

The truth is that nobody of any political affiliation likes to step in and take away the punchbowl when everyone's partying. Just look at the failure of anyone to do anything about this decade's housing bubble under President Bush or the stock market bubble that occurred during Bill Clinton's second term.

Bubbles are caused by human nature. Since regulators are human beings, they are as susceptible as anyone else. How many home-owning regulators of any political affiliation would have wanted to reign in the rapid rise in housing prices, for example?

Instead what are needed are mathematical rules, such as requiring home buyers to make 20% down payments when buying homes. (Note that under President Obama and a Democratically-controlled Congress, the FHA is actively encouraging absurdly low 3.5% down payments.)

Larger down payments would encourage home buyers to care less about monthly payments and more about overall price. They also would give home owners a bigger buffer to protect themselves when home prices fall. They would also force home buyers to have more skin in the game, so they will be less inclined to just walk away when their home price falls.

All financial institutions should be required to maintain sufficient capital reserves, not just traditional banks. The required reserve ratio should automatically rise during booms and fall during busts. Countercyclical reserve policy like this would help stabilize both the financial system and the money supply.

Finally, teaser rates should be outlawed. Teaser rates are intended to take advantage of people's innate susceptibility to hyperbolic discounting. If someone isn't willing to buy a home based on the regular interest rate and the regular monthly payments, then they shouldn't be buying the home.

Economists should stop ignoring bubbles

Yale economist Robert Shiller has constructive criticism for his own profession:

The widespread failure of economists to forecast the financial crisis that erupted last year has much to do with faulty models. This lack of sound models meant that economic policymakers and central bankers received no warning of what was to come.

As George Akerlof and I argue in our recent book Animal Spirits, the current financial crisis was driven by speculative bubbles in the housing market, the stock market, energy and other commodities markets. Bubbles are caused by feedback loops: rising speculative prices encourage optimism, which encourages more buying and hence further speculative price increases — until the crash comes.

You won’t find the word “bubble,” however, in most economics treatises or textbooks. Likewise, a search of working papers produced by central banks and economics departments in recent years yields few instances of “bubbles” even being mentioned. Indeed, the idea that bubbles exist has become so disreputable in much of the economics and finance profession that bringing them up in an economics seminar is like bringing up astrology to a group of astronomers.

The fundamental problem is that a generation of mainstream macroeconomic theorists has come to accept a theory that has an error at its very core — the axiom that people are fully rational.

Meredith Whitney predicts bad year for banks

While many investors are calling a bottom in financials, banking analyst Meredith Whitney says not so fast. Meredith Whitney, in case you're unaware, was the first banking analyst to prominently point out the problems with the big banks.

A surge in borrower defaults and unemployment pressures will make 2009 an even uglier year for banks than last year, analyst Meredith Whitney said.

She predicted "breakups and M&As on a grand scale" as the industry seeks to remake itself in the face of all its capital pressures.

"I don't think this year is going to look any better than last year," Whitney said in an interview Tuesday on CNBC. "In fact it will look worse because there's so much credit coming out of the system."

Whitney, a former analyst at Oppenheimer who recently opened her own firm, is renowned for calling out the problems with banks' toxic assets before the issue became widespread.

As some have been predicting the worst may be over for the banking sector, Whitney countered that many of the statements about some of the big banks showing profits ignore the burden that additional writedowns will pose through the year. In particular, she said Citigroup's statement that it had turned a profit the first two months of 2009 might came back to haunt it once a fuller picture was presented.

Consumers also will face pressure as unemployment grows and banks and credit card companies start calling in credit lines to avoid getting stuck with even more bad debt.

"The probability of more people going into default is higher, so the banks are going to have a tough time," she said.

She also predicts that U.S. home prices will fall 40%+ peak to trough. I'd say she's dead-on accurate.

