## September 13, 2011

### Investment Behavior and Policy Implications

Over the weekend, both Professors Barro and Mankiw wrote on investment in the New York Times. As Modeled Behavior observed, the focus on business fixed investment (BFI) or nonresidential investment was somewhat odd because BFI behavior had not been particularly anomalous in the recovery. Here, I extend upon that analysis, and draw some policy implications.

Investment Behavior in Context

Figure 1 below highlights the depth of the last recession, and the dropoff in nonresidential fixed investment.

Figure 1: Four quarter growth rate in GDP (dark blue) and in nonresidential fixed investment (red). Growth rates calculated as log differences. NBER defined recession dates shaded gray. Source: BEA, 2011Q2 2nd release, NBER and author’s calculations.

Consider the relationship between q/q growth rate of investment on current and three lags of q/q output growth over periods of expansion:

Δ bfi t = -0.001 + 1.253 Δ y t + 0.188 Δ y t-1 + 0.332 Δ y t-2 + 0.417 Δ y t-3 + u t     (1)

Adj. R2 = 0.22, SER = 0.015, Breusch-Godfrey LM(2) = 3.18 [p-val.=0.204]. Bold face denotes significance at 10% level.

Whatever instability exists in this relationship, it is not evident in the most recent expansion:

Figure 2: One step ahead recursive residuals test for equation (1). Source: Author’s calculations.

The instability seems more marked earlier in the sample, in the 1980's. A CUSUM test also fails to reject stability overall.

In fact, it is interesting that nonresidential investment has performed better in this recovery from recession as opposed to the preceding recovery from the 2001Q1-2001Q4 recession.

Figure 3: Log difference of nonresidential investment and GDP, versus 2009Q2 (blue) and versus 2001Q4 (dark red). Source: BEA, 2011Q2 2nd release and author’s calculations.

One might want to take into account the fact that the recession has been particularly deep. I have normalized on the beginning of the downturn (2008Q2 and 2000Q4) instead of the trough.

Figure 4: Log difference of nonresidential investment and GDP, versus 2008Q2 (blue) and versus 2000Q4 (dark red). Source: BEA, 2011Q2 2nd release and author’s calculations.

Hence, taking into account the depth of the recession, one finds that BFI is doing better than in the recovery from the previous recession (as well as the previous recession+recovery). It makes one wonder about this argument that great regulatory uncertainty is dampening business enthusiasm for capacity increases. After all, this bivariate logic would imply that regulatory uncertainty was greater in the years after the first Bush recession, relative to now.

Policy Implications

As noted in several previous posts, investment in the previous recovery from the first Bush recession (2001Q1-01Q4) was itself lackluster [1] [2] . Hence, one needs to take seriously the arguments regarding how to encourage more rapid investment.

Here is where I found the two op-eds this weekend of interest. Professor Mankiw notes the demand side motivation for investment, while stressing the user cost of capital:

The relationship between investment and the overall economy is what an engineer would call a positive feedback loop. Greater business investment would increase hiring, both by those who produce the investment goods and those who buy them. Greater employment would mean more workers taking home paychecks, which in turn would increase the overall demand for goods and services. When businesses saw more customers coming through their doors, they would then increase investment spending yet again.

WHAT can policy makers do to stoke animal spirits and encourage businesses to invest?

One obvious step would be a cut in the taxation of income from corporate capital. According to a 2008 study by the Organization for Economic Cooperation and Development, “Corporate taxes are found to be most harmful for growth.” Tax reform that reduced the burden on capital income and shifted it toward consumption would improve prospects for long-run growth and, in so doing, encourage greater investment today.

I’ll just observe while the US corporate tax rate is relatively high, according to the CBO, it isn’t relative to other G-7, and the effective corporate tax rate is not particularly high [3].

I had a dream that Mr. Obama and Congress enacted this fiscal reform package -- triggering a surge in the stock market and a boom in investment and G.D.P. -- and that he was re-elected.

His fiscal reform package includes abolishing the corporate and estate taxes, implementing a VAT, and cutting government spending. He also argues for reducing regulatory uncertainty

I think all of these factors in principle could be determinants of investment. The question is really the magnitude, empirically, of these effects. One way of assessing the relative importance of each variable is to conduct a horse race of the various models; I cited a Kopcke study from 2001 in this post.

