6/17/09 9:26 PMNotes and Handouts for Berkeley Physics Colloquium, May 11, 2009

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May 11, 2009

Notes and Handouts for Berkeley Physics Colloquium, May 11, 2009

Audio: http://www.j-bradford-delong.net/2009_mov/20090511_physics.m4a

The fall in the adult employment-population ratio

The increase in risk and the collapse in risk tolerance

The fall in monetary velocity

What determines monetary velocity?

Policy to fix it 1: dump money into the economy

Is Your Bank At Risk?Is Your Bank Or Insurance Failing? Free Report Available. Get It Now!www.moneyandmarkets.com

6/17/09 9:26 PMNotes and Handouts for Berkeley Physics Colloquium, May 11, 2009

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Unjust enrichment

Inflationary overhang

Might not work when i<<1

Policy to fix it 2: raise Treasury bond interest rates

By making Treasury bonds less attractive to hold--flood the zone

But then you have to spend the money you have earned by selling the Treasury bonds

By making corporate bonds more attractive to hold

Guarantees

Asset repurchases

Bank recapitalizations

How did we get here?

Herd behavior

Short horizons

Limits to arbitrage

What do we do for the long term?

What is happening to employment?...

Increasing risk and collapsing risk tolerance...

6/17/09 9:26 PMNotes and Handouts for Berkeley Physics Colloquium, May 11, 2009

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Are the banks about to fail?...

Increasing risk and collapsing risk tolerance affect all asset prices...

6/17/09 9:26 PMNotes and Handouts for Berkeley Physics Colloquium, May 11, 2009

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Why asymmetry? The fall in monetary velocity...

Asymmetry arising from deflation...

6/17/09 9:26 PMNotes and Handouts for Berkeley Physics Colloquium, May 11, 2009

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Flight to safety produces a collapse in monetary velocity...

Normally we deal with collapsing velocity via monetary policy...

6/17/09 9:26 PMNotes and Handouts for Berkeley Physics Colloquium, May 11, 2009

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But may not work if interest rates are very low...

Guess where we are now?

6/17/09 9:26 PMNotes and Handouts for Berkeley Physics Colloquium, May 11, 2009

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Time to try alternative policies to try to raise the short-term interest rate on Treasury bonds...

How did we get here?

6/17/09 9:26 PMNotes and Handouts for Berkeley Physics Colloquium, May 11, 2009

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6/17/09 9:26 PMNotes and Handouts for Berkeley Physics Colloquium, May 11, 2009

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6/17/09 9:26 PMNotes and Handouts for Berkeley Physics Colloquium, May 11, 2009

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What do we do to improve the system?

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Brad DeLong on May 11, 2009 at 10:14 AM in Berkeley: the University, Economics, Economics: Federal Reserve, Economics:

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Panic happens when short term losses appear to rapidly turn into long term losses.

Posted by: Mattyoung | May 11, 2009 at 10:59 AM

You might like:

The Effects of Fiscal Policy in 2009 and Beyond: A Discussion of Cogan-Cwik-Taylor-Wieland (@this site)

Guest Post: Is Inflation Inevitable? (@naked capitalism)

6/17/09 9:26 PMNotes and Handouts for Berkeley Physics Colloquium, May 11, 2009

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We can go a little more beyond handwaving about "feelings" to explain the asymmetry. For one thing, up and down are processes of

building and dismantling institutions and relationships. Bernanke's work on the Great Depression gets this; Minsky is still unmatched

for the larger view.

This might also be a moment to reconsider this blog's lack of interest in Paul Davidson, because if you want to develop *from the

ground up* an economic theory in which the direction of time matters, _Money and the Real World_ (2nd ed) is a good place to

start.

Posted by: Colin Danby | May 11, 2009 at 11:03 AM

diff between a bubble and bust seem to be:

-- bubble there is the expectation that borrowing, buying, holding and selling will make you money; this means the borrower thinks

there is a negative real interest rate, that someone will pay you to borrow. there is also the non-gentle coaxing of the market:

watching others get 'rich' (at least nominally) and later the 'last chance to jump in' prisoners dilemma (i may never be able to buy a

house if i don't buy one this year)

antidote: 'not everyone can be lucky'. are spreads consistent with reasonable loss rates (corporate spreads > 2%?), and are prices

consistent with prices (ie rent vs buy). 'if this is all i have to do to make money, why aren't the banks doing it'?

