by Stian Reimers¤
University College London
Abstract
Taxation policy is driven by many factors, including public opinion, but little research has examined the strength and
stability of the public’s taxation preferences. This paper demonstrates one way in which preferences for progressiveness
depend on the framing of the question asked. Participants indicated how they would share a fixed tax burden between
two individuals who earned different amounts of money, either by adjusting the amount of tax paid by the two individuals,
or by adjusting the amount of post-tax income retained. The units in which tax was described — amount of money
or percentage tax rate—were manipulated orthogonally. There was a strong metric effect: Participants favored progressiveness
more when tax was described as a percentage rather than amount. However, there was also a clear interaction:
for amounts, participants favored progressiveness significantly more when considering post-tax money retained rather
than tax paid; for percentages, no such effect was found.
Keywords: tax, framing, psychology, judgment, heuristics, biases.
1 Introduction
Progressiveness in tax is a topical issue. Recently in
the United States and United Kingdom there has been
a move to increase the progressiveness of taxation: One
of U.S. President Obama’s campaign pledges was to increase
the highest rate of income tax to just under 40%.
Similarly, the United Kingdom government has recently
announced it will introduce a new higher tax band of
50% for people earning over £150,000 ($225,000) a year.
Conversely, several countries, like Russia, Ukraine, and
the Baltic States, have in recent years introduced versions
of flat taxes, where all citizens pay the same proportion
of their income no matter what its absolute value.
(These “flat” taxes often come with significant tax-free
allowances, meaning the overall tax system is still slightly
progressive. For a review of flat taxes, see Keen, Kim, &
Varsano, 2008.)
The structuring of income tax systems generally has
multiple — often conflicting — goals. The most obvious
goal is raising revenue to spend on public services:
balancing the potential extra revenue taken by high tax
rates with the disincentive to work and temptation to illegally
evade taxes that high tax rates induce. Another key potential of taxation is distributional: using, for example,
utilitarian or egalitarian criteria to redistribute wealth
between the rich and poor (see Musgrave & Musgrave,
1989, for a review).
Although the issue provokes strong opinions about the
optimal progressiveness of a tax regime, one area that is
often ignored is the extent to which the public believe
progressive taxation is fair and appropriate, and the ways
in which psychological mechanisms for representing fairness
affect tax progressiveness preferences. Existing data
give a mixed picture. Generally, when asked whether
those on higher incomes should pay a higher marginal
rate of tax, people agree (e.g., Edlund, 2003; see Kirchler,
2007, for a review). However, people’s progressiveness
preferences appear to depend on the way in which questions
are posed. For example, Roberts, Hite, and Bradley
(1994) found that when participants were asked abstract
questions about progressiveness — in the form of “are
progressive tax rates more or less fair than flat tax rates”
— students with some tax education indicated strongly
that progressive taxation was more fair, in line with other
studies. However, when asked concrete questions—how
much more tax somebody earning $40,000 should pay
relative to somebody earning $20,000 — the same participants
indicated a preference for flat taxes, in this case
the dominant response being that the former should pay
double. On the other hand, Edlund (2003) showed that
Swedish taxpayers favored progressiveness for both abstract
and concrete questions, a finding he attributed to
Swedes’ better awareness of the welfare state and other provisions paid for by taxation. Similarly, Lewis (1978)
found that participants who gave preferences for taxation
at different incomes favored progressiveness.
This inconsistency is perhaps not surprising given the
large body of work that shows that preferences are often
unstable, and the way in which options are framed
can affect people’s preferences in a large number of areas
(e.g., Kahneman & Tversky, 1979; Tversky & Kahneman,
1981; De Martino et al., 2006). Framing effects
have been specifically found in tax preferences (for reviews
see McCaffery & Baron, 2005, 2006a). For example,
McCaffery and Baron (2004) demonstrated several
framing effects in participants who chose tax regimes
for different family situations. Among other things, they
found participants indicated that regimes in which the
taxation system was described in terms of tax bonuses for
certain groups rather than tax penalties for other groups
were fairer, even though the situations were numerically
identical. They also found what they called a “metric” effect
in which participants favored more progressive taxation
when taxation levels were described as percentages
of gross income rather than absolute number of dollars.
Finally, they found a modest status quo effect: Participants
were drawn towards the initial taxation structure.
One intriguing finding of Roberts et al. (1994) was that
participants were less inconsistent between abstract and
concrete questions when concrete questions were framed
in terms of the amount of money left after tax rather than
the amount of tax paid. Furthermore, the authors note in
passing that their pattern of results “indicates that changing
the reference point from taxes to residual income produced
a shift away from regressive taxes and toward flat
and progressive taxes” (p. 182), although the assertion
was not tested statistically.
This framing effect deserves further investigation, for
at least two reasons. First, although asking people about
the amount of tax that should be paid by people on different
incomes seems the most direct way to assess preferences,
asking people about money left after tax may be
more grounded in people’s experience of paying tax, and
hence have a greater stability and validity: It is likely that
people are more able to report how much money they take
home after tax — not least because that amount appears
on their bank statements — than the amount of money
they pay in tax in a given month. Second, psychological
wellbeing appears to be associated with the—relative or
absolute – amount of consumption that a person is able
to do, or, crudely, the amount of money they have left after
tax and other unavoidable drains on resources are met
(e.g., Alpizar, Carlsson, & Johansson-Stenman, 2005).
This suggests that attempts to determine people’s preferences
for taxation should use a frame in which residual
income is foregrounded. The experiment reported here examines the effects of
two variables, in a completely between-subjects factorial
design: the effect of “tax paid” versus “money left” framing;
and the effect of describing tax as percentages or
amounts — the “metric effect” investigated by McCaffery
and Baron (2004), and interactions between the two
variables. The surface features of the task are similar to
those used by Roberts et al. (1994), using two taxpayers
who have different gross incomes. However, the response
method is different. In Roberts et al.’s paper, people were
asked about ratios of taxes, in the form “if Andy earns
$80k and Bob earns $40k, how much more tax should
Andy pay than Bob?”, and then marking on a scale with
labels of “the same amount,” “twice as much,” and so on,
which may bias people towards responding heuristically
with “twice as much,” the most available and justifiable
ratio. What I do is introduce a similar scenario, but inform
participants that the total amount of money to be
taken from Andy and Bob together will be fixed, and have
participants move a slider to indicate how the tax burden
should be split.
2 Method
2.1 Participants
A total of 384 participants were recruited using the
ipoints scheme (www.ipoints.co.uk), a UK-based internet
rewards scheme in which members accrue points for
making purchases and completing surveys. These can be
exchanged for products — such as CDs and DVDs —
and services—such as cinema and theme park tickets. A
subset of members who had opted-in to complete surveys
received an email from ipoints with a link to the experiment.
Participants were paid 50 ipoints (which had a
value of approximately 25 pence / USD 0.40 to the respondent)
for completing the two-minute experiment.
2.2 Design and procedure
The experiment was written in Adobe Flash (Reimers &
Stewart, 2007) and run online. The progressiveness question
was described in one of four ways, with a 2-factor,
2-levels-per-factor between-subjects design. The factors
were framing (money left after tax vs. money paid in tax)
and units (tax/residual income described as a percentage
vs. tax/residual income described as an amount). Each
participant completed a single trial, which used one of
the four possible descriptions, randomly allocated to each
participant. In all conditions, participants were told that
Andy earned £50,000 before tax and Bob earned £20,000
before tax, and that the total amount of tax to be paid between
the two of them would be £19,000. (This is close to the actual amount of tax they would pay between them
in the UK.) A screenshot from one condition is shown
in Figure 1, and the experiment itself is available to
try at http://www.newresearchshows.co.uk/tax.html. Instructions
for the task were the same in all conditions,
except for the penultimate paragraph. Participants in the
“money left” framing condition were given the following
line:
How much do you genuinely believe Andy and
Bob should each have once they’ve paid tax?
Participants in the “tax paid” framing condition were
given the following line:
How much do you genuinely believe Andy and
Bob should pay respectively?
In all 4 conditions, participants responded in the same
way, by moving a slider to set the distribution of tax
burden between Andy and Bob (as shown in Figure 1).
In the “money left” framing condition, “Andy pays . . .
in tax” and “Bob pays . . . in tax” were replaced with
“Andy keeps . . . after tax” and “Bob keeps . . . after tax”,
displayed in the same way, and numbers were recalculated
appropriately. In the “percentage” units condition amounts in pounds were replaced with integer percentages,
representing the same tax take. All other text remained
the same.
Participants were instructed to click and drag on a 250-
pixel gray bar. To avoid anchoring effects based on the
initial position of the slider, the slider was initially invisible:
participants clicked on the grey bar to make the
slider, which moved along the bar, visible at the location
where they first clicked. They could then drag the slider
between the extremes. At the left extreme, Bob paid all of
the £19,000 tax, and Andy nothing; at the right extreme,
Andy paid all of the tax and Bob nothing. The scale
was linear, and values updated as the slider was dragged.
