Don’t Fear the Inflation, Goldman Says

Via FT Alphaville:

Goldman Sachs is putting an end to the deflation vs inflation debate, once and for all!

In a 30-page research note out on Wednesday, the bank comes down firmly on the side of (moderate) deflation in the near-term.

Here, GS analyst Andrew Tilton says, is why:

• Inflation is already low, with the core CPI down to 1.4% on a year-overyear basis and the overall CPI in deflation territory.

• Excess capacity in the economy is huge, probably at least 6% of GDP and possibly at its highest level since the Great Depression.

• Spare capacity is likely to persist for years [see below table]. While the financial crisis and recession probably have reduced the economy’s production capacity somewhat, we do not see strong evidence for persistently lower growth of capacity going forward. Even if we assume substantially above-trend real GDP growth of, say, 5% per year, it will take more than three years to get back to equilibrium in the labor market and two in the manufacturing sector. Our own assumptions of a somewhat slower recovery suggest it could well take more than five years to reach equilibrium in the labor market and nearly as long in housing.

• Monetary policy is arguably too tight despite a near-zero funds rate and unconventional easing. Our own calculations using estimated Taylor rule parameters, as well as those in recent research from the San Francisco Fed, point to an `appropriate’ funds rate of -5% or below.
  

• The default path of current policy is for removal of stimulus. Fed asset purchase programs are scheduled to end within the next several months and its balance sheet will begin to shrink after that point, while the growth impact of fiscal stimulus is already peaking.

Nevertheless, Goldman’s Tilton gets why investors are worried about inflation, and the bank itself is not oblivious to the possibility, given the massive unconventional fiscal and monetary policies undertaken by the Federal Reserve. In fact, Tilton says, there are a few inflationary warnings signs investors should be looking out for.

Continue reading the article here

Can Irrationality Be Rational?

Barry Ritholtz responds to John Cassidy’s Rational Irrationality article:

(Cassidy’s analysis) asks us to ignore the repercussions of our behaviors. We can rationalize short term gains at the expense of long term losses, because we need to obtain quarterly profits regardless. Apparently, when it bankrupts the company, only then with the benefit of hindsight can we see what went wrong.

I am terribly sorry, but that is precisely the sort of thinking that led to the crisis in the first place. Making loans to people who cannot pay them back is not rational when its profitable — its NEVER rational.

Goldman Sachs avoided most of the credit debacle — were they being irrational when they forewent short term profits for a few years — but avoided the worst of the sub-prime debacle? And what about hedge fund manager John Paulson? His fund bet against all of these other players, netting several billions in profits while others suffered from their “Rational Irrationality.” How irrational was Paulson’s investment posture?

On a risk adjusted basis, the behaviors of Citi, Bear, Lehman, New Century and others was hardly rational. Call it whatever you want, but do not forget this simple fact: It was the sort of narrow, risk-ignoring thinking that is ALWAYS rewarded in the short term, and ALWAYS punished in the long term.

Great stuff from BR! Read the full post here

Why Capitalism Fails

This is an interesting and insightful article from the Boston Globe by professor Stephen Mihm on Hyman Minsky. If, like many people, you have never heard of Minsky before, this will help get you caught up to speed:

…Where most economists drew a single, simplistic lesson from Keynes – that government could step in and micromanage the economy, smooth out the business cycle, and keep things on an even keel – Minsky had no interest in what he and a handful of other dissident economists came to call “bastard Keynesianism.” Instead, Minsky drew his own, far darker, lessons from Keynes’s landmark writings, which dealt not only with the problem of unemployment, but with money and banking. Although Keynes had never stated this explicitly, Minsky argued that Keynes’s collective work amounted to a powerful argument that capitalism was by its very nature unstable and prone to collapse. Far from trending toward some magical state of equilibrium, capitalism would inevitably do the opposite. It would lurch over a cliff.

This insight bore the stamp of his advisor Joseph Schumpeter, the noted Austrian economist now famous for documenting capitalism’s ceaseless process of “creative destruction.” But Minsky spent more time thinking about destruction than creation. In doing so, he formulated an intriguing theory: not only was capitalism prone to collapse, he argued, it was precisely its periods of economic stability that would set the stage for monumental crises.

