The real cause of the crisis

Read this very interesting article from Wired Magazine. It argues that a formula devised by David Li, published in an article entitled "On Default Correlation: A Copula Function Approach", may have been at the root of the crisis. The point is that Li's formula allowed analysts to come up with a relatively simple way of pricing risk of portfolios of assets with correlated returns. This in turn allowed the market for the notorious CDOs to develop rapidly. It seems that the tractability of the formula which delivered a simple number is what mattered; the fact that the number may have been built on very dodgy foundations did not matter. (A bit like exam marks perhaps?) Once the number existed, markets could be developed. And everyone used this approach.

Ricardian Equivalence

Adapted from Escher here. Ricardian equivalence is the idea that tax cuts finaced by extra government borrowing don't affect spending because people save the extra income to pay for the future taxes that will be needed to service the extra government debt. See this article in Wikipedia.

What is quantitative easing?

Confused? Here are some useful references from (Kings' EcBSt blog):
Bank to request permission to print (Independent)
Stephanie Flanders on quantitative easing
Times graphic explaining quantatative easing
Guardian Q&A on quantative easing

More on deflation

(Click to enlarge.) These are "fan" charts of the Bank of England's output (GDP) growth and inflation predictions respectively, as of this month (Feb 09; for full details, click here). Inflation here is defined as the annual % rate of change in the CPI (see below), which currently stands at 3.0%. This appears to predict that inflation will not dip below zero with very high probability, but that, of course, is what they want us to believe. Output growth is expected to fall to around -4% but to get back to a positive level by the end of the year, which still looks fairly optimistic.

UK inflation rate declines:are we heading for deflation?

Retail Prices Index (RPI) inflation fell in January to 0.1% (the lowest since 1960) from December's 0.9%. This is the change in prices in % terms over the last year, so the rapid fall evident from the blue graph (see BBC News) is in a way even more dramatic as it does not capture the current rate (i.e., December - January) which is presumably quite negative. The RPI includes things like mortgage costs and these have fallen a lot in the last few months. The Consumer Prices Index (CPI) inflation rate (which does not include mortgage costs) only fell slightly, to 3.0% from 3.1%, a smaller fall than expected. The bad news for the readers of this blog is this smaller than expected fall was partly due to an increase in the price of alcohol, but also the falling pound pushing up import prices. Remember that it is really the future expected rate that matters for most things (such as real interest rates) so one can imagine that this is even lower for most people.

See this article in last week's Independent for further discussion of these inflation rate figures and why deflation is so feared. During 1930-33 prices fell at 10% in the US, turning recession into the Great Depression (deflation in the UK was much lower though).

Sean's tangents

A few of Wikipedia links which relate to my side-talks earlier today:

For the 9-11 tutorial, here is the sad tale of Didius Julianus and his ill-fated auction.

For the 11-1 tutorial, here are the covers of Metallica's Load and ReLoad albums, as well as the artist Andres Serrano (you can find some really strange stuff linking from that last page).

Britain's fallen star

An excellent article in the Economist compares Britain's economic position to that of her peers. The conclusion:

But just as there was too much optimism during the good times, so there can be too much pessimism in the bad times.... Provided sound policies are pursued, above all credible plans to restore the public finances once a sustainable recovery has started, there is a way out of the mess. And, given the vigour with which monetary and fiscal policy has been eased, that recovery might just come sooner to Britain than to countries that look more resilient now.

Thursday's lecture

Apologies for the disruption with the venue move due to the occupation of George Square Lecture Theatre. I think everyone made it in the end. The late arrival of half the class possibly meant that the trading experiment didn't go quite as well as hoped, although there was some convergence towards the equilibrium price. Any comments on how it can be improved for future use gratefully received (just click on comments below this post - you can be anonymous!). For example was it clear what you had to do, or should we have gone through an example first? I will try to post some more analysis of this experiment when I have time.

Thursday's Lecture Moved

Thursday 12 Feb we will be in the DHT lecture theatre B, not George Square.

Japan and the zero rate bound

Here are the two graphs from today's lecture. The bottom one is the inflation rate, the salient point being that is has been negative, i.e., deflation, for quite a lot of the past 10 years. The top one shows the Bank of Japan's interest rate, which has hit zero (recall that a negative nominal interest rate isn't possible as people would be better off holding cash under their mattresses if necessary). Even at a zero nominal interest rate, negative expected inflation means that the real rate of interest is positive.