Across all conditions a given position of the slider represented
the same tax split. Only the description of the split
varied.
3 Results
The following data were excluded: Duplicate submissions
(2 cases); participants who spent less than 45 seconds
in total reading the instructions for the scenario
and choosing their response (63 cases). Exploratory data
analyses conducted separately for each condition identified
total of 8 data points which were more than 3 in terquartile ranges away from the median for that condition,
which were excluded as outliers. Of the remaining
participants, 34.8% were male, and mean age was 42.2
years (SD = 13.1 years).
Overall, participants favored a mildly progressive tax
regime, with mean tax rate for Andy of 29% (£14,600
of £50,000) and for Bob of 22% (£4,400 of £20,000).
This is almost exactly the current rate of tax Andy and
Bob would pay under the current UK regime, perhaps
demonstrating a status quo bias. Means and standard
errors for participants across conditions can be seen in
Figure 2. A two-factor ANOVA, with factors units (percentage,
amount) and framing (money left, tax paid) revealed
a main effect of units, F(1, 307) = 24.3, p < .001,
with participants’ preference for more progressive taxation
stronger when taxes were described as percentages
rather than sums of money. There was no significant
effect of framing, but there was an interaction between
framing and units, F(1, 307) = 15.0, p < .001.
An analysis of simple main effects showed a marginal
effect of framing for tax rates described as percentages
F(1, 307) = 3.60, p = .059, with progressiveness favored
slightly more in the “tax paid” condition. But there was a
highly significant effect of framing for tax rates described
as amounts F(1, 307) = 12.4, p = .001, in which participants
favored significantly more progressiveness when the tax regime was described as money left after tax than
amount of tax paid.
This analysis emphasizes the “tax paid” nature of the
task. An alternative analysis could emphasize money retained,
for example by using the ratio of income remaining
between Bob and Andy, as a dependent measure, with
higher values indicating more progressiveness (in other
words, Bob’s post-tax income gets closer to Andy’s as the
ratio increases). The two dependent variables, (1) proportion
of tax paid by Andy and (2) ratio of Bob’s income remaining
to Andy’s income remaining, are monotonically
but not linearly related.
Unsurprisingly, the pattern of results obtained using
ratio of residual income is similar to that for proportion
of tax paid by Andy: the amount of money Bob retains
after tax, as a proportion of the amount of money
Andy retains after tax, is .469 (Tax Paid/Percentage), .451
(Money Left/Percentage), .407 (Tax Paid/Amount), and
.443 (Money Left/Amount). A two-factor ANOVA using
this measure as a dependent variable, rather than proportion
of tax paid by Andy, as above, showed the same
pattern of significant results: A main effect of units, F(1,
307) = 24.7, p < .001, no significant effect of framing,
and an interaction between framing and units, F(1, 307)
= 14.6, p < .001. The simple main effects were also as
before: A marginally significant effect of framing for percentages,
F(1, 307) = 3.50, p = .062, and a highly significant
effect of framing for amounts F(1, 307) = 12.0, p =
.001. The second part of the analysis was to examine the effects
of gender, age, education, and income on tax preferences.
One unexpected but notable trend was a quadratic
relationship between income and tax preference (Figure
3), suggesting that people on incomes significantly below
those of both Andy and Bob, had less of a preference
for progressiveness than those whose income is approximately
that of Bob’s, or between that of Andy and Bob.
To examine the significance of this effect, a multiple
regression analysis was used, with proportion of tax paid
by Andy as the dependent variable, and gender, age, education,
income, and income-squared as the independent
variables. To account for group differences across the 4
framing-units cells, experimental condition was recoded
as a 4-level dummy independent variable. The model was
a significant fit, F(8,281) = 6.76, p < .001, and as well as
significant effects of the experimental conditions, there
was a significant effect of income, (¯ = -0.60, t = 2.57, p
= .01), income-squared, (¯ = -0.71, t = -3.05, p = .002),
and a marginal effect of age (¯ = 0.09, t = 1.67, p = .096),
suggesting older participants favored more progressiveness.
One potential explanation for unexpected effect of income
might be due to other factors being confounded
with income. Most saliently, many of the people on low
incomes might be retired, and so have significant assets,
and a history of high earning, yet with a current low income.
To examine this, the analysis was repeated excluding
all participants aged 60 or over (in the UK few
people retire before the age of 60). The same general
pattern of results was seen, and most importantly, the effect
of income-squared in the regression remained significant.
This suggests retirement is not what drives the
curvilinear association between income and progressiveness
preferences. However, there may be other variables,
which were not examined in this post hoc analysis, that
could underlie this result, so conclusions from this relatively
uncontrolled sample must be tentative.
4 Discussion
People’s preferences for tax progressiveness were affected
both by framing the scenario in terms of income
retained versus tax paid, and by describing the tax paid by
individuals as percentages versus amounts. People preferred
more progressive taxation when the scenario was
described as percentages of income rather than absolute
amounts of money. There was also an interaction: When
taxation was described as absolute amounts of money,
people preferred more progressiveness when thinking
about post-tax income retained rather than amount of tax
paid. There was no such effect for taxes described as percentages.
The metric effect — people preferring more progressiveness
when tax is described as percentages of income
rather than amounts — replicated previous work by Mc-
Caffery and Baron (2004), and reflects the fact that describing
tax as an amount can give the impression of progressiveness
even when the percentage tax rate is low. For
example, if Andy and Bob in the experiment each paid
20% tax, Andy would pay £10,000 a year and Bob would
pay £4,000.
The framing effect for amounts was perhaps the most
important novel finding of this experiment, building on
the observation of Roberts et al. (1994). Participants preferred
more progressive taxation when the magnitude of
tax burden was described in terms of amount of money
Andy and Bob had left after tax rather than the amount of
money paid in tax.
One possible explanation is that different framing conditions
activate different notions of fairness. Framing
the task as “tax paid” could lead participants to consider
what constitutes a fair contribution to society. Framing
the task as “money left” could lead participants to consider
what is a fair amount of money for an individual to
live on. It may also affect reference points: “Tax paid”
framing could plausibly make people evaluate post-tax
income relative to gross income, whereas “money left”
could make people evaluate post-tax income relative to
zero income.
Another interesting finding was the fact that the metric
effect was substantially smaller in the money left condition
than the tax paid condition. Clearly this may be a
finding specific to the values used in this experiment. On
the other hand, if people are more consistent across units
in the money left condition, it might be because they find
that condition easier to represent, and exhibit more stable
and firmly-held preferences in that condition.
Research on attitudes towards progressiveness has
largely used questions focusing on the amount of tax paid.
There are obvious reasons for this, but if what matters to
people — and what is most readily represented — is the
amount of money they have in their pay check after tax
has been deducted, it may suggest that asking about people’s
preferences described as money left rather than tax
paid may reduce “isolation” effects (McCaffery & Baron,
2006b), focusing attention on the bottom line implications
of different degrees of progressiveness, grounded
in experience, rather than activating an abstract notion of
what a fair amount of tax to pay is. Using “money left”
framing could give a better insight into genuine preference,
and possibly reduce metric effects and other framing
or contextual biases.
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Senin, 15 Maret 2010
Jumat, 14 November 2008
Economic Update
Richard Hoey
Chief Economist
November 12, 2008
The historic election of Barack Obama occurred at a specific cyclical inflection point and a specific secular inflection point. From a cyclical perspective, it occurred just as the financial crisis moved the U.S. recession, the G-7 recession and the global recession into an intensified stage of economic contraction. From a long-term secular perspective, it occurred just as the domestic savings and spending imbalances and the global trade and current account imbalances (resulting from debt-financed demand expansion in the G-7 and export-driven growth in emerging countries) have begun to correct.
Many of the current economic and financial trends are built in and won't be that heavily influenced by the election in the near term. There should be broad bipartisan support for further fiscal stimulus in the U.S. given how weak the economy has become. New political leadership always brings uncertainty and so it will take some time for all of the policies of the new Obama administration to be fully defined. There will be a sharp rise in the U.S. unemployment rate and that will create pressures for a strong policy response. An Obama administration is likely to take a succession of very aggressive actions to limit foreclosures and to respond to the U.S. recession.
After a half-decade of probably the fastest pace of global economic growth in the history of the world, we are now in a U.S. recession, a G-7 recession and a full-scale global recession. As in many past cycles, the recession is the lagged result of central bank tightening and a major spike in oil prices. The world economy did not decouple from the U.S. economy. Other countries should feel the full impact unless they mobilize their resources to stimulate their domestic economies. Policies to stimulate domestic demand need to be adopted worldwide since demand financed by private sector debt is unlikely to be strong even after the U.S. recession ends.
In the U.S., we expect a concentrated economic decline over the next six months. Fourth quarter real GDP growth is likely to be quite weak in the U.S. We expect further economic declines in early 2009 and a recession trough by mid-2009 followed by a subpar recovery. A rise to 8% in the unemployment rate is likely next year in response to the overlapping of a housing recession, a consumer recession and a capital spending recession.
