John Taylor at Vandy

The Department of Economics is pleased to announce that Professor John Taylor of Stanford University and the Hoover Institution will deliver the David Steine Memorial Lecture on Tuesday, March 10th from 4 to 5:30 PM in Wilson Hall 103. The title of Professor Tayor's talk is: "Getting Off Track: How Government Caused, Prolonged, and Worsened the Financial Crisis."

John Taylor served as senior economist on the President's Council of Economic Advisors from 1976-1977 and as a member of the President's Council of Economic Advisors from 1989 to 1991. He was also a member of the Congressional Budget Office's Panel of Economic Advisers from 1995 to 2001. The lecture will also be streamed live on this web site and will be archived for future viewing.

Iceland is a hedge fund

Iceland is interesting mainly because it is so closely associated with the inflating and bursting of the world's credit bubble:

it is Iceland’s de facto bankruptcy—its currency (the krona) is kaput, its debt is 850 percent of G.D.P., its people are hoarding food and cash and blowing up their new Range Rovers for the insurance—resulted from a stunning collective madness. What led a tiny fishing nation, population 300,000, to decide, around 2003, to re-invent itself as a global financial power?

How did this happen?

For the past few years, some large number of Icelanders engaged in the same disastrous speculation. With local interest rates at 15.5 percent and the krona rising, they decided the smart thing to do, when they wanted to buy something they couldn’t afford, was to borrow not kronur but yen and Swiss francs. They paid 3 percent interest on the yen and in the bargain made a bundle on the currency trade, as the krona kept rising. “The fishing guys pretty much discovered the trade and made it huge,” says Magnus. “But they made so much money on it that the financial stuff eventually overwhelmed the fish.” They made so much money on it that the trade spread from the fishing guys to their friends.

It must have seemed like a no-brainer: buy these ever more valuable houses and cars with money you are, in effect, paid to borrow. But, in October, after the krona collapsed, the yen and Swiss francs they must repay are many times more expensive. Now many Icelanders—especially young Icelanders—own $500,000 houses with $1.5 million mortgages, and $35,000 Range Rovers with $100,000 in loans against them. To the Range Rover problem there are two immediate solutions. One is to put it on a boat, ship it to Europe, and try to sell it for a currency that still has value. The other is set it on fire and collect the insurance.

Sometimes you measure your accomplishments by the enemies you make

By this account, our own Jim Cooper is doing pretty well, although we are hoping he moves up on Pelosi's list.

5. Rep. Jim Cooper (D-Tenn.). The fiscally conservative gadfly would have topped the list had he not reversed his first stimulus “no” by voting in favor of the final package.

Even so, the most outspoken of the Blue Dog Democrats is still on thin ice with leadership, thanks to his comment that he “actually got some quiet encouragement from the Obama folks” for initially bucking Pelosi on the stimulus. That required a hasty Obama-Pelosi cleanup effort that resulted in a Cooper clarification - although he continues to express dissatisfaction with what he sees as Pelosi’s top-down leadership style.

Market timers vs. asset allocators

Modern Portfolio Theory tells us to hold a balanced portfolio of stocks and bonds. If we want higher returns, we have to increase the portion of our portfolios devoted to risky stocks.

Jeremy Siegel takes this argument one step further and notes that if you have a longer time horizon, e.g., 20 years, there is no tradeoff between risk and return: holding bonds serves only to reduce return:

Stocks on the long term have returned 6.8% per year after inflation, whereas gold has returned -0.4% (i.e. failed to keep up with inflation) and bonds have returned 1.7%. The equity risk premium (excess return of stocks over bonds) has ranged between 0 to 11%, it was 3% in 2001^[8]also.

John Mauldin has a good column on the revenge of the market timers. He shows, in the table below, that it matters when you get into the market.

The implied prescription is to look at market fundamentals and enter the market only when stocks are relatively cheap (as Shiller's methodology currently says it is).

Next time, we won't be so easily duped

Martin Marietta and Vulcan Materials Company produce construction aggregates in the United States. When President Obama sold us on the $800B stimulus bill in December, it was mostly about bridges and roads, precisely the kinds of projects that would benefit the two companies. Consequently, their stock prices soared.