Oops

I came across this article (from 2006) profiling Bernanke (chairman of the US Federal Reserve). Robert Shiller could hardly have been more wrong:

Robert Schiller, a Yale economist and author of Irrational Exuberance, warns
that Mr Bernanke's focus on the Great Depression has trained him to fight the
wrong war.

The article also says:

The nub of his argument is that falling prices combine with debt to create a deadly cocktail. Central banks cannot cut rates below zero, so "real" interest rise as the economy slides deeper into deflation. Farmers defaulted en masse in 1933, toppling the banking system.
But there are other ways to counter deflation, Mr Bernanke explained with rather too much flourish as fresh Fed governor in 2003.
"The US government has a technology called a printing press that allows it to produce as many US dollars as it wishes at essentially no cost," he said.
Ultimately, the Fed can flood the system by buying any kind of asset, or even dropping bank notes from helicopters, he said. The speech earned him the epithet "Helicopter Ben" and perhaps a fatal notoriety as a inflationist, however unfairly.

Paul Krugman points out that the personal savings rate is rising rapidly, as people try to cut their debt levels. He says this is a variant on Keynes's "paradox of thrift". Keynes argued that if everyone wants to save more (as a fraction of their income), for whatever reason, the net effect is that aggregate income falls (as people spend less) until it reaches a new equilibrium level at a sufficiently low level that savings have been brought back down to their original level (so that S=I again, investment having stayed constant in the basic Keynesian model). So all the individual attempts to save more get cancelled out. Krugman here says that a similar logic applies because people feel too indebted; they try to save more to pay back debt, income falls as in the above argument, and they end up even more indebted:

Yesterday’s report on consumer incomes, spending, and saving showed a sharp rise in the personal savings rate; it also showed a decline in nominal personal incomes, the third in a row, reflecting the weakening economy.
I don’t know who else has made this point, but it’s quite clear that we’re in serious paradox of thrift territory here. Or perhaps more accurately, we’re in a paradox of debt.
Consumers are pulling back because they’ve realized that they’re too far in debt. The economy is shrinking in large part because consumers are pulling back. And the result, almost surely, is to leave household balance sheets worse than ever. I can’t do this accurately until the Federal Reserve’s flow of funds data have been updated, but almost without question the ratio of household debt to personal income has been rising, not falling, as consumers try to save more.
Damnification in action.

Network Externalities

This is the link for Craiglist, discussed in today's lecture, and I used the Wayback machine to look at old ads (just enter, e.g., http://edinburgh.craigslist.org/apa/ in the box) or directly follow this link to look at old Edinburgh ads.

Productivity Growth

This is the link for the item from Cafe Hayek in today's lecture about how many hours you have to work to buy a particular item.

Do Giffen goods exist?

From Greg Mankiw:

Chapter 21 of my favorite economics textbook has a brief discussion of Giffen goods--goods for which a lower price decreases the quantity demanded. This occurs when a negative income effect (the good is inferior) exceeds the substitution effect.Do such goods ever exist? A new study by Robert Jensen and Nolan Miller, economists at Harvard's Kennedy School, answers this question in the affirmative:

we conducted a field experiment in which for five months, randomly selected households were given vouchers that subsidized their purchases of their primary dietary staple. Building on the insights of our earlier analysis, we studied two provinces of China: Hunan in the south, where rice is the staple good, and Gansu in the north, where wheat is the staple. Using consumption surveys gathered before, during and after the subsidy was imposed, we find strong evidence that poor households in Hunan exhibit Giffen behavior with respect to rice. That is, lowering the price of rice via the experimental subsidy caused households to reduce their demand for rice, and removing the subsidy had the opposite effect. This finding is robust to a range of alternative specifications and methods of parsing the data. In Gansu, the evidence is somewhat weaker, and relies to a greater extent on segregating households that are poor from those that are too poor or not poor enough. We attribute the relative weakness of the case for Giffen behavior in Gansu to the partial failure of two of the basic conditions under which Giffen behavior is expected; namely that the staple good have limited substitution possibilities, and that households are not so poor that they consume only staple foods. Focusing our analysis on those whom the theory identifies as most likely to exhibit Giffen behavior, we find stronger evidence of its existence....

To the best of our knowledge, this is the first rigorous empirical evidence of Giffen behavior. It is ironic that despite a long search, in sometimes unusual settings, we found examples in the most widely consumed foods for the most populous nation in the history of humanity.

Further reading material for the discussion question of Tutorial Sheet 3

I found that the link of discussion question on tutorial sheet 3 is no longer valid.
Here is the updated link for your reference.