Federal Reserve Bank of St. Louis Review

A quarterly research journal intended for an economically informed but broad readership—from the undergraduate student to the PhD. In print and online.


NOVEMBER/DECEMBER 2006 88(6)

Chinese Growth: A Source of U.S. Export Opportunities

This article was originally presented as a speech to the Fiscal Affairs and Government Operations Committee, Council of State Governments’ Southern Legislative Conference (SLC), Louisville, Kentucky, July 31, 2006.

Money and Monetary Policy for the Twenty-First Century

This essay challenges the conventional wisdom about money and monetary policy. The role of money in fostering prosperity is a function of the quality, as well as the quantity, of money. Inflation always harms the performance of an economy. Deflations caused by productivity and innovation can be virtuous. A definition of a non-inflationary environment is set forth. Rapid real growth and low unemployment cannot cause inflation. There is no trade-off between inflation and employment. Higher commodity prices or “weak” exchange rates cannot cause inflation. High market interest rates are a symptom of inflationary policies. Low interest rates are a reflection of successful anti-inflationary policies, not “easy money.”

Rising Natural Gas Prices and Real Economic Activity

In the aftermath of the disruptions caused by hurricanes Katrina and Rita, natural gas prices rose to record-high levels. Because natural gas is an important energy source for the U.S. economy, there was widespread concern that these high prices might cause a significant slowing in the economy—especially among those manufacturing industries that heavily consume natural gas. The analysis presented in this article suggests that output is responsive to natural gas prices in some manufacturing sectors. Although perhaps significant, this result must be balanced against the finding that, when the analysis is extended to the macroeconomy (real gross domestic product growth), increases in crude oil prices significantly predict real gross domestic product growth, but natural gas prices do not.

The Transition to Electronic Communications Networks in the Secondary Treasury Market

This article reviews the history of the recent shift to electronic trading in equity, foreign exchange, and fixed-income markets. The authors analyze a new data set: the eSpeed electronic Treasury network. They contrast the market microstructure of the eSpeed trading platform with the traditional voice-assisted networks that report through GovPX. The electronic market (eSpeed) has greater volume, smaller spreads, and a lower estimated trade impact than the voice market (GovPX).

Please contact the author with questions regarding the program files.

What Are the Odds? Option-Based Forecasts of FOMC Target Changes

This article uses probability forecasts derived from options to assess evolving market uncertainty about Federal Reserve monetary policy actions in a variety of recent events and episodes. Options on federal funds futures contracts reveal a complete probability density function over possible Federal Reserve target rates, thus augmenting the expectations provided by federal funds futures contracts. Option-based forecasts are most useful when more than two federal funds target outcomes are plausible at an upcoming policy meeting.

 

SEPTEMBER/OCTOBER 2006 88(5)

Recent Trends in Homeownership

The homeownership rate began to trend upward in 1995 after years of being relatively constant, near 64 percent. This article describes recent changes in the share of U.S. housing that is owner-occupied and explores the reasons for the surprising rise over the past decade. Explanations that have been offered include demographics, low mortgage rates, changes in housing policy, and innovations in the mortgage financial market. Of all these explanations, the most plausible one is that innovations in the financial markets increased access to mortgage finance, mainly by reducing downpayment constraints and allowing younger people to buy homes.

What Happens to Banks When House Prices Fall? U.S. Regional Housing Busts of the 1980s and 1990s

The recent rapid appreciation of house prices in many U.S. markets has prompted concern over the possible effects of a sharp decline in prices, especially for commercial banks and other real estate lenders. This article examines regional real estate booms and busts in the 1980s and 1990s: Only about half of state house price booms were followed by a severe decline in prices, but large declines occurred in several states that did not have a prior boom. Banks in states that had large house price declines experienced high loan default rates and, thus, low profit and high failure rates. Although U.S. banks may have become more exposed to residential real estate recently, they appear less vulnerable to a decline in house prices than banks in states with large price declines in the earlier period.

Do Inflation Targeters Outperform Non-targeters?

