Marginal Revolution

How bad news can be good news

This is from an old MR post, summarizing Bernanke's contributions to economics:

1. The theory of irreversible investment, circa 1983. Before Bernanke, Dixit, and Pindyck, models often assumed that investments could be reversed or "taken back."  Bernanke outlined how the irreversibility of investment might matter.  Often individuals will choose to wait and sample more information, rather than make an immediate decision.  Small changes in information could lead to big fluctuations in investment.  Large changes in interest rates might have little effect.  Bad news can hurt you more than good news helps you.  This was Bernanke's first major contribution to economics [and I believe part of his doctoral dissertation].

In this model it is also the case that bad news can cause equity prices to rise.  If the bad news resolves outstanding uncertainty, people may be willing to go ahead and invest, rather than continue to play wait and see.  One way to think about it is that the news could always have been even worse, so bad news can in effect be good news.  Another way to think about it is even truly bad news gets the waiting over with and spurs investors to cross a "do something" threshold.  Now I'm not saying that is what happened today, I'm just saying that maybe this thought crossed Bernanke's mind...

Addendum: Elsewhere in the wonderful world of finance, here is why Bear Stearns is selling for more than $2 a share...

Markets in *everything*, a continuing series

*Tenure*, the movie, starring Luke Wilson.  Seriously.  They are about to start shooting.

Fear

We have nothing to fear but fear itself, but fear itself can be pretty scary.

...Fear is ruling the financial markets. Billions of dollars have been lost in mortgage-related investments. The Federal Reserve worked madly over the weekend to engineer a takeover of Bear Stearns and avert a systemic meltdown. But the big fear remains. How low will house prices go?

If prices continue to fall, mortgage defaults will move well beyond the subprime sector. Trillions of dollars in losses for investors are not impossible. But that doesn't mean they are inevitable.

That's me in today's New York Times.  Believe it or not, my piece is one of the more optimistic pieces you are likely to read on the housing crisis.

I think that housing prices went beyond the fundamentals sometime around 2004 (and I said so in 2005, see here and also note my warning that prices could fall dramatically here).   But 2004 levels are still well above long run trend.  Thus my optimism stems from thinking that unlike Japan, our housing prices need not fall back to long run trend (see my piece for graphs).

But the problem is that we can overshoot the fundamentals going down as well as going up and the United States now faces two potentially self-fulfilling prophecies.

If the financial markets can predict where and when house prices will stabilize, then credit conditions can quickly return to normal, the economy can expand and house prices will indeed stabilize.

But if the financial markets remain uncertain about when the decline in house prices will end, then fear will tighten credit even further, which would strangle the housing market and generate even more fear.

Unfortunately, I do not know what will push us into the right prophecy (but read my piece, that will help!)  Thus, I am more optimistic than Paul Krugman, who thinks that we may have slipped into the state where no prophecy can bring us back to a good equilibrium, but I'm not that much more optimistic.

Claims about Spanish banks

...perhaps the most important reason why the Spanish financial system is unlikely to suffer a meltdown is the virtual absence of Special Investment Vehicles (SIV) and conduits. These animals allow banks to move mortgage-backed securities off their balance sheets, thus obscuring the exposure of individual institutions and escaping capital requirements.

There is much more here.  Note also that Spanish originators keep a share of each mortgage they securitize.  In case you didn't know it, Spain too has had a bursting of its real estate bubble, although so far they have not had comparable troubles with their banks.

gdp vs. gdp per capita

Using growth in GDP per head rather than crude GDP growth reveals a strikingly different picture of other countries' economic health. For example, Australian politicians often boast that their economy has had one of the fastest growth rates among the major developed nations—an average of 3.3% over the past five years. But Australia has also had one of the biggest increases in population; its GDP per head has grown no faster than Japan's over this period. Likewise, Spain has been one of the euro area's star performers in terms of GDP growth, but over the past three years output per person has grown more slowly than in Germany, which like Japan, has a shrinking population.

Some emerging economies also look less impressive when growth is compared on a per-person basis. One of the supposedly booming BRIC countries, Brazil, has seen its GDP per head increase by only 2.3% per year since 2003, barely any faster than Japan's. Russia, by contrast, enjoyed annual average growth in GDP per head of 7.4% because the population is falling faster than in any other large country (by 0.5% a year). Indians love to boast that their economy's growth rate has almost caught up with China's, but its population is also expanding much faster. Over the past five years, the 10.2% average increase in China's income per head dwarfed India's 6.8% gain.

Here is more.  Of course it is wrong to think that one measure is necessarily better than the other.  And immigration and more births both raise absolute gdp though you may not view the gdp gains in each case as having the same moral status.  One simple adjustment that could be made is to subtract the income an immigrant would have earned, had he or she not moved to a new country.