16. Sidney Homer and Richard Sylla, A History of Interest Rates, 3rd ed. (New Brunswick, NJ: Rutgers University Press, 1991), p. 340.
17. Clearly that was not the case for the savings and loan industry that had assumed interest rates would remain low forever. They did not. Their predominantly short-term funding costs rose dramatically in the early 1980s. The return on their mortgage portfolios, however, rose only modestly. Nearly 750 S&Ls failed in the years following.
18. A normal distribution reflects the probability of events that approximate coin-tossing outcomes.
19. Immediately subsequent to Lehman, a number of investment firms constructed probability distributions of outcomes employing, as the negative tail, data based on the post-Lehman experience. Using Monte Carlo simulations and other techniques, they concluded, not unexpectedly, that the probability of a financial crisis as severe as the one that followed the Lehman default was much higher than indicated by models in which risk is more normally distributed. Such evidence suggests that the probability of the onset of what was previously thought to be a “hundred-year flood” is higher than once in a century.
20. The higher the level of market participants’ capital, the greater the degree of liquidity. The larger the restrictions on the mobility of collateral, the less the needed capital. The larger the size of the combined equity of market participants, the larger the pool available to fund narrow bid‒asked spreads.
21. Sebastian Mallaby, More Money Than God: Hedge Funds and the Making of a New Elite (London: Bloomsbury, 2010).
22. See endnote 15 in Chapter 2 regarding the SEC’s position on generic bank reserves.
23. Although Gramm-Leach-Bliley repealed the Glass-Steagall Act of 1933, the mandatory separation of commercial and investment banking had essentially already been nullified more than a decade earlier. An April 1987 court ruling had legalized an interpretation of Glass-Steagall that enabled bank holding companies to have affiliated investment banks. These affiliates that came to be known as Section 20 affiliates had become ubiquitous well before the passage of Gramm-Leach Bliley. The important contribution of Gramm-Leach-Bliley was the significant reduction of costs of engaging in both commercial and investment banking activities, achieved by repealing the barriers and red tape associated with Section 20 affiliates. The repeal of the Glass-Steagall Act in fact changed very little. From the enactment of Gramm-Leach-Bliley in 1999 to the Federal Reserve’s acceptance of Goldman Sachs and Morgan Stanley as financial services holding companies at the height of the crisis, no applications to employ the greater powers were forthcoming. That forbearance apparently reflected a desire to stay clear of the Federal Reserve’s regulatory embrace.
24. The seller of a CDS insures the holder of a particular debt instrument against loss in the event of default. Prices of CDSs are thus the most sensitive measure of the probability of bank default.
25. For five-year contracts, the average annual price of insurance was 0.14 percent of the notional amount of the underlying swap instruments.
26. Of course, in retrospect that proved to be insufficient compensation for the risk that was eventually revealed.
27. As fear of contagion from the European sovereign debt crisis mounted in the spring of 2010, CDS and LIBOR/OIS spreads rose markedly.
28. When, during the crisis, such assets appeared about to fail, sponsoring companies, fearful of reputation risk (a new insight?), reabsorbed legally detached affiliates at great loss.
29. See endnote 23 (pages 355–56).
30. Rates of return crashed during the first half of 2009, with declines matched (on an annual basis) only by those in the Depression years 1932–34. Both cases reflected a rare sharp breakout from the historical range, resulting mostly from large write-offs on previously extended loans.
31. Gary H. Stern, “Addressing the Too Big to Fail Problem.” Statement before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C., May 6, 2009.
32. Wayne Passmore, “The GSE Implicit Subsidy and the Value of Government Ambiguity,” Real Estate Economics, vol. 33, no. 3 (2005), pp. 465–86.
33. Kenichi Ueda and Beatrice Weder di Mauro, “Quantifying Structural Subsidy Values for Systemically Important Financial Institutions,” IMF Working Paper, May 2012.