The credit disruption today has some similarities to what occurred with the credit card controls in early 1980, which resulted in a real GDP decline at about an 8% annual rate in the second quarter of 1980, before a rebound fostered by Fed ease. While we don't expect it to be that severe this time, the economic decline in the fourth quarter of 2008 should be quite sharp. The shutdown of the financial system resulting from the Lehman bankruptcy immediately preceded the annual review period of business planning for the coming year, implying that the labor market is likely to deteriorate quickly. The weakness in job confidence should overwhelm the benefits of lower energy prices and result in a sharp decline in consumer spending. Capital spending orders are also weakening. In addition, residential construction continues to drop even though it has been declining for twelve consecutive quarters.
We do not share the superbear expectations that the recession could last another year or two. The U.S. was early in the peaking of private sector demand in late 2007 and the Fed was early in shifting to an easing policy. We expect an end to the decline in the U.S. economy around the middle of 2009. However, we do not expect a strong rebound. Because of the damage to the net worth of heavily indebted Americans from lower asset prices, we expect a subpar U.S. economic rebound, despite strong monetary and fiscal stimulus. This should provide little increase in demand for the rest of the world. The economic weakness should persist longer elsewhere in the world, especially where authorities are slow to stimulate domestic demand. There is a risk of rising protectionist pressures as unemployment rates rise in many countries and excess capacity and low shipping costs intensify competition. Differences between countries in the speed by which they adopt carbon amelioration policies may create tensions. The risks to the free trade system will need to be carefully managed by world leaders over the coming years.
In a U.S. recession, G-7 recession and global recession, it should hardly be a surprise that commodity prices dropped sharply as the global economy shifted from a global boom to a global recession. Inflation is dropping very quickly in the U.S. and overseas. The 12-month rate of change of consumer prices in the U.S. should decline from its recent peak of over 5% towards 1% by late 2009. Capacity utilization has dropped worldwide, so inflation has peaked for this cycle in most countries. During 2009, we expect that the fears will be about deflation not inflation. Asset deflation has already occurred and commodity prices and goods prices are likely to be weak, but moderately rising wages and easier monetary policy should support a trend of gradually rising consumer prices in the major industrial countries. For consumer prices, we expect disinflation rather than sustained deflation, since the central banks will resist any sustained deflation of consumer prices. As the Fed funds rate gets closer to zero, we see tentative indications that the Fed is already moving towards a form of quantitative easing. As Fed Chairman Ben Bernanke noted in a speech on November 21, 2002, "... a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition."
There are some concerns that aggressive monetary ease today will breed a major future upsurge in inflation in future years. We are skeptical of this thesis. While Fed actions to supply liquidity have been aggressive, this has occurred in a context in which the desire to hoard liquidity is strong. It is not just the supply of credit that is weak. The demand for credit to finance new spending is also weak. The central banks will need to carefully withdraw excess liquidity once the risk-averse psychology eases, but by that time the inflation rate will have already dropped sharply. Long-term inflation trends depend on public opinion and political preferences as they influence central bank independence. It is premature to know what choices the Obama administration will make with respect to Federal Reserve appointments, central bank independence and inflation policy.
After a multiyear downtrend, the dollar has found a bottom in recent months. To some degree, this was due to (1) a correction of undervaluation, (2) an unwind of overcrowded speculation against the dollar and excess leverage in foreign portfolio investment, and (3) the scarcity of dollar funding in the credit crunch. However, the main cyclical reason for the dollar bottom was the weakening of many foreign economies. The world economy has recoupled on the downside, with foreign countries joining the U.S. in cyclical weakness in a lagged response to the financial crunch and the prior oil and food price shocks. The depressed level of the dollar after a multiyear decline has made the U.S. competitive against other industrial countries. There has been an improvement in the non-oil trade deficit as U.S. exports have been strong until recently and U.S. imports have been weak. Debt-financed consumption and housing in the U.S. should remain weak for an extended period and so should U.S. imports. Worries about the large U.S. oil import bill have also eased somewhat as oil prices have declined sharply. With a major fall in the U.S. trade deficit, the structural bear case on the dollar has been weakened.
What caused the financial crisis? In a broader context, the combination of export-dependent growth overseas and the rising debt burden in the U.S. in recent years was unsustainable and generated global and domestic imbalances. In a narrow context, there was a collapse of credit discipline in recent years in the U.S., especially in the residential mortgage sector. We believe that there were four key elements to the financial crisis: (1) the housing boom and bust, (2) high leverage and an ambiguous private/public status at the mortgage GSEs (Fannie Mae and Freddie Mac), (3) high leverage among financial institutions, especially at the investment banks, and (4) a set of rules and behaviors that exacerbated financial stresses. The primary cause of the U.S. financial crisis was the true economic loss from the decline in house prices. We expect more aggressive policies to be adopted in 2009 to limit the magnitude of further weakness in house prices.
We believe that in recent months U.S. monetary policy has been quite easy on a gross basis, but has been relatively tight on a net basis, after adjusting for private sector financial stresses. Monetary policy is easy as measured by most traditional indicators. Real interest rates are negative. After adjusting for the current risk stresses in the financial system, however, we believe that monetary policy has been somewhat tight on a net basis. As the financial crisis eases, net monetary policy should begin to ease.
In response to massive intervention by the governments and central banks of the large industrial countries, the fever appears to have broken in the interbank market among core banks. We believe that a transition from disorderly deleveraging to semi-orderly deleveraging has already occurred with the transition to fully orderly deleveraging yet to come.
There has been an alphabet soup (TAF, TSLF, PDCF, TARP, AMLF, CPFF, TLGF, TOP, MMIFF) of Treasury and Fed programs to reliquify the financial system. As a result, measures of interbank funding stress have finally eased, including LIBOR rates, the TED spread and LIBOR-OIS spreads. We believe these indicators confirm that the risks in the core of the banking system in the major countries have dropped in the aftermath of aggressive government and central bank action. But this is a very recent development and the financial system has not yet returned to normal.
The money markets are also healing, but somewhat more slowly than the interbank market. Stresses in the money markets have begun to calm since the opening of the Fed's commercial paper facility on October 27. The Fed's purchases of term commercial paper has helped improve funding for high quality corporations. The return of private sector buyers to the term commercial paper market is more tentative and will be a critical step in the normalization of the financial system.
Banks and major corporations throughout the world obtain much of their short-term financing in dollars. A combination of a strong rally in the dollar and risk-aversion in the financial system generated a scarcity of dollar funding for foreign borrowers. The Fed's aggressive currency swap arrangements, first with the traditional industrial countries and then with four major emerging countries (Singapore, Korea, Brazil and Mexico) have provided foreign central banks with the resources to fund the core of their own banking systems. In addition, the IMF is providing credit to a growing number of other countries. The corporate bond markets — both high grade and high yield — have been slower to improve than the short-term markets. Combined with low stock prices, the result is a high cost of capital for corporations, which is restraining capital spending and employment.
We expect the new Obama administration to move quickly to (1) redefine the regulatory regime for financial institutions, (2) adopt another round or two of fiscal stimulus, and (3) attempt to reduce the pace of foreclosures. Overall, our view is that while the economies are weak, policy is powerful and the willingness to aggressively use stimulative monetary and fiscal policy is strong in the U.S. and increasingly so elsewhere.
Chief Economist
November 12, 2008
The historic election of Barack Obama occurred at a specific cyclical inflection point and a specific secular inflection point. From a cyclical perspective, it occurred just as the financial crisis moved the U.S. recession, the G-7 recession and the global recession into an intensified stage of economic contraction. From a long-term secular perspective, it occurred just as the domestic savings and spending imbalances and the global trade and current account imbalances (resulting from debt-financed demand expansion in the G-7 and export-driven growth in emerging countries) have begun to correct.
Many of the current economic and financial trends are built in and won't be that heavily influenced by the election in the near term. There should be broad bipartisan support for further fiscal stimulus in the U.S. given how weak the economy has become. New political leadership always brings uncertainty and so it will take some time for all of the policies of the new Obama administration to be fully defined. There will be a sharp rise in the U.S. unemployment rate and that will create pressures for a strong policy response. An Obama administration is likely to take a succession of very aggressive actions to limit foreclosures and to respond to the U.S. recession.
After a half-decade of probably the fastest pace of global economic growth in the history of the world, we are now in a U.S. recession, a G-7 recession and a full-scale global recession. As in many past cycles, the recession is the lagged result of central bank tightening and a major spike in oil prices. The world economy did not decouple from the U.S. economy. Other countries should feel the full impact unless they mobilize their resources to stimulate their domestic economies. Policies to stimulate domestic demand need to be adopted worldwide since demand financed by private sector debt is unlikely to be strong even after the U.S. recession ends.
In the U.S., we expect a concentrated economic decline over the next six months. Fourth quarter real GDP growth is likely to be quite weak in the U.S. We expect further economic declines in early 2009 and a recession trough by mid-2009 followed by a subpar recovery. A rise to 8% in the unemployment rate is likely next year in response to the overlapping of a housing recession, a consumer recession and a capital spending recession.