An updated version of this approach was undertaken by Rapach and Wohar (J.Forecasting, 2007). [Ungated working paper version, Rapach and Wohar (2005).]:

we run horse races involving a number of forecasting models of US real fixed private non-residential investment spending growth over the 1995:1–2004:2 out-of-sample period, a volatile period marked by an investment ‘boom and bust’ cycle. The forecasting models we consider are based on the familiar Accelerator, Neoclassical, Average Q, and Cash-Flow models of investment spending, and we also consider two forecasting models suggested by the more recent work of Barro (1990) and Lettau and Ludvigson (2002). The Average Q model produces the most accurate forecasts at the 1-quarter horizon, while the Barro (1990) Stock Price model generates the most accurate forecasts at horizons beyond 1 quarter. At longer forecast horizons, forecast encompassing tests indicate that the Stock Price model contains most of the information useful for forecasting US business fixed investment spending growth for the 1995:1–2004:2 out-of-sample period relative to the other models. These results point to an important predictive role for the stock market with respect to the recent course of US business fixed investment spending growth. While stock prices appear important in forecasting the recent behavior of US business investment spending growth, robustness checks show that other variables are often more important over the 1975:1–1984:4 and 1985:1–1994:4 out-of-sample periods. Furthermore, we obtain extensive in-sample evidence of multiple structural breaks in all of the forecasting models. These results question whether the Stock Price model will continue to produce the most accurate forecasts outside the 1995:1–2004:2 period, and they suggest that structural instability will make it difficult in general to forecast US business fixed investment spending growth using conventional and several recently proposed models.

Barro’s assertion that a stock price boom would induce an investment increase seems at least somewhat validated by this analysis. However, the outperformance is not uniform, as the authors note. And it is important to highlight that while Barro asserts fiscal reform would cause the boom in the stock market, that particular step is more conjecture (hope?) than analysis.

Recall in the risk neutral version of stock price valuation model, the stock price is the present discounted value of dividends and the discount rate used for equities [4]. At some level, the amount of dividends paid out depends on profits, and these in turn will depend on the level of economic activity. Hence, if fiscal reform incorporates contractionary fiscal policy, one may very well get a stock market decline (so I am arguing against expansionary fiscal contraction) [5] [6] [7] [8].

Now, it could be that fiscal reform that induces lower interest rates and hence a lower discount rate for equities that results in a stock market boom. But interest rates, both nominal and real, are at quite low rates. Hence, the scope for fiscal consolidation to effect a stock market boom via real rates over the relevant period seems limited.

Professor Barro also stresses eliminating regulatory uncertainty as an impediment to investment. It could be that regulatory uncertainty is depressing stock prices (and hence investment). It would be interesting to see this effect quantified, in a manner that controlled for concurrent macro uncertainty.

By the way, the fact that investment responds to real stock prices most, rather than the user cost of capital key in the neoclassical model, suggests that further tax measures are unlikely to have a big impact. That's not an exact formulation, since some tax provisions that affect the user cost of capital can affect after tax cash flow and hence stock prices. But the fact that much movement in stock prices has occurred with high corporate-to-GDP ratios suggests that this link, if it exists, is not very operative at the moment.[9] At the very least, fantastical effects used in the Heritage Foundation’s Center for Data Analysis "analysis" of the Ryan Plan [10] [11] [12] [13] are unlikely to materialize. (Where is William Beach these days?)

Additional discussion of the investment issue at Free Exchange, which cites Modeled Behavior.

Posted by Menzie Chinn at September 13, 2011 03:45 PM

digg this | reddit

Regulatory uncertainty is not the only kind of uncertainty out there. Just because the pattern of investment of late is similar to the pattern of 01-02 does not mean that there was just as much regulatory uncertainty then as now.

And after reading this entire post, I'm left wondering what exactly is your point? You say that one needs to take seriously the arguments on how to encourage investment, yet the only comment you have for Mankiw is that our corporate tax rates are not abnormal. I hardly call that serious analysis of any sort. Then you spend a bit of effort criticizing Barro for suggesting that stock returns induce investment, something I don't think he even claims. The only message I get from either articles is that fiscal reform will improve the long-term prospects of the economy. Is that really something you disagree with, or are you really just upset that they aren't endorsing additional fiscal stimulus?

Posted by: Jeff at September 13, 2011 08:00 PM

We get regular 1-5% ++ moves in stock prices on a weekly/monthly/quartley basis. No rational CFO is going to alter planned investment spending based on temporary moves in equity prices.