-- bust there is the speculative demand for money -- price deflation + waiting for the bottom plus a serious utility concavity -- i could

take a 10% loss near the top but the same nominal loss down fifty percent hurts more; then add the fear of unemployment / lower

wage employment.

then fear of bernanke turning on the sprinklers after the fire. will the money i saved be worth anything, anyway?

Posted by: babar | May 11, 2009 at 11:51 AM

Physics department might be a very good place to look for models of instability, phase change, emergent states, transition analysis.

Eh, Hari?

Posted by: Neal | May 11, 2009 at 01:55 PM

Tell the physics guys to assume all humans have a comfortable yield curve, in percentage terms relative to their current wealth, that is

constant in shape and size. The tell them that aggregation requires each individual to match their yield curve to the economic wide

yield curve. With that, I think, they get you to specific configurations, or patterns of sectorial decomposition that are fixed, stable and

unique configurations for any economy.

Think of the economy as a directed graph, moving over an arbitrary Chinese checkerboard (you know with the arrays of dimples). A

directed graph of vertices with specific rank and breadth fixed. This directed graph of vertices moves along the checkerboard finding

the best array of dimples locally that allows each vertex to find its spot. When there is no exact match, the graph vertices must shed or

gain value to adjust the inter-vertex link spacing and thus find a dimple fit.

Posted by: Mattyoung | May 11, 2009 at 02:19 PM

It feels as though what you need to get the asymmetry is leverage. Leverage is generally the real world reason that a portfolio gets

liquidated in a down market.

Also, is there someplace that we can get see a version of this where the equations are clearer. I really like the model and would like to

think about it with paper and pencil in hand.

Posted by: Kathleen M. | May 11, 2009 at 05:45 PM

I am reminded somewhat of

Lazer and McKenna, "Large-amplitude periodic oscillations in suspension bridges: some new connections with nonlinear analysis",

SIAM Review, Volume 32 , Issue 4 (December 1990)

Broadly summarized: it sure makes the math easier to assume Hookes' Law and linearity, but in fact, you cannot push a rope, and

this makes bridges fall down. In particular, the Tacoma Narrows.

Posted by: dr2chase | May 11, 2009 at 07:25 PM

6/17/09 9:26 PMNotes and Handouts for Berkeley Physics Colloquium, May 11, 2009

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Brad: On velocity,

V=V(Rshort,Rlong)

If you doubt this I can dig up econometric money demand studies that show that money demand depends on long interest rates.

V becomes infinitely elastic wrt both rates as they approach zero. But when the short rate is near zero, it does not increase the

derivative with respect to the long rate, as you seem to assume. With 10 year bond rates at around 2.5%, the long rate derivative of

velocity is not tending towards infinity.

So if we pump money into long bond markets, it should work to offset the fall in velocity. Conversely, if the derivative of velocity with

respect to long rates was tending toward infinity because of the 2nd derivative wrt long then short rates, it would not be possible to

drive long bond rates down.

Of course, compressing the yield curve like that also requires a violation of the expectations theory of the yield curve. But experience

with operation twist, Thatchers overfunding, and Japan's quantitative easing shows that such violations are possible.

- Tim

Posted by: Tim Peterson | May 11, 2009 at 09:53 PM

Hmm...

The way I expressed the position on long rates and velocity above just made me realize that Brad is partly right, but the actual

specifics are more complicated than depicted on his LM diagram.

Consider an open market operation to buy long bonds, where neither long nor short rates are at minimum. Under the expectations

theory of the yield curve, that would have exactly the same effect as an open market operation to buy short bonds. Most of the fall in

interest rates would be at the short end, and the fall in long rates would be due to the liquidity effect (anticipation of looser monetary

policy, eg lower short interest rates, into the future).

Now consider a case where long and short bonds are imperfect substututes. Here, the open market purchase is going to massage

down the term premium, and may decrease long rates by more than short rates.

The point here is that downward pressure at the long end pushes short rates down - creates increased demand for the short bond that

raises its price.