The credit disruption today has some similarities to what occurred with the credit card controls in early 1980, which resulted in a real GDP decline at about an 8% annual rate in the second quarter of 1980, before a rebound fostered by Fed ease. While we don't expect it to be that severe this time, the economic decline in the fourth quarter of 2008 should be quite sharp. The shutdown of the financial system resulting from the Lehman bankruptcy immediately preceded the annual review period of business planning for the coming year, implying that the labor market is likely to deteriorate quickly. The weakness in job confidence should overwhelm the benefits of lower energy prices and result in a sharp decline in consumer spending. Capital spending orders are also weakening. In addition, residential construction continues to drop even though it has been declining for twelve consecutive quarters.
We do not share the superbear expectations that the recession could last another year or two. The U.S. was early in the peaking of private sector demand in late 2007 and the Fed was early in shifting to an easing policy. We expect an end to the decline in the U.S. economy around the middle of 2009. However, we do not expect a strong rebound. Because of the damage to the net worth of heavily indebted Americans from lower asset prices, we expect a subpar U.S. economic rebound, despite strong monetary and fiscal stimulus. This should provide little increase in demand for the rest of the world. The economic weakness should persist longer elsewhere in the world, especially where authorities are slow to stimulate domestic demand. There is a risk of rising protectionist pressures as unemployment rates rise in many countries and excess capacity and low shipping costs intensify competition. Differences between countries in the speed by which they adopt carbon amelioration policies may create tensions. The risks to the free trade system will need to be carefully managed by world leaders over the coming years.
In a U.S. recession, G-7 recession and global recession, it should hardly be a surprise that commodity prices dropped sharply as the global economy shifted from a global boom to a global recession. Inflation is dropping very quickly in the U.S. and overseas. The 12-month rate of change of consumer prices in the U.S. should decline from its recent peak of over 5% towards 1% by late 2009. Capacity utilization has dropped worldwide, so inflation has peaked for this cycle in most countries. During 2009, we expect that the fears will be about deflation not inflation. Asset deflation has already occurred and commodity prices and goods prices are likely to be weak, but moderately rising wages and easier monetary policy should support a trend of gradually rising consumer prices in the major industrial countries. For consumer prices, we expect disinflation rather than sustained deflation, since the central banks will resist any sustained deflation of consumer prices. As the Fed funds rate gets closer to zero, we see tentative indications that the Fed is already moving towards a form of quantitative easing. As Fed Chairman Ben Bernanke noted in a speech on November 21, 2002, "... a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition."
There are some concerns that aggressive monetary ease today will breed a major future upsurge in inflation in future years. We are skeptical of this thesis. While Fed actions to supply liquidity have been aggressive, this has occurred in a context in which the desire to hoard liquidity is strong. It is not just the supply of credit that is weak. The demand for credit to finance new spending is also weak. The central banks will need to carefully withdraw excess liquidity once the risk-averse psychology eases, but by that time the inflation rate will have already dropped sharply. Long-term inflation trends depend on public opinion and political preferences as they influence central bank independence. It is premature to know what choices the Obama administration will make with respect to Federal Reserve appointments, central bank independence and inflation policy.
After a multiyear downtrend, the dollar has found a bottom in recent months. To some degree, this was due to (1) a correction of undervaluation, (2) an unwind of overcrowded speculation against the dollar and excess leverage in foreign portfolio investment, and (3) the scarcity of dollar funding in the credit crunch. However, the main cyclical reason for the dollar bottom was the weakening of many foreign economies. The world economy has recoupled on the downside, with foreign countries joining the U.S. in cyclical weakness in a lagged response to the financial crunch and the prior oil and food price shocks. The depressed level of the dollar after a multiyear decline has made the U.S. competitive against other industrial countries. There has been an improvement in the non-oil trade deficit as U.S. exports have been strong until recently and U.S. imports have been weak. Debt-financed consumption and housing in the U.S. should remain weak for an extended period and so should U.S. imports. Worries about the large U.S. oil import bill have also eased somewhat as oil prices have declined sharply. With a major fall in the U.S. trade deficit, the structural bear case on the dollar has been weakened.
What caused the financial crisis? In a broader context, the combination of export-dependent growth overseas and the rising debt burden in the U.S. in recent years was unsustainable and generated global and domestic imbalances. In a narrow context, there was a collapse of credit discipline in recent years in the U.S., especially in the residential mortgage sector. We believe that there were four key elements to the financial crisis: (1) the housing boom and bust, (2) high leverage and an ambiguous private/public status at the mortgage GSEs (Fannie Mae and Freddie Mac), (3) high leverage among financial institutions, especially at the investment banks, and (4) a set of rules and behaviors that exacerbated financial stresses. The primary cause of the U.S. financial crisis was the true economic loss from the decline in house prices. We expect more aggressive policies to be adopted in 2009 to limit the magnitude of further weakness in house prices.
We believe that in recent months U.S. monetary policy has been quite easy on a gross basis, but has been relatively tight on a net basis, after adjusting for private sector financial stresses. Monetary policy is easy as measured by most traditional indicators. Real interest rates are negative. After adjusting for the current risk stresses in the financial system, however, we believe that monetary policy has been somewhat tight on a net basis. As the financial crisis eases, net monetary policy should begin to ease.
In response to massive intervention by the governments and central banks of the large industrial countries, the fever appears to have broken in the interbank market among core banks. We believe that a transition from disorderly deleveraging to semi-orderly deleveraging has already occurred with the transition to fully orderly deleveraging yet to come.
There has been an alphabet soup (TAF, TSLF, PDCF, TARP, AMLF, CPFF, TLGF, TOP, MMIFF) of Treasury and Fed programs to reliquify the financial system. As a result, measures of interbank funding stress have finally eased, including LIBOR rates, the TED spread and LIBOR-OIS spreads. We believe these indicators confirm that the risks in the core of the banking system in the major countries have dropped in the aftermath of aggressive government and central bank action. But this is a very recent development and the financial system has not yet returned to normal.
The money markets are also healing, but somewhat more slowly than the interbank market. Stresses in the money markets have begun to calm since the opening of the Fed's commercial paper facility on October 27. The Fed's purchases of term commercial paper has helped improve funding for high quality corporations. The return of private sector buyers to the term commercial paper market is more tentative and will be a critical step in the normalization of the financial system.
Banks and major corporations throughout the world obtain much of their short-term financing in dollars. A combination of a strong rally in the dollar and risk-aversion in the financial system generated a scarcity of dollar funding for foreign borrowers. The Fed's aggressive currency swap arrangements, first with the traditional industrial countries and then with four major emerging countries (Singapore, Korea, Brazil and Mexico) have provided foreign central banks with the resources to fund the core of their own banking systems. In addition, the IMF is providing credit to a growing number of other countries. The corporate bond markets — both high grade and high yield — have been slower to improve than the short-term markets. Combined with low stock prices, the result is a high cost of capital for corporations, which is restraining capital spending and employment.
We expect the new Obama administration to move quickly to (1) redefine the regulatory regime for financial institutions, (2) adopt another round or two of fiscal stimulus, and (3) attempt to reduce the pace of foreclosures. Overall, our view is that while the economies are weak, policy is powerful and the willingness to aggressively use stimulative monetary and fiscal policy is strong in the U.S. and increasingly so elsewhere.
Kamis, 13 November 2008
Economic Update
The historic election of Barack Obama occurred at a specific cyclical inflection point and a specific secular inflection point. From a cyclical perspective, it occurred just as the financial crisis moved the U.S. recession, the G-7 recession and the global recession into an intensified stage of economic contraction. From a long-term secular perspective, it occurred just as the domestic savings and spending imbalances and the global trade and current account imbalances (resulting from debt-financed demand expansion in the G-7 and export-driven growth in emerging countries) have begun to correct.
Many of the current economic and financial trends are built in and won't be that heavily influenced by the election in the near term. There should be broad bipartisan support for further fiscal stimulus in the U.S. given how weak the economy has become. New political leadership always brings uncertainty and so it will take some time for all of the policies of the new Obama administration to be fully defined. There will be a sharp rise in the U.S. unemployment rate and that will create pressures for a strong policy response. An Obama administration is likely to take a succession of very aggressive actions to limit foreclosures and to respond to the U.S. recession.
After a half-decade of probably the fastest pace of global economic growth in the history of the world, we are now in a U.S. recession, a G-7 recession and a full-scale global recession. As in many past cycles, the recession is the lagged result of central bank tightening and a major spike in oil prices. The world economy did not decouple from the U.S. economy. Other countries should feel the full impact unless they mobilize their resources to stimulate their domestic economies. Policies to stimulate domestic demand need to be adopted worldwide since demand financed by private sector debt is unlikely to be strong even after the U.S. recession ends.