The cause of the housing bubble and financial crisis

Nobel Laureate Paul Krugman gives his thoughts on what caused the housing bubble and resulting financial crisis:

How did this global debt crisis happen? Why is it so widespread? The answer, I’d suggest, can be found in a speech Ben Bernanke, the Federal Reserve chairman, gave four years ago. At the time, Mr. Bernanke was trying to be reassuring. But what he said then nonetheless foreshadowed the bust to come.

The speech, titled "The Global Saving Glut and the U.S. Current Account Deficit," offered a novel explanation for the rapid rise of the U.S. trade deficit in the early 21st century. The causes, argued Mr. Bernanke, lay not in America but in Asia.

In the mid-1990s, he pointed out, the emerging economies of Asia had been major importers of capital, borrowing abroad to finance their development. But after the Asian financial crisis of 1997-98 (which seemed like a big deal at the time but looks trivial compared with what’s happening now), these countries began protecting themselves by amassing huge war chests of foreign assets, in effect exporting capital to the rest of the world.

The result was a world awash in cheap money, looking for somewhere to go.

Most of that money went to the United States — hence our giant trade deficit, because a trade deficit is the flip side of capital inflows. But as Mr. Bernanke correctly pointed out, money surged into other nations as well. In particular, a number of smaller European economies experienced capital inflows that, while much smaller in dollar terms than the flows into the United States, were much larger compared with the size of their economies. ...

For a while, the inrush of capital created the illusion of wealth in these countries, just as it did for American homeowners: asset prices were rising, currencies were strong, and everything looked fine. But bubbles always burst sooner or later, and yesterday’s miracle economies have become today’s basket cases, nations whose assets have evaporated but whose debts remain all too real. ...

If you want to know where the global crisis came from, then, think of it this way: we’re looking at the revenge of the glut.

Which banks will pass the stress test?

Morningstar runs its own stress test of the banks. Only half pass the test.

Bank collapse could cause financial panic in Venezuela

It looks like the anti-American dictator might have his hands full:

The collapse of a Venezuelan bank owned by R. Allen Stanford, the Texas financier accused of fraud, is raising concern that the run on its deposits could spread to other banks, threatening the nation's economy.

On Saturday, President Hugo Chávez blamed his political enemies for rumors about mass withdrawals, and urged depositors not to pull their savings from domestic banks. ...

Mr. Chávez moved to restore confidence a day after speculation spread among brokerage-house trading desks and businessmen that at least one major bank had faced unusually large deposit withdrawals. The speculation is difficult to confirm because it is too recent to be reflected in the latest official bank data.

While Mr. Chávez may succeed in restoring confidence, the concerns underscore the problems facing the 54-year-old, anti-American former soldier, who recently completed a decade in power and last month won a referendum to alter the constitution to permit indefinite re-election.

Mr. Chávez's ability to fund welfare programs and other subsidies at the core of his popularity is undercut by plunging oil prices. Increasingly, residents of Venezuela say they believe Mr. Chávez will have to devalue the "strong bolivar" currency he introduced last year. Price controls meant to contain 30% inflation have led to food shortages. On Saturday, Mr. Chávez dispatched troops to force rice makers to boost production.

That last sentence is classic! You've gotta love economically ignorant dictators.

A bubble warning from Warren Buffett

From Berkshire Hathaway's newly release shareholder letter:

The investment world has gone from underpricing risk to overpricing it. This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable — in fact, almost smug — in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear commentators proclaim "cash is king," even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.

Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns.

I agree that intense fear has caused a high risk premium. This risk premium has caused a bubble in ultra-safe assets (i.e. government bonds) and an incredible long-term investment opportunity in riskier assets (i.e. stocks). Ordinary investors worried about the possibility of being laid off during this recession, however, have no choice but to make sure they have an unusually large emergency fund.

The gradual decline of the housing bubble is causing this recession. Since housing is still overvalued, it will continue declining in the near term, which will continue to weaken the economy as well. When the pace of the housing decline slows, it will probably be time to go full-bore into the stock market even if the economy has not yet recovered. (The stock market typically turns upward six months before the end of a recession, and it typically turns upward rapidly.)