The relationship between stock prices and investment seems pretty straight forward -- investors and CFO's observe the ingredients for a sustained recovery. Equity prices are nearly frictionless and respond instantly. Business investment responds with a lag because investment is sticky. CFO's wait to see if the recovery is sustainable before committing funds to new projects.

That logic probably explains the stock price/investment relationship. It works well for a standard 'excess capacity' recession. It breaks down if we experience a series of recessions like the 75-84 period because there is no sustained recovery to incent CFO's to invest. The current recession and the 89/90 recession (S&L's) included a financial crisis, causing CFO's to become more cautious.

Anything that compounds the standard excess capacity nature of recessions, like a financial crisis, series of oil shocks, etc, will drive a wedge between the relationship between stock prices and investment.

Posted by: tj at September 14, 2011 06:26 AM

"The instability seems more marked earlier in the sample, in the 1980's."

Maybe structural change. (OK, probably structural change, but what I meant was: "Maybe the structural change I'm about to mention.") Offshoring and global parts sourcing seem to have reduced volatility in a lot of measures of economic activity. US inventory volatility is way down, in part because of better inventory control, but also in part because US firms have pushed the inventory function onto overseas suppliers. They may also have pushed the volatility of capital investment outside the US border.

If that's the case, then we need to take this change into account when devising schemes to boost capital investment. Global firms can jolly well take care of their own investment needs. US policy ought to be aimed at the general welfare (yeah, I know - contrary to evidence) in the US. Policies that might have worked in an earlier regime might now serve no other purpose than transferring wealth from tax payers to share holders and executives.

Posted by: Anonymous at September 14, 2011 07:22 AM

This may be an overly simplistic explanation but I can't help but wonder if the Bush/Obama response to the credit collapse might play a role in the strong recovery of non-residential fixed investment. Wall Street walked away from the dust and debris of the housing bubble collapse with the mortgage-based portion of their wallets pretty much intact (courtesy of gov't bailouts). That money had to be invested somewhere and I don't know anybody who thought the residential side had yet reached a firm bottom at any point in 2009.

Posted by: JFK at September 14, 2011 07:32 AM

The single biggest issue for recovery may be the state of residential mortgages. I do not have data so I can be corrected. But I believe (from anecdotal reports on the success rate of HANP) that the overall effect of programs such as HAMP was to keep people from being able to sell houses at prices they could afford to sell at in neighborhoods with high levels of non-performing mortgages. There are other factors such as the robo-signing issue and judicial foreclosure delays throttling the foreclosure process too. Maybe reports of a massive uptick in foreclosure activity mean that we will finally see an end to the foreclosure mess.

The effect of the slowdown in RFI on business investment is indirect, but we might be in a different place today had everything been done to move foreclosures through the system. Among other things the demand for rental real estate might be higher today, thus making real estate in some areas a good cash flow investment. Rental property owners would be upgrading their properties, which would have some effect on both retail sales and employment.

This is not taking sides with either Mankiw or Chinn but simply stating that uncertainty abounds in the one area most responsible for employment recovery in many past recessions.

Posted by: colonelmoore at September 14, 2011 07:32 AM

Why not get the "Mankiw multiplier" going by means of a Walrasian pooling of conditional intentions among the largest firms via a computerized auctioneer (briefly described below)?

http://humanpredicament.blogspot.com/2011/09/walrasian-solution-to-our-current.html

Posted by: Greg Hill at September 14, 2011 07:35 AM

Difficult to match the present post,with:
q= capital market valuation of existing equipments/ cost of replacement of the equipments.This ratio has been propelled high enough throughout this decade and should have attracted a large investment in capital.The companies valuation were at their height.

With, the Real Gross Private Domestic Investment in USA, 3 Decimal (GPDIC96)cumulative since 1950
http://research.stlouisfed.org/fred2/series/GPDIC96
The GDI in 8 countries may supply a short term view of the Tobin q sensitivity in relation to equities markets.
http://research.stlouisfed.org/economy/indicators/RealInvestment.pdf
Difficult as well to match the increased corporate profits with above GDI (Corporate profits are expected to be better indicators of future investments)but everything becomes more intelligible when knowing:
30% of the total profits 2006 2007, in the SP were driven by the financial.
Corporate profits after taxes
http://research.stlouisfed.org/fred2/series/CP

Most likely debts,financial leverage, prices distortion,investments abroad should be given better consideration.

