Worthwhile Canadian Initiative

"The Bank of Canada should peg the TSE 300" - revisited

"The Bank of Canada should peg the TSE-300" is the title of a Carleton Economics Department working paper I wrote in 1992. (Sorry, but no web version available; this was in the olden days when all we had was paper, and when the TSX was the TSE.) Given the recent turmoil in financial markets, and the renewed interest in having central banks look at asset prices, I was wondering whether to resurrect this paper, but dithered. Now Roger Farmer has beaten me to it. Mark Thoma posted it on his blog, and Tyler Cowen on his.

The reactions in the comments are mostly either unfavourable, or incredulous. I thought I would write a few words in defence of the idea, and then say why I no longer support it.

The 15-year old Liquidity Trap

Macroeconomists think of the zero lower bound liquidity trap as something that only became a problem in 2008 (Japan aside). JKH, a commenter on this blog, says it became a problem for banks about 15 years ago.

"An interesting aspect of gap management is that the zero bound for interest rates has been a critical issue for banks for the past 15 years. This is because historic spreads between the prime rate and rates on some of the more passive core deposit and transaction accounts were quite wide. Spread compression began long before the fed funds rate or the Canadian bank rate got down to current levels. The zero bound isn’t a problem just for central banks."

Banking is a spread game. Banks borrow at lower interest rates, lend at higher interest rates, and make their income on the spread. Falling interest rates squeeze the bottom end of the spread against the zero lower bound, well before average interest rates approach zero. And the zero-bound spread-squeeze should affect financial markets more generally, not just financial intermediaries, in much the same way.

Job creation, job destruction, and the Detroit Three bailouts

The most compelling argument for the Detroit Three bailout is not that North America must always have a certain number of people working in the auto sector. Our economic history is one of industries that start from nothing, grow, and then are displaced (if not replaced) by even newer industries. There's nothing special about the auto industry that cries out for a minimum level of employment and output that must be enforced for all time. What we're worried about is a sudden disintegration.

But just how severe would be a sudden failure of the Detroit Three on labour markets? It's perhaps a commonplace to note that jobs are continually being destroyed and created, but I don't think that the scale of this phenomenon is sufficiently well known.

Here is a graph of hires and separations (quits + layoffs) in Canada between 1988 and 2006. The data are not seasonally adjusted and pretty noisy, so they are expressed as 12-month moving averages. They stop at the end of 2006, because they were very kindly passed onto me by Stephen Tapp (now at the Parliamentary Budget Office) for this post; updating them would cost me time and money.

The thing to take from this graph is the scale of the vertical axis. The most credible worst-case scenario of a collapse of the Detroit Three involve job losses of the order of 150k. (The estimate of 500k from the Ontario Manufacturing Council that made so many headlines is not credible.) Losing 150,000 jobs is certainly not good news, but in the context of an economy in which almost a quarter of a million jobs are lost every month, it's fair to wonder just how big of a deal that is. If those losses were spread across a few months, they would hardly show up in that graph.

In the US, the Bureau of Labor Statistics has data from 2001 that are publicly available over here, and it also provides a breakdown for how separations are divided between quits and layoffs:

Even after applying the rule of ten, the gross job flows from the US payroll survey are twice as large as those in Canada. I don't know if that is due to differences in survey methodology, or if the US labour market really is that much more dynamic. But it's pretty clear that the gross job flows are an order of magnitude greater than the net flows that make the headlines each month.

It's also interesting to see just how stable the flow of layoffs has been. It's not hard to imagine why hires and quits would be pro-cyclical, but it's surprising to see that the flow of layoffs (at least in this short sample) does not appear to be much affected by the business cycle.

In the US, the predicted employment losses associated with a collapse of the Detroit Three are in the range of 2m. Once again, if they were spread over a number of months, they wouldn't show up on that graph.

I don't want to be misunderstood here: notwithstanding these considerations, the short-term consequences of an immediate, catastrophic collapse are severe enough to justify spending public money in order to prevent it. Hiring rates are not yet strong enough to absorb that kind of shock.

But if the shock is spread out over a long enough period of time, they will be.

Economists' fatal flaw: diffidence

Paul Krugman asks why more economists didn't make more of an effort to draw attention to the bubbles in the US housing market. My answer is that economists are by training - if not by nature - perhaps too diffident. If people behave in a way that cannot be reconciled with what our theories predict, our instinct is to presume that our models are wrong.