Bank of America's tangible common equity ratio is roughly 0.7% using mark-to-market accounting

Tangible common equity is one important ratio the Treasury is believed to be using in it's "stress test" of banks. Citigroup's low tangible common equity ratio is believed to be the reason common shareholders are having their stakes massively diluted.

The formula for the tangible common equity ratio is:

tangible common equity ratio = (common shareholder's equity – goodwill – intangible assets) ÷ (total assets – goodwill – intangible assets)

Bank of America recently reported a tangible common equity ratio of 2.6%. However, things are much worse if you use mark-to-market accounting for the loans on their books.

Loans held to maturity are not subject to mark-to-market accounting, but banks do have to report the mark-to-market value once per year. Bank of America just released that number yesterday. According to Bloomberg, the mark-to-market value of their loans is $44.6 billion less than what the balance sheet says. So, by looking at their balance sheet and doing a little math, we can figure out Bank of America's mark-to-market tangible common equity ratio.

First let's figure out the tangible assets. A month ago they reported total assets as $2,485.2 billion. Goodwill was $87.3 billion and intangible assets were $14.3 billion. That gives us tangible assets worth $2,383.6 billion.

Second, let's calculate tangible common equity. Bank of America didn't list their common equity separately from their preferred equity, but we can easily figure out their tangible common equity by multiplying their tangible assets by 2.6%. That gives us $62 billion in tangible common equity.

Third, to figure out the mark-to-market tangible common equity ratio, we need to subtract $44.6 billion from both tangible assets and tangible common equity. That gives us $2,339 billion and $17.4 billion, respectively.

Finally, divide $17.4 billion by $2,339 billion to get 0.7%. Yikes!

For Bank of America's sake, let's hope a temporarily high risk premium (market fear) is causing the mark-to-market value of the loans to be unreasonably undervalued.

Update: Morningstar suggests a minimum acceptable tangible common equity ratio should be about 3%.

Fed President Lockhart: Bank nationalization unlikely

Atlanta Fed President Dennis Lockhard doesn't expect the U.S. to nationalize banks:

Nationalizing banks is "substantially" off the table, Federal Reserve Bank of Atlanta President Dennis Lockhart said following a speech in Alabama.

Speaking to reporters after his speech, Lockhart said he was "unaware" of any serious consideration of bank nationalization. ...

Lockhart said correctly valuing assets is a central challenge to fixing banks and that the Treasury is not ruling out guarantees of toxic assets.

Fed Chairman Ben Bernanke also opposes nationalization, but does see it as a possible temporary option:

Ben Bernanke, the chairman of the Federal Reserve, expressed skepticism Wednesday about the prospect of nationalizing troubled banks and suggested that President Obama’s administration would much prefer to keep financial institutions in private hands.

His comments, at a luncheon at the National Press Club, came shortly after his predecessor, Alan Greenspan, told The Financial Times that temporary nationalization of some banks might be the “least bad solution” to the current banking crisis. Many were surprised that Mr. Greenspan, long a fan of self-regulation in the financial sphere, would even suggest such a move.

“As a general rule, it’s very challenging for governments to manage banks for a protracted period,” Mr. Bernanke said Wednesday after being asked about Mr. Greenspan’s comments, The Charlotte Observer reported.

Later, he added: “Whatever action would need to be taken at one point or another, there’s a very strong commitment on the part of the administration to keep banks private and return them to private hands as quickly as possible.”

A temporary nationalization would be as bad for shareholders as a semi-permanent nationalization. For the economy as a whole, semi-permanent nationalization would be far worse. Treasury Secretary Tim Geithner is also known to oppose nationalization. My guess is even temporary nationalization is off the table as long as a bank is solvent. If a bank becomes insolvent, then something needs to be done.