Posted by: ppcm at September 14, 2011 08:03 AM

Jeff: You missed my (perhaps too subtle sarcastic) point, which I tried to flag by the phrase "bivariate logic", which I see used all too often in policy debates (but not necessarily where you work).

In addition, I wasn't criticizing Barro's model of investment; I was wondering about his link from fiscal reform to stock market boom, which is not the "model" per se, but his "dream".

tj: The regressions are couched in autoregressive distributed lag (ARDL) specifications, so obviously these stock price effects are not contemporaneous/short term in nature. Your same argument should apply to the average Q model, so the mystery is partly why omitting some information (book value of capital stock, tax effects) leads to less predictive power at horizons greater than one quarter.

Posted by: Menzie Chinn at September 14, 2011 08:05 AM

Barro: I had a dream that Mr. Obama and Congress enacted this fiscal reform package -- triggering a surge in the stock market and a boom in investment and G.D.P. -- and that he was re-elected.

Of course that would be his dream, because in his dream, Obama would be indistinguishable from Romney.

Posted by: Anonymous at September 14, 2011 09:11 AM

What kind of investment is this? Is it new investment to expand business? If so, why is there no increase in employment?
Or are businesses simply replacing old equipment and machinery?
Moreover, your only comparison is with the previous recovery -- which was exceedingly weak, and therefore, not a very good yard stick.

Posted by: Ellis at September 14, 2011 09:34 AM

Gee Menzie, maybe Harvard should fire Barro and hire you. It is clear you know everything that supports your preconceived Keynesian views of the 1960s. .

Why I bet you win the Nobel Prize before Barro.....after all your 'reserch', unlike his, is widely cited (not!) and has a profound effect on .....your ego.

Posted by: Bob at September 14, 2011 09:58 AM

Based on historical voting patterns during periods of high unemployment, it seems likely that the next Chief officer of the Titanic* (AKA the President), will be a Republican, but the GOP is really determined to make sure it happens.

An item linked on Drudge, from Mother Jones, on the GOP's plans to change how Electoral College votes are allocated within a state (instead of winner take all, it would largely be by Congressional District, at least in some states, like Pennsylvania):

http://motherjones.com/politics/2011/09/gop-electoral-college-plan-beat-obama-2012#corrected

*Very few politicians, in public at least, are so far willing to address resource limits, or they openly endorse the infinite growth model.

Posted by: Jeffrey J. Brown at September 14, 2011 10:16 AM

Bob: I'm sorry -- did you read the post I wrote? My discussion of the empirics, based on the Rapach-Wohar paper, was supportive of the Barro (1990) model of investment. All I'm questioning is the link from fiscal reform to stock market boom, which is not substantiated in the op-ed, nor to my knowledge in the empirical literature. So please clarify the source of your visceral dislike for the post.

Posted by: Menzie Chinn at September 14, 2011 10:45 AM

Minor correction: The following item was linked on Huffington Post:

http://motherjones.com/politics/2011/09/gop-electoral-college-plan-beat-obama-2012#corrected

Posted by: Jeffrey J. Brown at September 14, 2011 10:47 AM

@ Menzie,

You state, "Hence, one needs to take seriously the arguments regarding how to encourage more rapid investment."

I am a big fan of increased investment. However, your use of the word, rapid, got me thinking about the impact of rash investment decisions. Which in turn got me thinking about how consumption drives investment decisions (i.e. increased demand for widget A increases investment in widget A production).

A large proportion of total gov't expenditures is now taken up by transfer payments. As a % of nominal GDP it has gone from ca. 2% to 16% (from 1960 to now, using FRED data). As a % of overall consumption it has gone from ca. 3% to 22% in that time period.

Now, if the subset population spending transfer payment dollars is pretty much like the subset population that provides those dollars and both are pretty much like the overall population in its spending habits...no worries. However, given that the SSA and Medicare/Medicaid payments predominate, the transfer payment subset of the population is best characterized as older, poorer, unemployed/retired, and less healthy than the population that provides the dollars or the population as a whole. So, it is unlikely that the consumption decisions of that subset would match the other subset or the population as a whole.

I am rather ambivalent about any particular subset of the population (I used to be in one subset but am increasingly successful at becoming an older, retired person of declining health). Still, the investment allocation decisions will be driven by the consumption decisions.

The change in influence of the transfer payment subset of the population leaves open the possibility that investment allocations will start reflecting what best serves the consumption allocations dictated by social policy rather than by market forces. There must be some policy implications of the fact that transfer payments are skewing how consumption decisions are made (reducing the influence of the net producers of wealth while increasing the influence of the net consumers of wealth) which, in turn, will affect how investment decisions are made.