34. The FDIC has experienced large losses in the value of assets taken over in resolution during the last five years.
35. At the end of 2007, Lehman Brothers had thirty-one times; Bear Stearns, thirty-four; and Citigroup, eighteen.
36. Partnership capital is often lost to a partnership when partners retire. Corporate capital is far more stable.
37. With rare exceptions it has proved impossible to identify the point at which a bubble will burst, but its emergence and development are visible in credit spreads.
38. Alan Greenspan, “Banking Supervision.” Speech before the American Bankers Association, Washington, D.C., September 18, 2000.
39. In 1903, O. Henry (W. S. Porter), who had more than a passing relationship with banking shenanigans, wrote in “A Call Loan” about a fictional bank examiner from the Office of the Comptroller of the Currency who was obsessed with the collateral backing a $10,000 loan. Such detailed scrutiny is exceptionally rare in today’s larger banks.
40. Having served on JP Morgan’s board for a decade just before my joining the Federal Reserve, I had an extended insight into the effectiveness of that company’s counterparty surveillance of Citicorp, Bank of America, Wells Fargo, and others, relative to the regulatory surveillance by Federal Reserve banks.
CHAPTER 6: SCHOONER INTELLIGENCE AND THEN SOME
1. Willard Long Thorp, Business Annals, National Bureau of Economic Research, 1926.
2. First published in 1827.
3. One of the founders of the Journal of Commerce was the multitalented Morse, whose invention of the telegraph (and its extension to the transatlantic cable in 1866) undermined the competitive advantage of earlier “schooner” intelligence. Communication times collapsed (from the ten days it took a ship to bring information across the Atlantic to a matter of minutes).
4. On March 26, 1860, the New York Herald carried an announcement by the Central Overland California and Pike’s Peak Express Company offering mail delivery from New York “to San Francisco in eight days. The first courier of the Pony Express will leave the Missouri River on Tuesday, April 3 at 5:00 pm, and will run regularly, weekly, hereafter, carrying letter mail only.” The first lap of this relay between New York and St. Joseph, Missouri, was by telegram. But the line ended there.
5. The telephone (1876), and later, the wireless telegraph and radio, increased the scope and convenience of communications but reduced the time of transmission only modestly.
6. The Homestead Act, signed into law by President Lincoln on May 20, 1862, formally established an application and acquisition process by which any U.S. citizen (or intended citizen) could settle a 160-acre plot of federal land west of the Mississippi River. By 1934, the Homestead Act had transferred 10 percent of all U.S. lands from the government to individuals.
7. To close the loop of personal coincidences, the Conference Board was my first employer upon graduating from New York University.
8. Alvin Hansen: Full Recovery or Stagnation? (New York: W. W. Norton, 1938), and Fiscal Policy and Business Cycles (New York: W. W. Norton, 1941).
9. Klein ended up winning the Nobel Prize in Economics in 1980 for his contributions to computer-based econometric models.
10. The merger formed Global Insight, which was later acquired by IHS Inc.
11. Much of what follows is drawn from The Age of Turbulence, published in 2007.
12. The Ford administration did get enacted a one-shot tax rebate, which probably did not provide a large boost to the economy but also probably did little harm.
13. I was always impressed at the high quality of economists and economic research that was the defining characteristic of the Council of Economic Advisers. It was an economic consul
ting organization with one client: the president of the United States. Burton Malkiel was the CEA member who was officially in charge of coordinating the CEA’s forecast with that of the U.S. Treasury and the president’s Office of Management and Budget. (In 1973 [revised in 2007], Malkiel authored the bestseller A Random Walk Down Wall Street [New York: W. W. Norton].) Three agencies crafted the administration’s official position on the outlook, though the CEA had more than equal influence.
14. See “Debt Matters” in Chapter 2, page 49.
15. Interestingly, in some quarters, the Federal Reserve has recently come under pressure in the wake of the crisis not to pursue more expansionary policies, at least those related to an expansion of its balance sheet.