In the U.S., we expect a concentrated economic decline over the next six months. Fourth quarter real GDP growth is likely to be quite weak in the U.S. We expect further economic declines in early 2009 and a recession trough by mid-2009 followed by a subpar recovery. A rise to 8% in the unemployment rate is likely next year in response to the overlapping of a housing recession, a consumer recession and a capital spending recession.
The credit disruption today has some similarities to what occurred with the credit card controls in early 1980, which resulted in a real GDP decline at about an 8% annual rate in the second quarter of 1980, before a rebound fostered by Fed ease. While we don't expect it to be that severe this time, the economic decline in the fourth quarter of 2008 should be quite sharp. The shutdown of the financial system resulting from the Lehman bankruptcy immediately preceded the annual review period of business planning for the coming year, implying that the labor market is likely to deteriorate quickly. The weakness in job confidence should overwhelm the benefits of lower energy prices and result in a sharp decline in consumer spending. Capital spending orders are also weakening. In addition, residential construction continues to drop even though it has been declining for twelve consecutive quarters.
We do not share the superbear expectations that the recession could last another year or two. The U.S. was early in the peaking of private sector demand in late 2007 and the Fed was early in shifting to an easing policy. We expect an end to the decline in the U.S. economy around the middle of 2009. However, we do not expect a strong rebound. Because of the damage to the net worth of heavily indebted Americans from lower asset prices, we expect a subpar U.S. economic rebound, despite strong monetary and fiscal stimulus. This should provide little increase in demand for the rest of the world. The economic weakness should persist longer elsewhere in the world, especially where authorities are slow to stimulate domestic demand. There is a risk of rising protectionist pressures as unemployment rates rise in many countries and excess capacity and low shipping costs intensify competition. Differences between countries in the speed by which they adopt carbon amelioration policies may create tensions. The risks to the free trade system will need to be carefully managed by world leaders over the coming years.
In a U.S. recession, G-7 recession and global recession, it should hardly be a surprise that commodity prices dropped sharply as the global economy shifted from a global boom to a global recession. Inflation is dropping very quickly in the U.S. and overseas. The 12-month rate of change of consumer prices in the U.S. should decline from its recent peak of over 5% towards 1% by late 2009. Capacity utilization has dropped worldwide, so inflation has peaked for this cycle in most countries. During 2009, we expect that the fears will be about deflation not inflation. Asset deflation has already occurred and commodity prices and goods prices are likely to be weak, but moderately rising wages and easier monetary policy should support a trend of gradually rising consumer prices in the major industrial countries. For consumer prices, we expect disinflation rather than sustained deflation, since the central banks will resist any sustained deflation of consumer prices. As the Fed funds rate gets closer to zero, we see tentative indications that the Fed is already moving towards a form of quantitative easing. As Fed Chairman Ben Bernanke noted in a speech on November 21, 2002, "... a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition."
There are some concerns that aggressive monetary ease today will breed a major future upsurge in inflation in future years. We are skeptical of this thesis. While Fed actions to supply liquidity have been aggressive, this has occurred in a context in which the desire to hoard liquidity is strong. It is not just the supply of credit that is weak. The demand for credit to finance new spending is also weak. The central banks will need to carefully withdraw excess liquidity once the risk-averse psychology eases, but by that time the inflation rate will have already dropped sharply. Long-term inflation trends depend on public opinion and political preferences as they influence central bank independence. It is premature to know what choices the Obama administration will make with respect to Federal Reserve appointments, central bank independence and inflation policy.
After a multiyear downtrend, the dollar has found a bottom in recent months. To some degree, this was due to (1) a correction of undervaluation, (2) an unwind of overcrowded speculation against the dollar and excess leverage in foreign portfolio investment, and (3) the scarcity of dollar funding in the credit crunch. However, the main cyclical reason for the dollar bottom was the weakening of many foreign economies. The world economy has recoupled on the downside, with foreign countries joining the U.S. in cyclical weakness in a lagged response to the financial crunch and the prior oil and food price shocks. The depressed level of the dollar after a multiyear decline has made the U.S. competitive against other industrial countries. There has been an improvement in the non-oil trade deficit as U.S. exports have been strong until recently and U.S. imports have been weak. Debt-financed consumption and housing in the U.S. should remain weak for an extended period and so should U.S. imports. Worries about the large U.S. oil import bill have also eased somewhat as oil prices have declined sharply. With a major fall in the U.S. trade deficit, the structural bear case on the dollar has been weakened.
What caused the financial crisis? In a broader context, the combination of export-dependent growth overseas and the rising debt burden in the U.S. in recent years was unsustainable and generated global and domestic imbalances. In a narrow context, there was a collapse of credit discipline in recent years in the U.S., especially in the residential mortgage sector. We believe that there were four key elements to the financial crisis: (1) the housing boom and bust, (2) high leverage and an ambiguous private/public status at the mortgage GSEs (Fannie Mae and Freddie Mac), (3) high leverage among financial institutions, especially at the investment banks, and (4) a set of rules and behaviors that exacerbated financial stresses. The primary cause of the U.S. financial crisis was the true economic loss from the decline in house prices. We expect more aggressive policies to be adopted in 2009 to limit the magnitude of further weakness in house prices.
We believe that in recent months U.S. monetary policy has been quite easy on a gross basis, but has been relatively tight on a net basis, after adjusting for private sector financial stresses. Monetary policy is easy as measured by most traditional indicators. Real interest rates are negative. After adjusting for the current risk stresses in the financial system, however, we believe that monetary policy has been somewhat tight on a net basis. As the financial crisis eases, net monetary policy should begin to ease.
In response to massive intervention by the governments and central banks of the large industrial countries, the fever appears to have broken in the interbank market among core banks. We believe that a transition from disorderly deleveraging to semi-orderly deleveraging has already occurred with the transition to fully orderly deleveraging yet to come.
There has been an alphabet soup (TAF, TSLF, PDCF, TARP, AMLF, CPFF, TLGF, TOP, MMIFF) of Treasury and Fed programs to reliquify the financial system. As a result, measures of interbank funding stress have finally eased, including LIBOR rates, the TED spread and LIBOR-OIS spreads. We believe these indicators confirm that the risks in the core of the banking system in the major countries have dropped in the aftermath of aggressive government and central bank action. But this is a very recent development and the financial system has not yet returned to normal.
The money markets are also healing, but somewhat more slowly than the interbank market. Stresses in the money markets have begun to calm since the opening of the Fed's commercial paper facility on October 27. The Fed's purchases of term commercial paper has helped improve funding for high quality corporations. The return of private sector buyers to the term commercial paper market is more tentative and will be a critical step in the normalization of the financial system.
Banks and major corporations throughout the world obtain much of their short-term financing in dollars. A combination of a strong rally in the dollar and risk-aversion in the financial system generated a scarcity of dollar funding for foreign borrowers. The Fed's aggressive currency swap arrangements, first with the traditional industrial countries and then with four major emerging countries (Singapore, Korea, Brazil and Mexico) have provided foreign central banks with the resources to fund the core of their own banking systems. In addition, the IMF is providing credit to a growing number of other countries. The corporate bond markets — both high grade and high yield — have been slower to improve than the short-term markets. Combined with low stock prices, the result is a high cost of capital for corporations, which is restraining capital spending and employment.
We expect the new Obama administration to move quickly to (1) redefine the regulatory regime for financial institutions, (2) adopt another round or two of fiscal stimulus, and (3) attempt to reduce the pace of foreclosures. Overall, our view is that while the economies are weak, policy is powerful and the willingness to aggressively use stimulative monetary and fiscal policy is strong in the U.S. and increasingly so elsewhere.
Many of the current economic and financial trends are built in and won't be that heavily influenced by the election in the near term. There should be broad bipartisan support for further fiscal stimulus in the U.S. given how weak the economy has become. New political leadership always brings uncertainty and so it will take some time for all of the policies of the new Obama administration to be fully defined. There will be a sharp rise in the U.S. unemployment rate and that will create pressures for a strong policy response. An Obama administration is likely to take a succession of very aggressive actions to limit foreclosures and to respond to the U.S. recession.
After a half-decade of probably the fastest pace of global economic growth in the history of the world, we are now in a U.S. recession, a G-7 recession and a full-scale global recession. As in many past cycles, the recession is the lagged result of central bank tightening and a major spike in oil prices. The world economy did not decouple from the U.S. economy. Other countries should feel the full impact unless they mobilize their resources to stimulate their domestic economies. Policies to stimulate domestic demand need to be adopted worldwide since demand financed by private sector debt is unlikely to be strong even after the U.S. recession ends.
In the U.S., we expect a concentrated economic decline over the next six months. Fourth quarter real GDP growth is likely to be quite weak in the U.S. We expect further economic declines in early 2009 and a recession trough by mid-2009 followed by a subpar recovery. A rise to 8% in the unemployment rate is likely next year in response to the overlapping of a housing recession, a consumer recession and a capital spending recession.