Love to hear your thoughts on this.

Posted by: JFK at September 14, 2011 11:23 AM

Barro's article is weak. Like a lot of the stuff that he's written lately it's like he just phoned it in. And even the last couple of NBER papers that he's written have been so sloppy that I didn't even bother to finish reading them. He's definitely slipping. And apparently his memory is slipping as he approaches his 67th birthday. For example, in the article he says that fiscal deficit stimulus spending was "warranted" in 2008-2010. Except that in Jan 2009 he wrote an op-ed piece for the WSJ strongly arguing against deficit stimulus:

http://online.wsj.com/article/SB123258618204604599.html

And Mankiw's piece isn't much better. Mankiw uses the GOP dog whistle term "business uncertainty," which is really code for "Obamacare," as a reason for the reluctance of businesses to hire new workers and expand capital. Should I remind Prof. Mankiw that labor makes up two-thirds of a Cobb-Douglas production function, so perhaps we ought to worry about labor uncertainty. When the GOP talks about defunding Obamacare, that causes uncertainty in the labor market. A major factor in a decision to move from a low marginal utility job to a higher marginal utility job is the concern that healthcare is not portable. Obamacare relieves some of that uncertainty and makes the labor market more mobile. And how does gutting labor unions introduce more certainty into the labor market? His own example of the Boeing plant trying to move to South Carolina actually argues against the point he's trying to make.

Mankiw correctly points out the importance of private investment to future growth; but he completely ignores the importance of public investment. It's not that he dismisses it entirely; it's rather that he completely ignores it. He's completely silent. Why? Afraid to jeopardize his position with the Romney campaign?

Finally, for a guy who has lately fallen in love with neoclassical growth models, Mankiw is unexpectedly taciturn about the relationship between the growth of an employable labor force and warranted capital investment in Domar and Harrod models. Again...just seems a bit "convenient" as the Church Lady used to say.

Posted by: 2slugbaits at September 14, 2011 03:06 PM

Here is my prediction of the future. Come 2013 the foreclosure mess will have passed as the banks are now starting to clean out the backlog. The EU will have either blown up and be cleaning up its mess or will have issued Eurobonds and be stabilizing its financial sector. The parts of our economy most susceptible to financial crises will no longer be contributing so much to GDP so their continuing doldrums will not subtract much from growth.

With the economy having hit a true bottom, businesses will finally begin to expand with the underemployed getting more hours, and eventually we will see more hiring.

There will be a GOP majority in the Senate and a GOP president. Of course the GOP will claim credit, as politicians always take credit for any good news on their shift while blaming the other side for any bad news. Democrats got good mileage out of blaming Bush for their problems and now the GOP is getting mileage out of the economy under Obama.

A lot of the bandwidth here and on other econ blogs is devoted to placing responsibity on one party or the other for the economy. But over the span of a single presidency, politicians cannot do much to move the economy very far in either a good or bad direction.

Polls show that the public has begun to doubt the power of politicians over the economy. This is a positive development.

Posted by: colonelmoore at September 14, 2011 07:05 PM

colonelmoore I'm not saying your prediction about the GOP winning is necessarily wrong, but if that does come to pass then I think voters will learn that policiticans can effect the economy in all kinds of ways...usually bad ways when the GOP is in charge. The GOP is bold in its recklessness while the Democrats are timid in their responsibility. If the GOP does win big, then you should expect the financial services sector to once again exert an out-of-proportion influence on the economy. Afterall, the GOP is doing its best to gut Dodd-Frank and they blocked Elizabeth Warren's nomination. Things can always get worse.

What's frustrating is that there's a stable of intellectually lazy academic economists willing to aid and abet this GOP recklessness by writing ill-conceived op-ed pieces. We saw that with the nonsense from Barro and Mankiw.

Posted by: 2slugbaits at September 15, 2011 02:37 AM

business survey after business survey (of corporate leaders) points to low demand, not uncertainty. People who claim "regulatory uncertianty" is hampering investment need to come up with examples of actual products and industries that would benefit. I don't think they will find many examples outside of oil and gas. Moreover, I think they will find the opposite... lots of business investment is on software to enhance productivity.