Ten years of empirical studies of inflation targeting have not uncovered clear evidence that monetary policy that incorporates formal targets imparts better inflation performance. The authors survey the literature and find that the “no difference” verdict concerning inflation targeting has been robust to a wide range of countries and methods of analysis, starting with a study by Dueker and Fischer (1996a). The authors present updated Markov-switching estimates from the original Dueker and Fischer (1996a) article and show that their early conclusions about inflation targeting among early adopters have not been overturned with an additional decade of data. These findings to date do not rule out the possibility, however, that formal inflation targets could prove pivotal if the global environment of disinflation were to reverse course.

A Close Look at Model-Dependent Monetary Policy Design

This article first explores the implications of model specification on the design of targeting rules in a world of model certainty. As a general prescription, a targeting rule must counterbalance the private-sector dynamics: The more backward-looking behavior is observed in either the output gap or inflation, the more forward-looking monetary policy should be. Likewise, a more forward-looking economy would require stronger backward-looking reactions of the nominal interest rate to the output gap or inflation. The article also analyzes the effects of implementing monetary policy in an environment with uncertainty. Our results indicate that a simple model-invariant rule of the style proposed by Taylor (1993) performs better than a model-dependent targeting rule in the presence of moderate parameter uncertainty.

 

JULY/AUGUST 2006 Vol. 88, No. 4

Federal Credit and Insurance Programs

Proceedings of the Thirtieth Annual Economic Policy Conference of the Federal Reserve Bank of St. Louis

Complete Issue

Proceedings of the Thirtieth Annual Economic Policy Conference of the Federal Reserve Bank of St. Louis

President's Message

Editors' Introduction

Is the United States Bankrupt?

Is the United States bankrupt? Many would scoff at this notion. Others would argue that financial implosion is just around the corner. This paper explores these views from both partial and general equilibrium perspectives. It concludes that countries can go broke, that the United States is going broke, that remaining open to foreign investment can help stave off bankruptcy, but that radical reform of U.S. fiscal institutions is essential to secure the nation’s economic future. The paper offers three policies to eliminate the nation’s enormous fiscal gap and avert bankruptcy: a retail sales tax, personalized Social Security, and a globally budgeted universal healthcare system.

Commentary

Commentary on "Is the United States Bankrupt?"

On the Importance of the Plumber: The Intersection of Theory and Practice in Policymaking for Federal Financial Institutions

The federal government’s role as lender and insurer is very important, with over $ 1.4 trillion of loans and guarantees and at least $ 7 trillion of insured risk. Tens of millions of Americans benefit from housing loans, student loans, flood insurance, etc. Yet the federal financial institutions established to run these activities are often created almost as an afterthought, with little focus on their structure. This paper emphasizes the crucial importance of ending this neglect and recognizing how proper structure can help avoid major failures, such as the current problems at the Pension Benefit Guaranty Corporation, and enhance successes. The author also challenges the economics profession to provide more guidance on a range of specific analytical issues with real-world implications, because economists have often failed to extend analyses derived from the private sector into useful formulations for public sector practitioners.

Commentary

Commentary on "On the Importance of the Plumber: The Intersection of Theory and Practice in Policymaking for Federal Financial Institutions"

Federal Credit and Insurance Programs: Housing

This paper reviews the evolution of the major credit and insurance programs undertaken by the U.S. government in support of urban housing. As the review makes clear, the Federal Housing Administration (FHA), Veterans Administration, Federal National Mortgage Association, and Federal Home Loan Mortgage Corporation have played major roles in the development of liberal and efficient primary and secondary mortgage markets in the United States. The development of capacity in mortgage lending and securitization in the private sector does suggest, however, that federally subsidizing mortgage market activities can be restrained with little effect on homeownership—the principal goal of this federal activity. In particular, the orderly reduction in the mortgage investment activities of the government-sponsored enterprises (GSEs) and the imposition of guarantee fees on mortgage-backed securities insured by the GSEs are first steps in restraining federal activity. More generally, a concentration of FHA and GSE activity on first-time homebuyers would reduce federal risk exposure while preserving the economic rationale for government activity.