The worst case scenerio for the big banks

From The New York Times' DealBook blog:

CreditSights ran the numbers, and found that according to its “severe” case situation, all the major banks and brokerages — Citigroup, Bank of America, Wells Fargo, JPMorgan Chase, Goldman Sachs and Morgan Stanley — might require further capital injections from the government.

CreditSights’ projections were driven by its own forecast for future credit losses based on how badly the market could perform over the next two years. Under these assumptions, the losses from mortgage-related products would be significantly higher than the amount the banks have set aside already. It also envisions an unemployment rate of 10 percent.

The future losses for some banks are staggering by CreditSights’ estimates: Wells Fargo, $119 billion; BofA, $99 billion; JPMorgan, $124 billion; Citi, $101 billion; Goldman Sachs, $47 billion; Morgan Stanley, $34 billion.

Government deserves much of the blame for the economic crisis

Stanford University economics professor John Taylor says the government bears a lot of responsibility for the housing bubble and the resulting financial crisis.

My research shows that government actions and interventions — not any inherent failure or instability of the private economy — caused, prolonged and dramatically worsened the crisis.

The classic explanation of financial crises is that they are caused by excesses — frequently monetary excesses — which lead to a boom and an inevitable bust. This crisis was no different: A housing boom followed by a bust led to defaults, the implosion of mortgages and mortgage-related securities at financial institutions, and resulting financial turmoil.

Regarding the housing bubble:

Monetary excesses were the main cause of the boom. The Fed held its target interest rate, especially in 2003-2005, well below known monetary guidelines that say what good policy should be based on historical experience. Keeping interest rates on the track that worked well in the past two decades, rather than keeping rates so low, would have prevented the boom and the bust. Researchers at the Organization for Economic Cooperation and Development have provided corroborating evidence from other countries: The greater the degree of monetary excess in a country, the larger was the housing boom.

The effects of the boom and bust were amplified by several complicating factors including the use of subprime and adjustable-rate mortgages, which led to excessive risk taking. There is also evidence the excessive risk taking was encouraged by the excessively low interest rates. ...

Other government actions were at play: The government-sponsored enterprises Fannie Mae and Freddie Mac were encouraged to expand and buy mortgage-backed securities, including those formed with the risky subprime mortgages.

Regarding the financial crisis:

A third policy response was the very sharp reduction in the target federal-funds rate to 2% in April 2008 from 5.25% in August 2007. This was sharper than monetary guidelines such as my own Taylor Rule would prescribe. The most noticeable effect of this rate cut was a sharp depreciation of the dollar and a large increase in oil prices. After the start of the crisis, oil prices doubled to over $140 in July 2008, before plummeting back down as expectations of world economic growth declined. But by then the damage of the high oil prices had been done.

After a year of such mistaken prescriptions, the crisis suddenly worsened in September and October 2008. We experienced a serious credit crunch, seriously weakening an economy already suffering from the lingering impact of the oil price hike and housing bust.

Many have argued that the reason for this bad turn was the government's decision not to prevent the bankruptcy of Lehman Brothers over the weekend of Sept. 13 and 14. A study of this event suggests that the answer is more complicated and lay elsewhere.

While interest rate spreads increased slightly on Monday, Sept. 15, they stayed in the range observed during the previous year, and remained in that range through the rest of the week. On Friday, Sept. 19, the Treasury announced a rescue package, though not its size or the details. Over the weekend the package was put together, and on Tuesday, Sept. 23, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified before the Senate Banking Committee. They introduced the Troubled Asset Relief Program (TARP), saying that it would be $700 billion in size. A short draft of legislation was provided, with no mention of oversight and few restrictions on the use of the funds.

The two men were questioned intensely and the reaction was quite negative, judging by the large volume of critical mail received by many members of Congress. It was following this testimony that one really begins to see the crisis deepening and interest rate spreads widening.