Posted by: dwb at September 15, 2011 04:41 AM

2sb, reminds me of Billy Madison:

"Mr. Madison, what you've just said ... is one of the most insanely idiotic things I have ever heard. At no point in your rambling, incoherent response were you even close to anything that could be considered a rational thought. Everyone in this room is now dumber for having listened to it. I award you no points, and may God have mercy on your soul."

Posted by: aaron at September 15, 2011 06:22 AM

dwb,

Low demand is due to declining discretionary disposable income. This is due to money pooling in financial services and obligations made under bad expectations (that high price were termporary and that borrowing was OK because promotions and raises were certain). Banks were protected from the new reality, but the same relief was not made to individuals. Reducing obligations or a true "money drop" is the only way for money to get money where it is needed for demand (which exists) to be expressed. Right now, people generally have no money to express their demands and their basic demands keep increasing in price, leaving less and less to their discretion.

On top not getting the raises expected, the debt needs to be paid back from less discretionary income than expected, requiring cutbacks in spending to below what it would have been if debt wasn't used for consumption previously and maintained for a longer time than the period of excess consumption. This is just to get balance sheets to where they should have been in 2005. The realization that uncertainty is higher than we thought means that we need to have more saving/investment than we thought back than.

We don't need new spending, we need debt relief.

Posted by: aaron at September 15, 2011 07:24 AM

2slugs, what I like about predictions is that they have a chance of be satisfied or falsified to some degree.

If I were a betting man I would ask us both to put money on the table. The reason is that, if I am right about the amount that politicians can affect, or have an effect on, the economy as a whole, then I have a decent chance of scoring. Once a sector of the economy has taken a severe hit, it becomes lower as a percentage of GDP and thus further falls have less effect. The odds of a recovery therefore increase.

Also, if I am wrong then it does not necessarily mean that you are right. Your assumption is that Dodd Frank and other applications of government intervention under the current administration have been a net positive and any economist who has different ideas is either lazy or dissembling. (This is a classic example of the ad hominum fallacy - I am right, therefore anyone who claims expert knowledge who disagrees with me is bad or stupid.) There is a chance that Dodd Frank is either exerting a net negative influence or that its positive influences are countered by its negative ones.

The notion of recklessness has its roots in an assumption that allowing risk takers to take risks without the firm hand of government has negative consequences. The belief is that firm regulatory policies can prevent the kinds of disasters that we have seen over the last decades. (See this video: http://www.youtube.com/watch?v=vidzkYnaf6Y)

Those who bother to read what I have written here in prior debates with Prof. Chinn can see that I am not a libertertarian. Instead I believe that many well meaning regulations misdiagnose what really ails us. Most people agree that the current troubles are a crisis of money, so it would be reasonable to look for the root cause in the control of the money supply.

I agree with the BIS 78th annual report (http://www.bis.org/publ/arpdf/ar2008e1.pdf) that the bubble was stimulated by Federal Reserve and other central bank loose money policies, reflected in low interest rates. In addition, I agree with OECD economists Adrian Blundell-Wignall and Paul Atkinson (http://www.oecd.org/dataoecd/33/6/42031344.pdf) that the loose capital requirements for securitized loans promoted under the Basel accords were particularly distorting of real estate investment. Neither has been rectified, in part because politicians get elected by blaming the ills of the world on other politicians, and so they and their camp followers must find fault with their ideological opponents.

This is not an ad-hominum attack on motives. We are all limited in our viewpoints and certainly people come by their beliefs honestly. But once we become narrowly focused on ideology, it becomes difficult to take the blinders off.

I am just as critical of the capitalist utopians that promise a golden age after the dead hand of government is released. Their trust in markets makes it seem that markets are some form of perfection. In fact markets are the place where buyers frequently become too optimistic and pay far too much for the fad of the decade, as we have seen.

However I think it is ridiculous to call this a market failure. It is more like a mass prediction failure on the part of folks that were chasing the next great thing, whether it be Internet pet food companies, residential real estate or Pebble Beach. The market did not fail for the folks that sold Pebble Beach to the Japanese for a grossly inflated price and they would have been sorely disappointed if government had prevented the sale on the grounds that the buyers did not have sound backing for their investment. Certainly though the idea that housing only goes up was aided and abetted by central bank policies.

There are many angles that I did not cover because this has already gone on too long. I may or may not respond to objections to what I have written - in other words I may give you the last word. My notions have been thoroughly disputed in the past and I have also tried to answer them thoroughly. (At some point in the discussion a devil in the machinery of this blog blocked me from continuing to post responses, coincident with a lengthy back and forth with Prof. Chinn, in spite of the fact that I tried to remain civil.) SInce those exchanges covered quite a bit of ground I am unlikely to repeat myself.