CHAPTER 7: UNCERTAINTY UNDERMINES INVESTMENT
1. Residential building has recovered in part since mid-2012 but as of June 2013 remains well below its peaks of 2006.
2. This calculation, by including foreign earnings retained abroad, represents U.S. nonfinancial corporations’ global consolidated cash flow, in which foreign retained earnings are net of capital investments of foreign affiliates. Corporate decision making, in my experience, is made on a worldwide basis.
3. Noncorporate investment as a share of gross savings in 2010 was the lowest in the postwar period, with the possible exception of one quarter in 1992.
4. The result is the same if motor vehicles and other somewhat shorter-lived consumer durables are included in investment.
5. Disposable personal income less personal consumption expenditures (less depreciation).
6. This is evidenced by the relationship between housing starts and the price of homes relative to their trailing three-year average (see Exhibit 7.4).
7. A clouded future will cause an existing homeowner to stay put and not take on the risk of a new home, but in addition, a large segment of households has chosen to switch to rentals (a short-term commitment). Of course, this swing reflects, in part, the sharp spike in home foreclosures.
8. Including both single-family and multifamily condominiums.
9. Long-lived structures, the mark of market expansion, were suppressed.
10. Real GDP barely declined in the “recession” of 1991 and not at all in 2001.
11. The rate of discount on expected returns from an investment tends to rise with maturity. This phenomenon is most visible in credit markets where yields on debt tend to increase with the maturity of the debt instrument—a rising “term structure,” as it is commonly known.
12. The history of the spread since 1900 is depicted in Exhibit 7.5.
13. Taking into consideration only the change in output itself.
14. While unemployment among construction workers soared, by far most of the rise in unemployment reflected tepid demand economywide.
15. Although short-lived business equipment and software investment rose moderately in 2010 and 2011, U.S. overall private fixed investment has fallen far short of the level that history suggests should have occurred given the recent dramatic surge in corporate profitability.
16. Risk managers, especially in the financial sector, having badly underestimated negative tail risk prior to the crisis, have become increasingly uncertain of their ability to evaluate risk.
17. Prior to 2008, the only actual breakdown in market structure of which I am aware occurred for one day at the height of the panic of 1907.
18. Of which $649 billion had been expended through the end of 2011.
19. See chapters 3 and 4, as well as the later sections of this chapter, for evaluations of private equity stimulus and fiscal stimulus as contributors to economic recovery.
20. Ex ante (before the fact) and ex post (after the fact), terms largely attributed to Swedish economist Gunnar Myrdal, are widely used in macroeconomics to define the process by which disparate levels of intended savings and investment (ex ante) are brought into equality, ex post, through interest rates and other rates of return on assets. Although we have no direct measure of ex ante, we assume that if, at an interest rate, saving intentions exceed investment intentions, the rate of interest will fall until both savings and investment are brought into equality. Similarly, rates will rise in the reverse situation.
21. Thomas Huxley, “Biogenesis and Abiogenesis” (presidential address at the British Association, 1870).
22. Repeated experiments dealing with the real world produce the same results time after time. In economics, the conditions never stay stable long enough to produce an exact repetition.
23. The cracks in market structures had been repaired by then.
24. Such fears were clearly evident as the 1929 stock market bubble burst. There were innumerable consortiums of large investors and financial institutions that tried to stem the fall and failed.
25. Auction sales of wholly illiquid assets into a market devoid of bids will, almost without exception, be at prices for which the market will immediately pounce, as was the case with the RTC’s novel auction initiative (see The Age of Turbulence, p. 117).
26. Chrysler had been bailed out by the federal government once before in 1980, but that incident apparently was not precedential.
27. The depression of 1896 was an exception.
28. Harold Cole and Lee Ohanian, “New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis,” Journal of Political Economy 112, no. 4 (August 2004): pp. 779–816.
CHAPTER 8: PRODUCTIVITY: THE ULTIMATE MEASURE OF ECONOMIC SUCCESS
1. The combined profit margin of manufacturing, mining, and trade (Census Bureau) more than doubled during 1993 and 1994, and then peaked in 2000.
