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Archive for May, 2009

My recent post comparing the magnitude of economic downturns certainly generated lots of feedback.  Some comments were constructive and inspired edits to the original post, some comments were constructive but didn’t lead me to change anything, and some were, er, less than constructive.

Taken together, the comments did inspire me to think through the issues again, and I realized that there is one significant limitation to my analysis that is worth emphasizing: the Long U problem.

Like many economists, I do not expect the U.S. economy to rebound briskly from its current troubles.  The economy may well return to positive growth in the third or fourth quarter, as many forecasters anticipate, but that doesn’t mean that the suffering is over.

In short, I don’t expect the recovery to be a V, with recent declines offset by a rapid recovery.  Nor, for that matter, do I expect a Japan-like L, in which the economy flattens at its new low level.  Instead, I expect a Long U, in which the economy heals slowly before eventually returning to solid growth.

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Readers seemed to enjoy my post about anomalies in the pricing of Citigroup securities, so I thought it would be fun to look at another anomaly, this time in the shares of Berkshire Hathaway, Warren Buffett’s famous company.

This pricing anomaly is small compared to the Citigroup one.  But it does raises some interesting questions about how well the markets are functioning (and, who knows, maybe someone can profit from it).

The root of the anomaly is that Berkshire Hathaway has two classes of shares: A and B.

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The fine folks at the Congressional Budget Office have a reputation as the number-crunching, uber-geeks of the Congressional budget process.  And that’s a reputation they wear proudly (and I am proud to wear as an alum).

But some of CBO’s most important decisions involve principles, not numbers.  For example, CBO has to decide when proposed policies should be treated as part of the government — and thus be recorded on the budget for Congressional purposes — and when not.  Many calls are easy: taxes and spending are clearly governmental, hence in the budget.  Many regulations (e.g., minimum wages and environmental rules) are clearly outside; they may create benefits and impose costs just as taxes and spending do, but they still leave most choice and control in private hands.

And then there are the hard cases such as health insurance reform.

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Treasury yields have been surging.  The yield on 10-year Treasuries, for example, closed at 3.71 percent on Wednesday, up more than 60 basis points over the past two weeks.  That’s a big move.

Economic commentators are grappling to understand the causes and implications of this increase.  Is it the return of bond vigilantes worrying about the grim U.S. fiscal situation?  Concern that aggressive policy actions will ignite inflationary pressures?  Or, perhaps, just a sign of healing in the financial markets?

I don’t have an answer for you today.  But I did find one tidbit that suggests that there’s something to the healing hypothesis.  Treasury yields – on both regular 10-year bonds and their inflation-indexed equivalents – are almost exactly where they were before the fall of Lehman:

                                    9/12/2008                           5/27/2009

     Regular                      3.74%                                      3.71%                                   

     Inflation-Indexed       1.79%                                      1.83%

In the months after Lehman’s fall, yields on regular Treasuries plummeted in a massive flight to liquidity, while yields on less-liquid inflation-indexed bonds rose sharply.

Those moves have reversed in recent months bringing both 10-year Treasury yields back to where they started.

Source: Federal Reserve Board, Release H.15

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Yesterday I cautioned against comparing the current economic downturn to the Great Depression.  The current recession is certainly severe, with overall economic activity on track to drop almost 4 percent.  But the Great Depression was incomparably worse, with output dropping almost 30 percent.

In the comments, Merle Hazard offers an important addendum to my argument, which I heartily endorse.  Merle says:

A plane crash averted does bear some resemblance to a plane crash that happened…not in the final outcome, but in the chain of events that took place up until the time the pilot pulled out of the nose dive.

The easiest way to see what Merle has in mind is to read John Kenneth Galbraith’s The Crash of 1929.  The parallels between the lead-up to the Great Depression and the lead-up to today’s severe recession are eerie.  Excess credit, reckless lending, high leverage, ponzi schemes … it’s all there.  Some enterprising author should (with permission) go through the book, change a few hundred words and numbers and reprint it as The Crash of 2009.

Except for one thing: the economic costs of today’s downturn, although severe, appear to be much lower (knock on wood).  The trillion dollar question is why.  I see three possible explanations:

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NEW UPDATE: For updated data and an even better discussion of the issues raised here, please start with this post from August 2, 2009.

UPDATE:  Please see two related posts:  “The Long U” and “A Plane Crash Averted?”