Posted by: colonelmoore at September 15, 2011 07:49 AM

A quick postscript:

In my world, central banking policies that favor high leverage tilt the playing field in favor of speculation. So it is reasonable to expect a huge increase in people doing finance for a living when leveraged speculation in its various forms can make far more money than providing goods and services more efficiently at lower cost. After the economy starts to recover, if we have not learned anything from the central banking money debacle (which Dodd Frank does nothing to combat and Basel III does little to change) yes we will see a return to dangerous financial practices. And they will happen in spite of Dodd Frank.

Posted by: colonelmoore at September 15, 2011 08:00 AM

colonelmoore I'm not particularly disagreeing with your prediction that the GOP will do well in the 2012 elections. You might be right. I'm simply pointing out that if the GOP wins things will almost certainly be even worse than today. And the investment banking folks will lead the charge as they return to their bad old ways. We know the GOP gameplan. They will pretend to be against bailing out the investment banks all the while they work at defanging an already weak Dodd-Frank bill. And then when it all collapses they will count on the Democrats to suck it up and come up with son-of-TARP. It's the old Br'er Rabbit strategy. Or, if you like, think of it as another version of hostage taking. Pretend to spout Tea Party rhetoric while creating the conditions for an unavoidable bailout in the future. But voters are stupid enough that the ploy might just work.

Posted by: 2slugbaits at September 15, 2011 03:54 PM

2slugs, it is getting to be a habit for me to ask you to reread what I wrote. In this case I questioned the idea that politicians have that much of an influence over the economy, versus the central banks. I referred to papers by the BIS and OECD, not the secret diaries of Karl Rove.

In response you laid out another liberal dose of the ad hominum fallacy, using motive as a means of discrediting those whose philosophy differs from yours.

From Boswell's Life of Johnson:

"You do not think then, Dr. Johnson, that there was much argument in the case." Johnson said, he did not think there was. "Why, truly," said the King, "when once it comes to calling names, argument is pretty well at an end."

Posted by: colonelmoore at September 15, 2011 04:32 PM

colonelmoore Central banks might deserve some of the blame for the financial recession, but most of it belongs to politicians that allowed investment banks to go wild. Countries that had tight controls over investment banks were not impacted by the global financial meltdown while countries that had little or no regulation got clobbered. Canada has tight controls and was barely touched. Ireland had virtually no regulations and got creamed. And then Irish politicians tried to absorb massive private losses. And in Europe we see where strong political forces are exerting strong influence over the ECB, only making a bad situation worse. In this country we have idiot politicians threatening the Fed Head with treason, so are we surprised that the Fed has been reluctant to pursue a massive QE3? I'm pretty sure that Bernanke would be doing the right thing today if he didn't feel threatened by Congressional pressure from the right wing. Afterall, the Fed is formally a creature of Congress and ultimately answers to Congress.

I would agree that politicians have little positive effect on the long run supply side of the economy. That's mostly driven by technology growth and population increase, but they can make a hash of things in the short to medium term and especially on the demand side. Today's problem is on the demand side.

Posted by: 2slugbaits at September 16, 2011 02:38 AM

At this point if we only took out the question of politicians and simply talked about proper regulation then we would have no argument.

As you know, I am not averse to regulation if it is the right kind, only regulation that misses the point. If you read the OECD report I linked to it said that the Basel regime was a large part of the problem with banking. Guess who was in charge of those requirements? The central banks. Guess whose central bank uniquely did not allow its member banks to participate by securitizing off-balance mortgages, instead holding them to a simple capital adequacy requuirement> Canada.

Since the OECD report makes for dense reading, here is a quick summary of the Basel problem: http://www.washingtonpost.com/opinions/is-another-financial-crisis-looming-in-europe/2011/09/15/gIQAD2EfVK_story.html

By the way your statement about relative blame is identical to Prof. Chinn's response to me awhile ago. I won't go into the reason why I disagreed other than to say that it involved my posing a question using third grade arithmetic. I never got a satisfactory explanation from him as to why my arithmetic was wrong. Instead I got blanket statements identical to the one you just made that sidestepped my question. Finally I was cut off entirely.

Posted by: colonelmoore at September 16, 2011 08:07 AM