In the case where short rates are at or near their minimum this demand is going to go straight into money, reducing velocity. So I was

wrong about the effect of short rates on the derivative of velocity wrt long rates.

The situation is not as Bad as makes out, at least not for quantitative easing to buy long bonds, where these are imperfect substitutes

for short bonds. This is because most of the incipient demand for assets generated by the easing goes into long bonds.

But an unusually large percentage of that demand goes into money when short rates are at minimum. This explains why, in the

Japanese quantitative easing, it took a large increase in the money supply to generate a small increase in nominal GDP.

But the point is that quantitative easing is still going to work, it just takes more and more money to get the same result. Since

monetary base is costless to create, this is not a problem.

And as for monetary overhang when downturn is over, if the asset purchases are high quality (as in the UK), just resell those assets in

another open market operation.

The situation in the US is less pure; some of the assets are low quality & their sale may destabilize financial markets, some of the

monetary injection corresponds to credit easing and can't immediately be unwound because of the term of the loans, and the Fed may

come under a lot of poilitical pressure not to unwind the credit easing and sell those assets.

There is a solution, though. The Fed can re-establish control over the federal funds rate with minimal open market asset sales by the

simple expedient of varying the interest it pays on reserves. Expensive at a time of swolen bank reserves, but it will work (and have

the added benefit of confering much more precise control over the federal funds rate than the Feds usual proceedure).

- Tim

6/17/09 9:26 PMNotes and Handouts for Berkeley Physics Colloquium, May 11, 2009

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Me: Economists:

Paul Krugman

Mark Thoma

Cowen and

Tabarrok

Chinn and

Hamilton

Juicebox Mafia:

Ezra Klein

Matthew Yglesias

Spencer

Ackerman

Dana Goldstein

Moral

Philosophers:

Hilzoy and

Friends

Crooked Timber

of Humanity

Mark Kleiman and

Friends

Eric Rauchway

and Friends

Posted by: Tim Peterson | May 11, 2009 at 10:53 PM

I am confused. Short rates haven't moved since the Fed drove the Fed funds rate close to zero. Have long rates fallen so drastically

since September to give us the decline in velocity that we see? Is the demand for money so highly interest elastic M1 and M2? Perhaps

it is my ignorance but the equation of exchange may

be a definition but the quantity theory is a theory and may fail as such to describe our short run reality.

Posted by: malcolm | May 12, 2009 at 08:26 AM

"Policy to fix it 2: raise Treasury bond interest rates"

But logic and your own nearby text suggest you mean "lower" Treasury bond interest rates.

Posted by: kharris | May 12, 2009 at 10:27 AM

Malcom:

The decline in long bond rates of late will produce extra large falls in velocity due to the interaction between the long and short ends

of the market, as I pointed out in my revised post above (again, this doesn't mean that quantitative easing won't work, just that the

bang for the buck is comparatively small. No big deal, with bank reserves costlessly created at the press of a button).

Also, there is the 'flight to quality' effect at work, independant of interest rates.

Bear in mind also that there is a 12 month lag from a typical monetary expansion to nominal income growth. Even without the above

effects this mechanically produces a fall in velocity out of high monetary growth and slow, not yet responding income growth.

- Tim

Posted by: Tim Peterson | May 12, 2009 at 10:26 PM

to capture the asymmetry: the utility function is asymmetric. an actor's utility per unit money is much higher during a bust because he

has less money and because having marginally less money is worse at that level than having marginally less money at a higher level.

Posted by: babar | May 18, 2009 at 05:53 AM

Profits give you power, which you can use to bend the rules through lobbying, party-financing, and so on. Losses mean you lose that

power - but who gains? It might be the institutions that cause the asymmetry. At least, that is what Minsky thought.

Posted by: Dirk Ehnts | May 18, 2009 at 08:11 AM

Add a leverage factor and a sudden downward revision to the dividend probability and it should go, no? What this represents is the

initial realization that incomes are not large enough to keep up with the debt service required to sustain the bubble (in the case of

housing) or corporate incomes will not sustain valuations (in the case of stocks). With leverage acquired during the run up, the speed

and magnitude of value loss should create a Minsky scenario.

Posted by: Mark Palermo | May 18, 2009 at 09:45 AM

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