This training starts early. I used to teach a course in which I would ask students to choose between the lotteries of the Allais Paradox, and then explain how only certain combinations of preferences could be consistent with the expected utility hypothesis. I would then go on to point out that the fact that a significant number of students made 'wrong' choices should be interpreted as a weakness of the theory, and not as evidence of the inability of certain students to think straight.

For example, I've not been able to make head nor tail of stock market data since 1995. But my reaction has been to shrug, and wonder where my thinking had gone wrong. It quite literally never occurred to me to write a series of op-eds warning of impending doom.

I wonder to what extent the world would be a better place if economists were as arrogant as non-economists claim they are.

Hair of the Dog

"Too much debt got us into this mess, and now central banks are trying to get us out of the mess by lowering interest rates to get us to borrow and spend more?"

It sounds very much like the cure for hangovers: "take some hair of the dog that bit you". At best, drinking more to cure a hangover merely postpones the problem.

All analogies have problems. No simile runs on four legs. But this dog is legless. It won't hunt.

Central Banks should bet on recovery - literally

Ben Bernanke should publicly bet $1 trillion dollars that the US economy will recover quickly from deflation and recession. He should make that bet on the Fed's behalf. The Treasury should publicly disavow all responsibility for bailing out the Fed if Bernanke loses the bet. If he loses the bet, it would be paid for by printing money.

A fiscal stimulus proposal that should be implemented, but won't be

A recession is here, the Bank of Canada is running out of bullets, and it's time for  a fiscal stimulus. The problem is that the worst possible signal has been sent out to the usual gang of well-connected, media-savvy interest groups: "We're giving money away, and we really don't care who gets it!".  This has resulted in a contest in which those with the sharpest elbows and the best PR campaigns win.

This is not a game in which the most marginalised elements of society do well, so I was glad to see this proposal to increase the Child Tax Credit and the GST rebate. (The only thing I'd add would be a proposal to increase the Working Income Tax Benefit.)

Sadly, no political party is interested. Not even the NDP.

Always hire the worst

"Are you sitting comfortably? Then I'll begin.

Once upon a time, in a city called Ottawa...."

"I thought it was called Windsor?"

"No dear, that's another story. Once upon a time, the City of Ottawa needed to hire one person to do a job...."

"I thought it was a car factory?"

Deflation may be on its way, but it's still not here

Coverage of today's CPI release seems to be stressing the fall in the y/y all-items CPI inflation rate (example):

The recent fall in prices appears to have been entirely generated by the fall in gasoline prices, which has had the effect of canceling out the spike we saw a few months ago.

Here's what's happening with core inflation, the index on which the Bank of Canada focuses much of its attention:

The sharp drop at the end of last year was associated with the pass-through of an appreciating Canadian dollar: when the CAD-USD exchange rate hit 1:1, prices were revised sharply down as it became clear to even the most arithmetic-challenged consumer that Canadian prices were too high compared with what US retailers were offering. That one-off event has kept y/y core CPI inflation down for much of this year, but that's now starting to work itself out.

The Bank is unlikely to be displeased with these numbers. It'll still be possible to engineer negative real interest rates for awhile.

We will not be undersold! Budget advice available here at the low, low cost of 99 cents a year!

Finance Minister Jim Flaherty has announced the formation of a committee of outside experts, who will be paid $1/year (plus expenses) for their views. We here at WCI are prepared to use whatever means necessary to defend our market share: if our competitors want a price war, then that's what they'll get.

Multipliers in a liquidity trap; fixed vs. flexible exchange rates. Disagreeing with the IMF.

In a liquidity trap, interest rates are stuck at zero, so increases in government spending do not raise interest rates. What are the government spending multipliers in a liquidity trap? Closed/open economies; fixed/flexible exchange rates.

Some simple arithmetic of Canadian debt and deficits

Various numbers for projected deficits have been reported recently. This post tries to put those numbers into perspective.

Buiter, Krugman, Steinbrueck, free-riding, and the exchange rate

Warning: this post is difficult, and I'm not at all sure I've got it right. But I'm going to post it anyway.

What determines the exchange rate in a liquidity trap? [Prerequisite: second year Open Economy Macro]

In case you hadn't noticed, there's a small war going on, with Willem Buiter (UK) and Paul Krugman (USA) on one side, and the German Finance Minister Peer Steinbrueck on the other. In a nutshell, Buiter and Krugman are saying that Germany (and other countries) should run deficits to stimulate their and the world's economies, and Germany is saying "No, and it's your big spending on borrowed money which got us into this mess in the first place".