The credit disruption today has some similarities to what occurred with the credit card controls in early 1980, which resulted in a real GDP decline at about an 8% annual rate in the second quarter of 1980, before a rebound fostered by Fed ease. While we don't expect it to be that severe this time, the economic decline in the fourth quarter of 2008 should be quite sharp. The shutdown of the financial system resulting from the Lehman bankruptcy immediately preceded the annual review period of business planning for the coming year, implying that the labor market is likely to deteriorate quickly. The weakness in job confidence should overwhelm the benefits of lower energy prices and result in a sharp decline in consumer spending. Capital spending orders are also weakening. In addition, residential construction continues to drop even though it has been declining for twelve consecutive quarters.
We do not share the superbear expectations that the recession could last another year or two. The U.S. was early in the peaking of private sector demand in late 2007 and the Fed was early in shifting to an easing policy. We expect an end to the decline in the U.S. economy around the middle of 2009. However, we do not expect a strong rebound. Because of the damage to the net worth of heavily indebted Americans from lower asset prices, we expect a subpar U.S. economic rebound, despite strong monetary and fiscal stimulus. This should provide little increase in demand for the rest of the world. The economic weakness should persist longer elsewhere in the world, especially where authorities are slow to stimulate domestic demand. There is a risk of rising protectionist pressures as unemployment rates rise in many countries and excess capacity and low shipping costs intensify competition. Differences between countries in the speed by which they adopt carbon amelioration policies may create tensions. The risks to the free trade system will need to be carefully managed by world leaders over the coming years.
In a U.S. recession, G-7 recession and global recession, it should hardly be a surprise that commodity prices dropped sharply as the global economy shifted from a global boom to a global recession. Inflation is dropping very quickly in the U.S. and overseas. The 12-month rate of change of consumer prices in the U.S. should decline from its recent peak of over 5% towards 1% by late 2009. Capacity utilization has dropped worldwide, so inflation has peaked for this cycle in most countries. During 2009, we expect that the fears will be about deflation not inflation. Asset deflation has already occurred and commodity prices and goods prices are likely to be weak, but moderately rising wages and easier monetary policy should support a trend of gradually rising consumer prices in the major industrial countries. For consumer prices, we expect disinflation rather than sustained deflation, since the central banks will resist any sustained deflation of consumer prices. As the Fed funds rate gets closer to zero, we see tentative indications that the Fed is already moving towards a form of quantitative easing. As Fed Chairman Ben Bernanke noted in a speech on November 21, 2002, "... a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition."
There are some concerns that aggressive monetary ease today will breed a major future upsurge in inflation in future years. We are skeptical of this thesis. While Fed actions to supply liquidity have been aggressive, this has occurred in a context in which the desire to hoard liquidity is strong. It is not just the supply of credit that is weak. The demand for credit to finance new spending is also weak. The central banks will need to carefully withdraw excess liquidity once the risk-averse psychology eases, but by that time the inflation rate will have already dropped sharply. Long-term inflation trends depend on public opinion and political preferences as they influence central bank independence. It is premature to know what choices the Obama administration will make with respect to Federal Reserve appointments, central bank independence and inflation policy.
After a multiyear downtrend, the dollar has found a bottom in recent months. To some degree, this was due to (1) a correction of undervaluation, (2) an unwind of overcrowded speculation against the dollar and excess leverage in foreign portfolio investment, and (3) the scarcity of dollar funding in the credit crunch. However, the main cyclical reason for the dollar bottom was the weakening of many foreign economies. The world economy has recoupled on the downside, with foreign countries joining the U.S. in cyclical weakness in a lagged response to the financial crunch and the prior oil and food price shocks. The depressed level of the dollar after a multiyear decline has made the U.S. competitive against other industrial countries. There has been an improvement in the non-oil trade deficit as U.S. exports have been strong until recently and U.S. imports have been weak. Debt-financed consumption and housing in the U.S. should remain weak for an extended period and so should U.S. imports. Worries about the large U.S. oil import bill have also eased somewhat as oil prices have declined sharply. With a major fall in the U.S. trade deficit, the structural bear case on the dollar has been weakened.
What caused the financial crisis? In a broader context, the combination of export-dependent growth overseas and the rising debt burden in the U.S. in recent years was unsustainable and generated global and domestic imbalances. In a narrow context, there was a collapse of credit discipline in recent years in the U.S., especially in the residential mortgage sector. We believe that there were four key elements to the financial crisis: (1) the housing boom and bust, (2) high leverage and an ambiguous private/public status at the mortgage GSEs (Fannie Mae and Freddie Mac), (3) high leverage among financial institutions, especially at the investment banks, and (4) a set of rules and behaviors that exacerbated financial stresses. The primary cause of the U.S. financial crisis was the true economic loss from the decline in house prices. We expect more aggressive policies to be adopted in 2009 to limit the magnitude of further weakness in house prices.
We believe that in recent months U.S. monetary policy has been quite easy on a gross basis, but has been relatively tight on a net basis, after adjusting for private sector financial stresses. Monetary policy is easy as measured by most traditional indicators. Real interest rates are negative. After adjusting for the current risk stresses in the financial system, however, we believe that monetary policy has been somewhat tight on a net basis. As the financial crisis eases, net monetary policy should begin to ease.
In response to massive intervention by the governments and central banks of the large industrial countries, the fever appears to have broken in the interbank market among core banks. We believe that a transition from disorderly deleveraging to semi-orderly deleveraging has already occurred with the transition to fully orderly deleveraging yet to come.
There has been an alphabet soup (TAF, TSLF, PDCF, TARP, AMLF, CPFF, TLGF, TOP, MMIFF) of Treasury and Fed programs to reliquify the financial system. As a result, measures of interbank funding stress have finally eased, including LIBOR rates, the TED spread and LIBOR-OIS spreads. We believe these indicators confirm that the risks in the core of the banking system in the major countries have dropped in the aftermath of aggressive government and central bank action. But this is a very recent development and the financial system has not yet returned to normal.
The money markets are also healing, but somewhat more slowly than the interbank market. Stresses in the money markets have begun to calm since the opening of the Fed's commercial paper facility on October 27. The Fed's purchases of term commercial paper has helped improve funding for high quality corporations. The return of private sector buyers to the term commercial paper market is more tentative and will be a critical step in the normalization of the financial system.
Banks and major corporations throughout the world obtain much of their short-term financing in dollars. A combination of a strong rally in the dollar and risk-aversion in the financial system generated a scarcity of dollar funding for foreign borrowers. The Fed's aggressive currency swap arrangements, first with the traditional industrial countries and then with four major emerging countries (Singapore, Korea, Brazil and Mexico) have provided foreign central banks with the resources to fund the core of their own banking systems. In addition, the IMF is providing credit to a growing number of other countries. The corporate bond markets — both high grade and high yield — have been slower to improve than the short-term markets. Combined with low stock prices, the result is a high cost of capital for corporations, which is restraining capital spending and employment.
We expect the new Obama administration to move quickly to (1) redefine the regulatory regime for financial institutions, (2) adopt another round or two of fiscal stimulus, and (3) attempt to reduce the pace of foreclosures. Overall, our view is that while the economies are weak, policy is powerful and the willingness to aggressively use stimulative monetary and fiscal policy is strong in the U.S. and increasingly so elsewhere.
Selasa, 04 November 2008
Herd Behavior in Financial Markets: Theory and Evidence
Dr. Antonio Guarino
According to anecdotal evidence, herd behavior is diffused in financial markets. Some agents buy stocks simply "following the herd" in a bull market, or sell them in the wave of diffused pessimist in a bear market. While there is a large anecdotal evidence on herd behavior in financial markets, and the idea that traders herd is diffused among practitioners and market participants, our understanding of why herding can arise in the financial market is still limited. Furthermore, studies that have attempted to document and quantify the presence of herding in the market have obtained results that are far from conclusive. Most work remains to be done both at a theoretical and at an empirical level. My research activity is devoted to shed light on the phenomenon of herd behaviour in financial markets with a combination of theoretical, experimental and empirical work. Most of this work is a joint effort with Marco Cipriani , of George Washington University.
Herd behaviour is relevant for the financial market informational efficiency. Essentially, herd behaviour entails neglecting private information in trading a stock or a group of stocks, because of what previous traders have decided to do. Clearly, if an agent neglects private information and herds, the market will not be able to infer that private information from the choice of that agent, and the price will not be able to reflect it. If many traders herd, the stock price can be misaligned with respect to the true value of the stock. Cipriani and I have proven that, indeed, even if traders are perfectly rational Bayesian agents, herd behaviour occurs in the market because of traders' heterogeneity. Traders go to the market to exploit their private information and for non-informational (e.g., liquidity) motives. Over time, as trade proceeds, the informational reasons to trade become less important than the non-informational ones. At a certain point, all traders will neglect their private information and an "informational cascade" (i.e., a situation in which the traders' decisions are completely uninformative on the asset value) will arise. In a cascade the price does not react to the order flow and is stuck for ever. It may well be that the price remains stuck at a level far from the fundamental one. For instance, it may be that the value of a stock is high, but the price remains stuck at a low level, after a sequence of sell orders in the market. Therefore, herd behaviour can be a reason why we can observe a financial crisis even in an economy with sound fundamentals.