Minsky called his idea the “Financial Instability Hypothesis.” In the wake of a depression, he noted, financial institutions are extraordinarily conservative, as are businesses. With the borrowers and the lenders who fuel the economy all steering clear of high-risk deals, things go smoothly: loans are almost always paid on time, businesses generally succeed, and everyone does well. That success, however, inevitably encourages borrowers and lenders to take on more risk in the reasonable hope of making more money. As Minsky observed, “Success breeds a disregard of the possibility of failure.”

As people forget that failure is a possibility, a “euphoric economy” eventually develops, fueled by the rise of far riskier borrowers – what he called speculative borrowers, those whose income would cover interest payments but not the principal; and those he called “Ponzi borrowers,” those whose income could cover neither, and could only pay their bills by borrowing still further. As these latter categories grew, the overall economy would shift from a conservative but profitable environment to a much more freewheeling system dominated by players whose survival depended not on sound business plans, but on borrowed money and freely available credit.

Once that kind of economy had developed, any panic could wreck the market. The failure of a single firm, for example, or the revelation of a staggering fraud could trigger fear and a sudden, economy-wide attempt to shed debt. This watershed moment – what was later dubbed the “Minsky moment” – would create an environment deeply inhospitable to all borrowers. The speculators and Ponzi borrowers would collapse first, as they lost access to the credit they needed to survive. Even the more stable players might find themselves unable to pay their debt without selling off assets; their forced sales would send asset prices spiraling downward, and inevitably, the entire rickety financial edifice would start to collapse. Businesses would falter, and the crisis would spill over to the “real” economy that depended on the now-collapsing financial system.

Read the full article here

Hyman Minsky: Stabilizing an Unstable Economy

NYT: Where Politics Don’t Belong

Tyler Cowen has an interesting piece in today’s NYT titled “Where Politics Don’t Belong“:

FOR years now, many businesses and individuals in the United States have been relying on the power of government, rather than competition in the marketplace, to increase their wealth. This is politicization of the economy. It made the financial crisis much worse, and the trend is accelerating.

Well before the financial crisis erupted, policy makers treated homeowners as a protected political class and gave mortgage-backed securities privileged regulatory treatment. Furthermore, they allowed and encouraged high leverage and the expectation of bailouts for creditors, which had been practiced numerous times, including the precedent of Long-Term Capital Management in 1998. Without these mistakes, the economy would not have been so invested in leverage and real estate and the financial crisis would have been much milder.

But we are now injecting politics ever more deeply into the American economy, whether it be in finance or in sectors like health care. Not only have we failed to learn from our mistakes, but also we’re repeating them on an ever-larger scale.

I’ve made the point to my friends before that we do not (and have not for quite some time) live in a capitalistic society. We live in a mixed economy: one part capitalism and one part government owned. Mr. Cowen’s article brings back memories of Enron. Enron was totally government supported. Both Democrats and Republicans had their hands in the cookie jar. Enron would not have become what it did without the government’s support. If a business uses the government to gain power, cronyism runs rampant. Do you believe a truly free market would allow this? Let me know.

Why Is Capitalism So Unpopular?

Art Caden explains why he feels capitalism is so unpopular. Here’s an excerpt:

I think there may be a more straightforward explanation that plays a role in their dismissal of capitalism. To a “man of system,” to borrow Adam Smith’s terminology, capitalism just isn’t that exciting. Participants in the market economy are wholly beholden to consumer wants. The academics envision a grand world, where Great Men fight Great Wars, periodically inventing Great Things or developing Great Ideas. Instead, the market provides us with incremental processes, which expend enormous piles of resources, in a quest to make better Triscuits. It is hardly the stuff of high drama, to say nothing of Great History.

Under capitalism, the common man does not need an intellectual vanguard or a group of virtuous surrogates to make his decisions for him or to defend him against the rapacity of his fellows. He can do just fine without our help, thank you very much, and would be much obliged if we would go back to our ivory towers and leave him alone.

The idea that great statesmen are not needed — to say nothing about being wanted — can no doubt be galling to many who decry capitalism for its excesses. For the people who derive their self-worth from being paternalistic, this is a sorry state of affairs indeed.

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