Let's cut to zero too

OK, the US Federal Reserve has now cut interest rates essentially to zero. I think the Bank of Canada should now do the same.

But what would happen to the debt if we didn't run a deficit now?

If the government runs a deficit now, the debt-burden on future taxpayers will increase. But maybe the debt-burden would increase even more if we didn't run a deficit now?

The proper way to handle policy questions (in economics, or anywhere) is to compare what will happen with the proposed policy to what would happen under some alternative policy -- the counterfactual. Sometimes the counterfactual is simple: things will stay the same as they are now. But if we are talking about running a deficit to get the economy out of a liquidity trap, the counterfactual is not simple. About the only thing we can be certain of is that things will not stay the same as they are now.

On the economics of the MSM print media

Paul Wells, Andrew Potter and Dan Gardner have posted recently on the plight of the economic model of MSM journalism. What will happen to popular discourse if people stop buying newspapers and magazines because pretty much everything that's in them is available for free on the internet?

Well, let's consider what's at stake. From page 309 of Paul Wells' book Right Side Up on the aftermath of the 2006 election:

I do not believe there was nearly enough effort made by many of my colleagues, especially among newsroom managers, to understand how long-term trends toward fluffy, gossipy Ottawa coverage turned us into sitting ducks as soon as we tried to argue we were standing up for any kind of journalistic principle. We had razed forests to tell Canadians about Paul Martin's chef and Jean Chrétien's golf balls and Harper's formidable gut and the odd little fishing vest he wore in Cancun and the way he shook his daughter's hand when he dropped her off at school. And we were supposed to be the guardians of - what, precisely?

Sadly, his colleagues did not take this scolding to heart in the most recent election. As I ranted over here, "if you wanted to actually learn something about [the] issues, the very last place you should go searching for enlightenment is the mainstream media". Too many of them - with all-too few exceptions - made no effort to understand the issues; in particular, those who used the word 'complicated' to describe the Liberals' 'Green Shift' proposal have no business referring to themselves as professional journalists. I cannot believe that public discourse would have been degraded any further if the number of media types covering the last election had been reduced by half. Or two-thirds.

Which brings us to the MSM journalists' defense of their profession against the blogosphere. If all the journalists have to offer is insider access and re-writes of press releases, then they might as well hang up their skates; the insiders and PR types will eventually shift their attention to the bloggers. And quite frankly, the prospect of insiders and PR flaks scrambling to make their views known through a more fragmented set of stenographers doesn't fill me with despair.

Until recently, the MSM were able to act as oligopolists: media technology required a large fixed cost for distribution, and this led to the development of large networks and/or conglomerates. With that oligopoly position came oligopoly rents. But that technology has changed: it is no longer necessary to invest in an expensive distribution network to reach an audience, so media have moved closer to a competitive model. And in a competitive model, price equals marginal product.

In this sort of transition, the losers are the former oligopolists. But the winners are the consumers.

Trading volume, liquidity crises, Carl Menger, and "off-the-run" bonds

An asset which becomes less liquid (the costs of trading it increase) will be traded less frequently. If an asset is traded less frequently, it will become even less liquid.....

An asset which becomes more liquid (the costs of trading it decrease) will be traded more frequently. If an asset is traded more frequently, it will become even more liquid.....

The Bank of Canada's Financial System Review

The Bank of Canada published its December 2008 Financial System Review yesterday. I spent a few hours reading it through (something I had never bothered to do in the past).

Some observations:

Conflicting signals on the state of Canada's housing market

Something we've been looking for is evidence of an eventual decline in the Canadian housing market.

Today, StatsCan announced that new housing prices fell in October.

Also today, the CMHC announced that rental vacancy rates were down and that average rents were up from October of last year.

A softening of housing prices is to be expected; what we fear is an out-and-out collapse. But out-and-put housing collapses usually aren't triggered by falling vacancy rates and higher rents for apartments.

Why are forecasters predicting a mild recession for Canada?

Shock Minus Control notes that Canadian forecasters in both the public and private sector are predicting a short, mild recession and he provides a good graph that puts these forecasts in historical perspective. In addition, IMF and OECD forecasts for Canada are more optimistic than for most of the other developed countries.

But how and why can it be that anyone can think that Canada can escape with only a minor slowdown when pretty much everyone is predicting impending doom for the US?

To answer this, I'm going to do a quick, back-of-the envelope calculation, and then I'm going to do some moderately sophisticated econometrics. It turns out that both approaches yield almost identical responses.