2. Price = (Average Hourly Labor Compensation / Output per Hour) – Other Unit Costs = Profit per Unit of Output Divided by price: 1 – [Average Hourly Labor Compensation / (Output per Hour times Price)] – (Other Unit Costs/Price) = Profit Margin
3. To be sure, the BEA’s nonfinancial corporate productivity growth rate was stronger, but it, combined with the reliable nonfarm business measure, implied an implausibly prolonged deeply negative rate of productivity growth for the whole of noncorporate business, and was hence disregarded.
4. The Federal Reserve’s chief domestic economist at the time.
5. Laurence H. Meyer, A Term at the Fed (New York: Harper Collins, 2004), p. 125.
6. Real GDP actually grew during the recession years albeit at a subdued 1.8 percent annual rate from 2001 through 2003.
7. These five-year forecasts are statistically tied, significantly, to the average of the previous ten years.
8. See Chapter 10 on the issue of political culture and levels and growth of productivity.
9. A broader historical measure, of course, would include our farm workforce and its output—a major component of the U.S. economy into the early twentieth century. But two factors lead to the choice of examining the long-term trends in the nonfarm sector. First, the level of farm productivity tends to be far less than that of the nonfarm sector. And second, the share of our workforce devoted to farming has dwindled to around 2 percent (see Chapter 6), and the rapid replacement of low-output-per-hour farm workers with nonfarm workers imparted a rate of increase in national productivity heavily affected and distorted by the transfer of work from farm to nonfarm. But that came to an end in 2004, never to be repeated (Exhibit 8.2). Thus, tracing the nonfarm sector for long-term undistorted evaluation tends to be favored by economic forecasters.
10. An estimate for 1870 employs Angus Maddison’s 1.92 percent annual rate of change between 1870 and 1913 to obtain a number consistent with the series published by John W. Kendrick and the BLS covering the period 1889 to 2012. (Angus Maddison, The World Economy: A Millennial Perspective. Development Centre of the OECD, 2001).
11. I suspect that this surprising degree of long-term stability reflects, in part, a large and slowly growing capital stock with an average age of more than twenty years. Obviously, the greater the average age, the slower the rate of turnover and the more stable the flow of imput
ed “services” from that stock relative to other factors of growth. The “services” emanate daily from our capital infrastructure—our buildings, productive equipment, highways, and water systems, to identify just a few. And that relatively stable average age is itself reflecting the apparent stability of human time preference, a key animal spirit.
12. Virtually all of war-ravaged European plant and equipment was replaced with the newest technologies between 1950 and 1973.
13. See individual country data in Angus Maddison, The World Economy: A Millennial Perspective. Development Centre of the OECD, 2001.
14. The process of human adjustment to the real world may make it appear that, as a species, we are getting smarter. But that may reflect that the world in which we live is becoming ever more complex. The natural world had to seem more bewildering to people living one or two millennia ago. But raw intelligence at its highest levels appears little different now from our forebears of earlier millennia. For an interesting review of this controversial issue, see James R. Flynn’s Are We Getting Smarter (Cambridge University Press; 2012).
15. The development of that paradigm is principally attributed to John W. Kendrick (National Bureau of Economic Research and George Washington University) and Robert Solow (Massachusetts Institute of Technology).
16. See, for example, Stephen D. Oliner, Daniel E. Sichel, and Kevin J. Stiroh, Explaining a Productive Decade. Finance and Economics Discussion Series, Federal Reserve Board, Washington, D.C., August 2007.
17. Almost all such projections also adjust labor input as measured by hours worked for the projected quality of the workforce, often proxied by average levels of completed education and other characteristics thought to be associated with labor quality.
18. This is a measure of the amount of capital consumed in the production process and, as such, weights a dollar of short-lived fixed capital expenditures (in terms of economic deterioration) more heavily than a dollar of long-lived fixed capital expenditures.
The Map and the Territory Page 28