The realization by the public that the government's intervention plan had not been fully thought through, and the official story that the economy was tanking, likely led to the panic seen in the next few weeks. And this was likely amplified by the ad hoc decisions to support some financial institutions and not others and unclear, seemingly fear-based explanations of programs to address the crisis.

His conclusion:

It did not have to be this way. To prevent misguided actions in the future, it is urgent that we return to sound principles of monetary policy, basing government interventions on clearly stated diagnoses and predictable frameworks for government actions.

Massive responses with little explanation will probably make things worse. That is the lesson from this crisis so far.

One problem with this narrative is that we were already well into the housing bubble by 2003. Many economists say that the housing bubble was initially caused by excessive savings in China and the Middle East, which resulted in ultra-low interest rates in the U.S. Rather than creating the housing bubble, it is much more likely that the Federal Reserve poured gas on an already burning fire.

John Taylor has a new book about the financial crisis coming out soon.

Economic history lessons for today's financial crisis

From Carmen Reinhart and Kenneth Rogoff:

Until now, the U.S. economy has been driving straight down the tracks of past severe financial crises, at least according to a variety of standard macroeconomic indicators we evaluated in a study for the National Bureau of Economic Research (NBER) last December.

In particular, when one compares the U.S. crisis to serious financial crises in developed countries (e.g., Spain 1977, Norway 1987, Finland 1991, Sweden 1991, and Japan 1992), or even to banking crises in major emerging-market economies, the parallels are nothing short of stunning.

Let's start with the good news. Financial crises, even very deep ones, do not last forever. Really. In fact, negative growth episodes typically subside in just under two years. If one accepts the NBER's judgment that the recession began in December 2007, then the U.S. economy should stop contracting toward the end of 2009. Of course, if one dates the start of the real recession from September 2008, as many on Wall Street do, the case for an end in 2009 is less compelling.

On other fronts the news is similarly grim, although perhaps not out of bounds of market expectations. In the typical severe financial crisis, the real (inflation-adjusted) price of housing tends to decline 36%, with the duration of peak to trough lasting five to six years. Given that U.S. housing prices peaked at the end of 2005, this means that the bottom won't come before the end of 2010, with real housing prices falling perhaps another 8%-10% from current levels.

Equity prices tend to bottom out somewhat more quickly, taking only three and a half years from peak to trough — dropping an average of 55% in real terms, a mark the S&P has already touched. However, given that most stock indices peaked only around mid-2007, equity prices could still take a couple more years for a sustained rebound, at least by historical benchmarks.

Turning to unemployment, where the new administration is concentrating its focus, pain seems likely to worsen for a minimum of two more years. Over past crises, the duration of the period of rising unemployment averaged nearly five years, with a mean increase in the unemployment rate of seven percentage points, which would bring the U.S. to double digits. ...

Perhaps the most stunning message from crisis history is the simply staggering rise in government debt most countries experience. Central government debt tends to rise over 85% in real terms during the first three years after a banking crisis. This would mean another $8 trillion or $9 trillion in the case of the U.S.

Interestingly, the main reason why debt explodes is not the much ballyhooed cost of bailing out the financial system, painful as that may be. Instead, the real culprit is the inevitable collapse of tax revenues that comes as countries sink into deep and prolonged recession. Aggressive countercyclical fiscal policies also play a role, as we are about to witness in spades here in the U.S. with the passage of a more than $800 billion stimulus bill.

Needless to say, a near doubling of the U.S. national debt suggests that the endgame to this crisis is going to eventually bring much higher interest rates and a collapse in today's bond-market bubble. The legacy of high government debt is yet another reason why the current crisis could mean stunted U.S. growth for at least five to seven more years.

Graphs: The U.S. money supply

M2, the broadest measure of the money supply currently tracked by the Federal Reserve:


M1, a narrower measure of the money supply:


M0, the monetary base (currency plus central bank reserves), the portion of the money supply directly controlled by the Federal Reserve:


The Fed helicopters are a-flyin'!

Video: The prospects for the U.S. banking industry