To test theoretical models of herd behaviour is difficult. As I said, herding, at least in our framework, means neglecting private information because of the observations of previous traders' decisions. Therefore, ideally, to test such models one would need data on private information, which is of course difficult to obtain for actually running markets. This difficulty can be overcome in an experimental study. In an experiment we can observe variables not available for actual markets, in particular, the private information that agents have when making their decisions. For this reason, Cipriani and I have run a series of experiments in which we test whether herding arises as theory predicts or not. In our laboratory market, subjects receive private information on the value of a security and observe the history of past trades. Given these two pieces of information, they choose, sequentially, if they want to sell, to buy or not to trade one unit of the asset. By observing the way in which they use their private information and react to the decisions of the previous traders, we can directly detect the occurrence of herding. Our experimental results are encouraging for the theory. Although the laboratory reveals some anomalies in subjects' behaviour, i.e., some deviations from equilibrium behaviour, overall what we observe in the laboratory is quite consistent with the theoretical predictions. In particular, in a frictionless financial market in which traders trade for informational reasons only, and the price is efficiently set by a market maker in response to the order flow, herd behaviour is very limited. This agrees with the theory, according to which we should not observe herding at all. Market frictions, instead, generate informational inefficiencies both theoretically and experimentally. Cipriani and I have studied a market in which such frictions take the form a trade cost. We have shown that such a cost impairs the process of information aggregation and an informational cascade occurs almost surely. A cascade occurs since, after some trades, the gain form trading becomes lower than the cost, and agents prefer to abstain from trading. Interestingly, such behaviour is not only a theoretical result, but also occurs in the laboratory. Indeed, our experimental results are very close to the theoretical prediction. Transactions costs can be due, for instance, to transaction taxes, like the Tobin Tax. Therefore, our work has also some policy implications on the introduction of such a tax.
In more recent work, Cipriani and I have extended our research on herd behaviour by estimating a theoretical model of herding with field data. While in previous work we have brought the model to the laboratory, in this work we have brought the model to the real financial market. We use data on many days of trade for some specific stocks. We estimate the parameters of a theoretical model that predicts herd buying (or selling) when a sufficiently high sequence of traders have decided to buy (or sell) the asset. In the market there is a market maker who efficiently sets the prices for a stock according to the orders flow, and a sequence of traders, who can buy or sell at those prices. Herd buying arises when all traders value the asset more than the price posted by market maker, even if they have negative private information. Similarly, herd selling arises when all traders value the asset less than the market maker, even if they have positive private information. After we have estimated the parameters of the model, we are able to track down the beliefs that the market maker (the notional prices) and the traders have during each day of trading. By comparing these beliefs, we can identify the periods of the trading day in which herding occurs or not.
The research activity described so far refers to the analysis of a single market (for instance, a single stock, or a single country). An important development of this research is to consider many markets at the same time. This allows to studying phenomena of "financial contagion" due to learning or herding across markets. Cipriani and I have already given some theoretical contribution on this topic, but much more work needs to be done. Future research (joint with Steffen Huck) will be focused on understanding financial contagion due to informational spillovers in the laboratory. This research project is kindly supported by the ESRC (program on the World Economy and Finance).
While most of this research project on herding and learning focuses on financial markets, part of it is devoted to more general issues of "social learning." Herd behaviour in financial markets is a possible outcome of the traders' learning process. Traders try to learn from the trading decisions of the agents who went first to the market: it may happen that this learning process makes them just neglect their private information. This is what can happen in different social contexts too. When we have to decide which car to buy or which restaurant to go to, we do observe the decisions of other agents, for instance of our neighbours. After observing them, we may well decide to change our mind and, for instance, imitate their decisions, neglecting our original private information. The process of learning from the actions of others is what we call social learning. I am investigating issues of social learning not strictly related to the financial market in a number of papers. In a joint paper with Steffen Huck, and Thomas Jeitschko, we experimentally investigated a model of Bayesian learning that predicts sudden changes in the behaviour of agents and sudden crashes in the market. In the laboratory these changes (information avalanches) do not take place since decision makers are prone to a "solipsism bias," i.e., they are unable to imagine that others who play the same game may make quite different experiences than they themselves. We conjecture that this solipsism bias is of relevance in many fields of human decision making. In another work with Steffen Huck and Heike Harmgart, we analyze how agents learn by observing the number of agents who have already made a decision. For instance, agents have to decide to which of two restaurants to go, and they can infer the quality of the restaurant by some private information and by observing how many other agents have already chosen to go to the two restaurants. The question is whether the aggregation of information is efficient in this context or whether informational inefficiencies can arise. This work, still in progress, is both theoretical and experimental. If you are interested in this work, you can also look at Steffen Huck's research on social learning . In another project with Antonella Ianni we analyze the process of social learning in an economy in which agents can only observe the actions of their neighbours. The question is whether local interaction leads to complete learning in the entire society and whether convergence is fast or slow.
If what you have read so far seems interesting to you, and you want to know more, please visit the ELSE Working Papers Archive and my Personal Webpage, where you can find updated versions of my papers. adapted from http://else.econ.ucl.ac.uk/newweb/research/blurb1.php
According to anecdotal evidence, herd behavior is diffused in financial markets. Some agents buy stocks simply "following the herd" in a bull market, or sell them in the wave of diffused pessimist in a bear market. While there is a large anecdotal evidence on herd behavior in financial markets, and the idea that traders herd is diffused among practitioners and market participants, our understanding of why herding can arise in the financial market is still limited. Furthermore, studies that have attempted to document and quantify the presence of herding in the market have obtained results that are far from conclusive. Most work remains to be done both at a theoretical and at an empirical level. My research activity is devoted to shed light on the phenomenon of herd behaviour in financial markets with a combination of theoretical, experimental and empirical work. Most of this work is a joint effort with Marco Cipriani , of George Washington University.
Herd behaviour is relevant for the financial market informational efficiency. Essentially, herd behaviour entails neglecting private information in trading a stock or a group of stocks, because of what previous traders have decided to do. Clearly, if an agent neglects private information and herds, the market will not be able to infer that private information from the choice of that agent, and the price will not be able to reflect it. If many traders herd, the stock price can be misaligned with respect to the true value of the stock. Cipriani and I have proven that, indeed, even if traders are perfectly rational Bayesian agents, herd behaviour occurs in the market because of traders' heterogeneity. Traders go to the market to exploit their private information and for non-informational (e.g., liquidity) motives. Over time, as trade proceeds, the informational reasons to trade become less important than the non-informational ones. At a certain point, all traders will neglect their private information and an "informational cascade" (i.e., a situation in which the traders' decisions are completely uninformative on the asset value) will arise. In a cascade the price does not react to the order flow and is stuck for ever. It may well be that the price remains stuck at a level far from the fundamental one. For instance, it may be that the value of a stock is high, but the price remains stuck at a low level, after a sequence of sell orders in the market. Therefore, herd behaviour can be a reason why we can observe a financial crisis even in an economy with sound fundamentals.
To test theoretical models of herd behaviour is difficult. As I said, herding, at least in our framework, means neglecting private information because of the observations of previous traders' decisions. Therefore, ideally, to test such models one would need data on private information, which is of course difficult to obtain for actually running markets. This difficulty can be overcome in an experimental study. In an experiment we can observe variables not available for actual markets, in particular, the private information that agents have when making their decisions. For this reason, Cipriani and I have run a series of experiments in which we test whether herding arises as theory predicts or not. In our laboratory market, subjects receive private information on the value of a security and observe the history of past trades. Given these two pieces of information, they choose, sequentially, if they want to sell, to buy or not to trade one unit of the asset. By observing the way in which they use their private information and react to the decisions of the previous traders, we can directly detect the occurrence of herding. Our experimental results are encouraging for the theory. Although the laboratory reveals some anomalies in subjects' behaviour, i.e., some deviations from equilibrium behaviour, overall what we observe in the laboratory is quite consistent with the theoretical predictions. In particular, in a frictionless financial market in which traders trade for informational reasons only, and the price is efficiently set by a market maker in response to the order flow, herd behaviour is very limited. This agrees with the theory, according to which we should not observe herding at all. Market frictions, instead, generate informational inefficiencies both theoretically and experimentally. Cipriani and I have studied a market in which such frictions take the form a trade cost. We have shown that such a cost impairs the process of information aggregation and an informational cascade occurs almost surely. A cascade occurs since, after some trades, the gain form trading becomes lower than the cost, and agents prefer to abstain from trading. Interestingly, such behaviour is not only a theoretical result, but also occurs in the laboratory. Indeed, our experimental results are very close to the theoretical prediction. Transactions costs can be due, for instance, to transaction taxes, like the Tobin Tax. Therefore, our work has also some policy implications on the introduction of such a tax.