But by February, when it became clear that the stimulus contained only $30B for infrastructure, the stock prices told us what it was likely to accomplish.

Friedman can never be replaced

Uncle Milton famously predicted that the EU would not survive its first recession:

His theory is now being put to the test. A deep recession and a protracted credit crunch have munched their way across the eurozone, leaving the 16-nation currency bloc mired in crisis.

Economies are contracting at breakneck speed, social unrest - fuelled by soaring unemployment - is growing, and several member states have had their credit ratings downgraded. The possibility that at least one member of the zone will default on its debt in the coming months has alarmed economists and politicians alike.

There seem to be two big problems: (i) how to keep the PIGS (Portugal, Italy, Greece, Spain, and now Ireland) from a national default that would cause them to abandon their Euro; and (ii)

Some countries of Central Europe, like the Czech Republic and Poland, are doing relatively well. Others, like Hungary, Romania and the Baltic states, are in a state of near-meltdown. But only two newer members - tiny Slovenia and Slovakia - are protected by being inside the euro zone, and there was little support Sunday for changing the rules to allow more to join quickly.

Tobin Replacing Friedman?

Meet James Tobin, 1981 Nobel Prize winner and "inventor" of Tobin's Q.

After a three-decade run, the free-market philosophies of Friedman that shaped U.S. policy are being eclipsed by the pro- government ideas of Tobin, the late Yale economist and Nobel laureate who brought John Maynard Keynes into the modern era.

Tobin’s stamp is on the $787 billion stimulus signed by President Barack Obama, former students and colleagues say. His philosophies are influencing Austan Goolsbee, a former Tobin student advising Obama, and Ben S. Bernanke, head of the Federal Reserve. Unlike Friedman, Tobin provides guidance for today’s problems, said Paul Krugman, a Princeton University economist.

Atlas Shrugged vs. Audacity of Hope

If the economy keeps going the way it is, Ayn Rand will best the President:

Whenever governments intervene in the market, in short, readers rush to buy Rand’s book.

Heads, AIG wins; tails, the taxpayers lose.

Not only did AIG offer banks a way to make more risky bets,

How did banks get their risk measures low? It certainly wasn’t by owning less risky assets. Instead, they simply bought A.I.G.’s credit-default swaps. The swaps meant that the risk of loss was transferred to A.I.G., and the collateral triggers made the bank portfolios look absolutely risk-free. Which meant minimal capital requirements, which the banks all wanted so they could increase their leverage and buy yet more “risk-free” assets. This practice became especially rampant in Europe. That lack of capital is one of the reasons the European banks have been in such trouble since the crisis began.

But AIG didn't hedge any of their own bets:

At its peak, the A.I.G. credit-default business had a “notional value” of $450 billion, and as recently as September, it was still over $300 billion. (Notional value is the amount A.I.G. would owe if every one of its bets went to zero.) And unlike most Wall Street firms, it didn’t hedge its credit-default swaps; it bore the risk, which is what insurance companies do.

UPDATE: by propping up AIG, it looks like we are bailing out the European Banks.

Incentives and Security

This still doesn't seem right to me:

An employee of Whole Foods in Ann Arbor, Michigan, was fired in 2007 for apprehending a shoplifter. More specifically, he was fired for touching a customer, even though that customer had a backpack filled with stolen groceries and was running away with them....

Almost certainly, Whole Foods has a no-touching-the-customer policy because its attorneys recommended it. "No touching" is a security measure as well, but it's security against customer lawsuits. The cost of these lawsuits would be much, much greater than the $346 worth of groceries stolen in this instance. Even applied to suspected shoplifters, the policy makes sense: The cost of a lawsuit resulting from tackling an innocent shopper by mistake would be far greater than the cost of letting actual shoplifters get away. As perverse it may seem, the result is completely reasonable given the corporate incentives — Whole Foods wrote a corporate policy that benefited itself.

At least, it works as long as the police and other factors keep society’s shoplifter population down to a reasonable level.