The Great Depression was an unspeakably bad time for the U.S. economy.  I know that sounds obvious, but it seems necessary to say given all the recent rhetoric about “the worst economy since the Great Depression.”

Our economy has indeed been in terrible shape lately, with millions of families struggling with falling incomes, job losses, home foreclosures, and plummeting wealth.  The current recession is severe by any reasonable metric.  But it still pales in comparison to the Great Depression.

One simple way to see these basic facts — that the current recession is severe by historical standards, but falls far short of the Great Depression — is to consider how much overall economic output declined during past downturns.  The following chart shows the five largest declines in real gross domestic product (GDP) since the end of World War II.  For the current downturn, I have used official estimates of GDP through the first quarter of this year plus the median forecast for Q2 (-1.4 percent) from the Wall Street Journal’s May survey of forecasters).

Five Downturns

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People usually think of eBay as the master auctioneer of the Internet age.  As this month’s Wired points out, however, Google is the real master.

Google famously uses auctions to decide which ads appear in which positions when you do a search.  But Google takes auctions much further:

Google even uses auctions for internal operations, like allocating servers among its various business units. Since moving a product’s storage and computation to a new data center is disruptive, engineers often put it off. “I suggested we run an auction similar to what the airlines do when they oversell a flight. They keep offering bigger vouchers until enough customers give up their seats,” [Google Chief Economist Hal] Varian says. “In our case, we offer more machines in exchange for moving to new servers. One group might do it for 50 new ones, another for 100, and another won’t move unless we give them 300. So we give them to the lowest bidder—they get their extra capacity, and we get computation shifted to the new data center.”

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Summary: Treasury should give up on negotiated sales and simply auction the bank warrants it received through its TARP investments.  Auctioning the warrants will enhance the transparency of the process, ensure that taxpayers get a fair return on their investment, free banks from the nuisance of government involvement, and allow banks, if they choose, to preserve needed capital.

Healthy banks are anxious to escape from the government’s Troubled Asset Relief Program.  TARP capital seemed cheap at first since the government offered more generous financial terms than were available from private investors.  But now the hidden costs of government investments – compensation limits, tighter regulatory scrutiny, and a public backlash against financial bailouts – have become apparent.  As a result, many banks want to pay off Uncle Sam and free themselves from the TARP.

Repayment sounds simple.  Subject to regulatory approval, banks can simply write a check to Treasury that covers the amount of money they received (by selling preferred stock) plus any outstanding dividends.  But there’s a complication.  When Treasury purchased the preferred shares, it also received warrants to purchase common stock in the future.  To fully escape the burden and stigma of TARP, the banks thus need a way to get Treasury to relinquish those warrants.

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Summary: Something is amiss in the market for Citigroup securities: prices are out-of-whack with standard arbitrage relationships.  This suggests that (a) recent financial turmoil — or, perhaps, the policy responses to it — have undermined market efficiency and (b) some investors are over-paying.   

Recent weeks have witnessed yet another case of law-breaking in the financial sector: Citigroup is violating the law of one price.

When the market closed last Friday, there were at least three different ways you could invest in Citigroup’s common stock:

Simple: You could buy common shares of Citigroup, just as you would with any publicly-traded company.

Preferred: You could buy shares of preferred stock that will convert into common shares. Citi has announced, for example, that it intends to convert each share of Series F preferred into about 7.3 shares of common stock.

Synthetic: You could buy and sell options in a way that replicates the financial returns from owning Citi stock.  For example, you could buy a call option with a strike price of $4, sell a put option with the same strike price, and set aside $4 in a bank account.  Taken together, those investments will give you the same financial returns as owning a share of Citigroup common stock. (I am gliding over some small details here.)

In normal times, the law of one price would imply that you should pay nearly identical prices under any of these approaches.  Transaction costs might allow prices to stray a bit from one another, and the preferred might trade at a small discount if the conversion isn’t completely certain.  But any price differences should be small as arbitrageurs buy stock the inexpensive way and sell it the expensive way.

That isn’t the case today. (more…)

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Welcome

Welcome to my new blog.  This is an experiment.  I intend to use the blog to share thoughts on economics, finance, and, occasionally, life.  But we will see how it evolves.

Feedback is appreciated.  Please click on over to the contact form if you’d like to share any thoughts on the blog, on the economy, or if you would like to discuss speaking, writing, or consulting opportunities.

Also, please check out the email subscription and RSS feeds if you’d like to follow the blog in either of those ways.

Thanks.

–Donald

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