Marginal Revolution

What's going on with the economy?

Paul Krugman runs through some basic scenarios.  Remember when Philip Cagan asked why open market operations are performed in terms of money and T-Bills rather than other assets?

The final whammy may be this: the socialist calculation debate (remember that?) is now working against rather than for recovery.  Market prices communicate vital information but that assumes a critical mass of market participants is actually trading.  When trading dries up, prices go away.  When prices go away, the costs of trading rise and fewer people wish to trade.

Felix Salmon notes:

My feeling is that the credit markets are hysterical. They're not clearing, they're not acting efficiently, and spreads, especially on highly-rated debt, are much higher than credit risk alone could ever account for.

Trading in junk bonds hasn't been "right" since the fall.  Many of the markets for short-term debt securities are becoming illiquid as well.  Why markets are self-destructing in this way remains a puzzle; dump on markets all you want but why here and now?

Loyal MR readers will know that I am usually an economic optimist but at the moment I am worried.  I don't see the so-called "real side" of the economy as intolerable by any means.  But a weird financial dynamic seems to be feeding on itself in an unusually violent fashion.  Steve Waldman has an insightful albeit overstated argument; consider this:

The distinction between debt and equity is much murkier than many people like to believe. Arguably, debt whose timely repayment cannot be enforced should be viewed as equity. (Financial statement analysts perform this sort of reclassification all the time in order to try to tease the true condition of firms out of accounting statements.) If you think, as I do, that the Fed would not force repayment as long as doing so would create hardship for important borrowers, then perhaps these "term loans" are best viewed not as debt, but as very cheap preferred equity.

Is/was the subprime crisis simply a mask for a more general revaluation of the meaning and extent of liquidity?  Are such revaluations always so bumpy and so lacking in locally stable iterative processes?  As the Chinese would say, we live in interesting times.

10,000 B.C.

It's not a great movie but it does offer a model of economic growth and the rise of freedom.  To avoid unwanted spoilers, I'll put that model under the fold...

There are increasing returns to scale, set in a general Carneiro-Oppenheimer political equilibrium, albeit with multiple equilibria and possible revolution, depending on the behavior and path of charging woolly mammoths.  Hunter-gatherer societies have martial virtue and also an idea or at least practice of liberty.  They don't have agriculture or easy transport or efficient risk-sharing or an expensive priestly caste.  The desire for plunder, slaves, and tax revenue causes the wealthier agricultural societies to raid the hunter-gatherers.  The hunter-gathers can adopt the technologies of the wealthier peoples more easily than the overlords can/will adopt the ideologies of the hunter-gatherers.  If the revolt succeeds (see the above remarks about multiple equilibria), the result is both liberty and a higher standard of living.  For unknown reasons, female members of the hunter-gatherer society have market power in the agricultural society, even when they are slaves.

I'm not saying that model is true but I have heard worse from social scientists.

Is Haiti safe again?

I mean sort of safe.  "Haiti safe."  Reed Lindsay reports:

Today, Haiti's reputation is undeserved, say security analysts and officials from the U.N. peacekeeping mission. They argue that Haiti is no more violent than any other Latin American country.  "It's a big myth," said Fred Blaise, spokesman for the U.N. police force in Haiti. "Port-au-Prince is no more dangerous than any big city. You can go to New York and get pickpocketed and held at gunpoint."

He may not be a totally objective and disinterested observer.  How about this:

Reliable statistics are scarce in Haiti, but U.N. data indicate that the country could be among the safest in the region. The U.N. peacekeeping mission recorded 487 homicides in Haiti last year, or about 5.6 per 100,000 people.

A U.N.-World Bank study last year estimated the Caribbean's average homicide rate at 30 per 100,000, with Jamaica registering nearly nine times as many — 49 homicides per 100,000 people — as those recorded by the United Nations in Haiti.

In 2006, the neighboring Dominican Republic notched more than four times more homicides per capita than those registered in Haiti: 23.6 per 100,000, according to the Central American Observatory on Violence. Even the United States would appear to have a higher homicide rate: 5.7 per 100,000 in 2006, according to the U.S. Justice Department.

I believe these numbers; at some margin even murder is a normal good.  But most convincing, I think, is this:

Viva Rio, a Brazilian-based violence reduction group that came to Haiti at the request of the U.N. mission's disarmament program, has found Port-au-Prince's armed groups more receptive than those in Rio de Janeiro's slums.

Elsewhere in the country poor Haitians are eating cakes of dirt, and William Griffiths points me to this:

While millions of Haitians go hungry, containers full of food are stacking up in the nation's ports because of government red tape - leaving tons of beans, rice and other staples to rot under a sweltering sun or be devoured by vermin.

A government attempt to clean up a corrupt port system that has helped make Haiti a major conduit for Colombian cocaine has added new layers of bureaucracy - and led to backlogs so severe they are being felt 600 miles away in Miami, where cargo shipments to Haiti have ground almost to a standstill.

Brain twisters

Can the real interest rate be negative in a world where some but not all goods can be stored costlessly? Consider for illustration an economy with two goods, immortal potatoes and transient haircuts, with both items currently selling for $1 and both given equal weights in the CPI. If you put $2 into a 1-year TIPS with a real interest rate of -1% in that world, next year you'd have the ability to purchase 0.99 potatoes and 0.99 haircuts.

Why buy the TIPS when you could simply save the $2 in the form of 2 potatoes and still have those same 2 potatoes a year from now? If nothing else changes, and 2 potatoes were still worth 2 haircuts a year from now, everybody would want to do just that. If we were in long-run equilibrium before the real rate went negative, in response to a negative real interest rate, everybody would want to buy potatoes today as an investment vehicle. The price of potatoes today would have to be bid up to a point above the long-run equilibrium so that from here, potato prices are expected to rise less quickly than the price of hair cuts. Your 2 potatoes might be worth 2 haircuts today, but if they're only worth 1.96 haircuts next year, you might be just indifferent between an investment in TIPS or physically storing the commodity.

Here is much more.  Greg Mankiw, among others, has pointed out that we are seeing negative real rates of return in some credit markets.  I don't read this as a reflection of intertemporal preferences and constraints.  I read this as a (scary) sign of how segmented some credit markets have become.  More concretely, lots of people are running to Treasuries but out of a general sense of fear rather than from rational calculation.  Right now rational calculation is very difficult, agency problems are causing people to avoid the possible blame that can result from risky assets, and credit market arbitrage isn't much working.  It's no longer clear how much information prices are reflecting.