In more recent work, Cipriani and I have extended our research on herd behaviour by estimating a theoretical model of herding with field data. While in previous work we have brought the model to the laboratory, in this work we have brought the model to the real financial market. We use data on many days of trade for some specific stocks. We estimate the parameters of a theoretical model that predicts herd buying (or selling) when a sufficiently high sequence of traders have decided to buy (or sell) the asset. In the market there is a market maker who efficiently sets the prices for a stock according to the orders flow, and a sequence of traders, who can buy or sell at those prices. Herd buying arises when all traders value the asset more than the price posted by market maker, even if they have negative private information. Similarly, herd selling arises when all traders value the asset less than the market maker, even if they have positive private information. After we have estimated the parameters of the model, we are able to track down the beliefs that the market maker (the notional prices) and the traders have during each day of trading. By comparing these beliefs, we can identify the periods of the trading day in which herding occurs or not.
The research activity described so far refers to the analysis of a single market (for instance, a single stock, or a single country). An important development of this research is to consider many markets at the same time. This allows to studying phenomena of "financial contagion" due to learning or herding across markets. Cipriani and I have already given some theoretical contribution on this topic, but much more work needs to be done. Future research (joint with Steffen Huck) will be focused on understanding financial contagion due to informational spillovers in the laboratory. This research project is kindly supported by the ESRC (program on the World Economy and Finance).
While most of this research project on herding and learning focuses on financial markets, part of it is devoted to more general issues of "social learning." Herd behaviour in financial markets is a possible outcome of the traders' learning process. Traders try to learn from the trading decisions of the agents who went first to the market: it may happen that this learning process makes them just neglect their private information. This is what can happen in different social contexts too. When we have to decide which car to buy or which restaurant to go to, we do observe the decisions of other agents, for instance of our neighbours. After observing them, we may well decide to change our mind and, for instance, imitate their decisions, neglecting our original private information. The process of learning from the actions of others is what we call social learning. I am investigating issues of social learning not strictly related to the financial market in a number of papers. In a joint paper with Steffen Huck, and Thomas Jeitschko, we experimentally investigated a model of Bayesian learning that predicts sudden changes in the behaviour of agents and sudden crashes in the market. In the laboratory these changes (information avalanches) do not take place since decision makers are prone to a "solipsism bias," i.e., they are unable to imagine that others who play the same game may make quite different experiences than they themselves. We conjecture that this solipsism bias is of relevance in many fields of human decision making. In another work with Steffen Huck and Heike Harmgart, we analyze how agents learn by observing the number of agents who have already made a decision. For instance, agents have to decide to which of two restaurants to go, and they can infer the quality of the restaurant by some private information and by observing how many other agents have already chosen to go to the two restaurants. The question is whether the aggregation of information is efficient in this context or whether informational inefficiencies can arise. This work, still in progress, is both theoretical and experimental. If you are interested in this work, you can also look at Steffen Huck's research on social learning . In another project with Antonella Ianni we analyze the process of social learning in an economy in which agents can only observe the actions of their neighbours. The question is whether local interaction leads to complete learning in the entire society and whether convergence is fast or slow.
If what you have read so far seems interesting to you, and you want to know more, please visit the ELSE Working Papers Archive and my Personal Webpage, where you can find updated versions of my papers. adapted from http://else.econ.ucl.ac.uk/newweb/research/blurb1.php
Minggu, 02 November 2008
India feels crisis, Brown seeks cash for IMF
RIYADH: British Prime Minister Gordon Brown on Sunday called for billions of dollars in extra funding for the International Monetary Fund to prop
up struggling economies, while Chinese Premier Wen Jiabao said maintaining China's strong domestic growth was his priority.
Leaders from Mumbai to Moscow and Berlin moved to support their own economies on Saturday, with India's central bank cutting interest rates for the second time in two weeks, Russia putting 170 billion roubles ($6.4 billion) into a state bank and German Chancellor Angela Merkel pledging support for a big investment package to boost Europe's largest economy.
Brown, speaking in Riyadh, said oil-producing Gulf States and China should contribute money for the IMF to lend to countries at risk of financial collapse.
"If we are to stop the spread of the financial crisis, we need a better global insurance policy to help distressed economies," Brown said.
Chinese Premier Wen, writing in the ruling Communist Party's ideological journal, warned of growing domestic social risks from a global economic downturn.
"Against the current international financial and economic turmoil, we must must give even greater priority to maintaining our country's steady and relatively fast economic development," Wen wrote.
"We must be crystal-clear that without a certain pace of economic growth, there will be difficulties with employment, fiscal revenues and social development...and factors damaging social stability will grow."
China cut interest rates on Wednesday for the third time in six weeks to help the world's fourth-largest economy ride out the reverberations of the global financial crisis.
In India -- like China, a magnet for foreign investment in recent years as their economies roared -- the central bank on Saturday cut its main lending rate for the second time in as many weeks to ease a cash squeeze and spur economic growth.
INDIA WAS GETTING WORSE
Analysts said the surprise move showed Indian concern that strains on its economy were quickly becoming more severe.
"These actions were necessary (and had) to be taken on the liquidity front...the situation was getting worse," said Vikas Agarwal, a strategist at JP Morgan.
The central bank cut the repo rate, its main short-term lending rate, by 0.5 percentage point to 7.5 per cent and banks' cash reserve requirements by 1 percentage point to 5.5 per cent.
Policymakers around the world have slashed interest rates in recent weeks and injected huge amounts into their banking systems to try to combat the spillover effects of the global crisis, which has caused credit markets to freeze up and threatens to plunge the world economy into recession.
adapted from http://economictimes.indiatimes.com/
up struggling economies, while Chinese Premier Wen Jiabao said maintaining China's strong domestic growth was his priority.
Leaders from Mumbai to Moscow and Berlin moved to support their own economies on Saturday, with India's central bank cutting interest rates for the second time in two weeks, Russia putting 170 billion roubles ($6.4 billion) into a state bank and German Chancellor Angela Merkel pledging support for a big investment package to boost Europe's largest economy.
Brown, speaking in Riyadh, said oil-producing Gulf States and China should contribute money for the IMF to lend to countries at risk of financial collapse.
"If we are to stop the spread of the financial crisis, we need a better global insurance policy to help distressed economies," Brown said.
Chinese Premier Wen, writing in the ruling Communist Party's ideological journal, warned of growing domestic social risks from a global economic downturn.
"Against the current international financial and economic turmoil, we must must give even greater priority to maintaining our country's steady and relatively fast economic development," Wen wrote.
"We must be crystal-clear that without a certain pace of economic growth, there will be difficulties with employment, fiscal revenues and social development...and factors damaging social stability will grow."
China cut interest rates on Wednesday for the third time in six weeks to help the world's fourth-largest economy ride out the reverberations of the global financial crisis.
In India -- like China, a magnet for foreign investment in recent years as their economies roared -- the central bank on Saturday cut its main lending rate for the second time in as many weeks to ease a cash squeeze and spur economic growth.
INDIA WAS GETTING WORSE
Analysts said the surprise move showed Indian concern that strains on its economy were quickly becoming more severe.
"These actions were necessary (and had) to be taken on the liquidity front...the situation was getting worse," said Vikas Agarwal, a strategist at JP Morgan.
The central bank cut the repo rate, its main short-term lending rate, by 0.5 percentage point to 7.5 per cent and banks' cash reserve requirements by 1 percentage point to 5.5 per cent.
Policymakers around the world have slashed interest rates in recent weeks and injected huge amounts into their banking systems to try to combat the spillover effects of the global crisis, which has caused credit markets to freeze up and threatens to plunge the world economy into recession.
adapted from http://economictimes.indiatimes.com/
Kamis, 30 Oktober 2008
Overview of Economic
Economics is the UK and European adaptation of Greg Mankiw’s classic textbook, expertly adapted by Mark Taylor so as to be even more relevant to a UK and European audience. A major strength of the original - that the authors present economics from the viewpoint of a reader completely new to the subject – has been maintained. Research shows that the book appeals particularly well to the more applied, business-oriented courses. The conversational yet precise writing style is superb for presenting the politics and science of economic theories to tomorrow's decision-makers. The book stands out amongst all other principles texts by encouraging students to apply an economic way of thinking in their daily lives. Economics is written to provide students with a robust conceptual understanding of the subject using contemporary approaches to theory where possible. It follows the structure of the original book while reflecting European economic structures and institutions and adapting the language and cultural references for a European readership. In the first Part, the opening chapter sets out ten important principles, which are revisited throughout the text. The second chapter is an introduction to thinking like an economist and the third introduces interdependence and gains from trade. The following Parts cover microeconomics (19 chapters) and macroeconomics (15 chapters), with the latter Part preserving Mankiw’s trademark long run-short run approach. Economics uses the euro as the basic currency referred to throughout the book. Case studies, examples, In The News and For Your Information features largely refer to the European and UK economies. Major changes in content are evident in Chapter 12 on the taxation system , Chapter 29 on the monetary and financial system and in a new Chapter on common currency areas and European Monetary Union (Chapter 36). adapted from http://estore.bized.co.uk
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