Commentary

Commentary on "Federal Credit and Insurance Programs: Housing"

On Asset-Liability Matching and Federal Deposit and Pension Insurance

Asset-liability mismatch was a principal cause of the Savings and Loan Crisis of the 1980s. The federal government's failure to recognize the mismatch risk early on and manage it properly led to huge losses by the Federal Savings and Loan Insurance Corporation, which had to be covered by taxpayers. In dealing with the problems now facing the defined-benefit pension system and the Pension Benefit Guaranty Corporation (PBGC), the government seems to be making some of the same mistakes it made then. Among the causes is the fallacious belief that because pension funds have a long time horizon the risk of investing in equities is negligible. In fact, the opposite is true. Moreover, for the PBGC, the mismatch risk is magnified by moral hazard and adverse selection. Distressed companies facing the prospect of bankruptcy have an incentive to underfund their pension plans and adopt risky investment strategies; healthy companies have an incentive to terminate their plans and exit the system. The paper explores some ways to limit the costs of a potential PBGC bailout.

Commentary

Commentary on "On Asset-Liability Matching and Federal Deposit and Pension Insurance"

Should the Government Provide Insurance for Catastrophes?

This paper evaluates the need for a government role in insuring natural and man-made catastrophes in the United States. Although insurance markets have been stressed by major natural catastrophes, such as Hurricane Katrina, government involvement in the market for natural catastrophe insurance should be minimized to avoid crowding-out more efficient private market solutions, such as catastrophe bonds. Instead, government should facilitate the development of the private market by reducing regulatory barriers. The National Flood Insurance Program has failed to cover most property owners exposed to floods and is facing severe financial difficulties. The program needs to be drastically revised or replaced by private market alternatives, such as federal “make available” requirements with a federal reinsurance backstop. A federal role may be appropriate to insure against mega-terrorist events. However, any program should be minimally intrusive and carry a positive premium to avoid crowding-out private market alternatives.

Commentary

Commentary on "Should the Government Provide Insurance for Catastrophes?"

 

MAY/JUNE 2006 Vol. 88, No. 3

Inflation Targeting

This article was originally presented as a speech to Junior Achievement of Arkansas, Inc., Little Rock, Arkansas, February 16, 2006.

The Geography, Economics, and Politics of Lottery Adoption

Since New Hampshire introduced the first modern state-sponsored lottery in 1964, forty-one other states plus the District of Columbia have adopted lotteries. Lottery ticket sales in the United States topped billion in 2004, with state governments reaping nearly billion in net lottery revenue. In this paper the authors attempt to answer the question of why some states have adopted lotteries and others have not. First they establish a framework for analyzing the determination of public policies that highlights the roles of individual voters, interest groups, and politicians within a state as well as the influence of policies in neighboring states. The authors then introduce some general explanations for the adoption of a new tax that stress the role of economic development, fiscal health, election cycles, political parties, and geography. Next, because the lottery adoption decision is more than simply a tax decision, a number of factors specific to this decision are identified. State income, lottery adoption by neighboring states, the timing of elections, and the role of organized interest groups, especially the opposition of certain religious organizations, are significant factors explaining lottery adoption.

The 1990s Acceleration in Labor Productivity: Causes and Measurement

The acceleration of labor productivity growth that began during the mid-1990s is the defining economic event of the past decade. A consensus has arisen among economists that the acceleration was caused by technological innovations that decreased the quality-adjusted prices of semiconductors and related information-communications technology (ICT) products, including digital computers. In sharp contrast to the previous 20 years, services-producing sectors—heavy users of ICT products—led the productivity increase, besting even a robust manufacturing sector. In this article, the authors survey the performance of the services-producing and goods-producing sectors and examine revisions to aggregate labor productivity data of the type commonly discussed by policymakers. The revisions, at times, were large enough to reverse preliminary conclusions regarding productivity growth slowdowns and accelerations. The unanticipated acceleration in the services sector and the large size of revisions to aggregate data combine to shed light on why economists were slow to recognize the productivity acceleration.

The Learnability Criterion and Monetary Policy

Expectations of the future play a large role in macroeconomics. The rational expectations assumption which is commonly used in the literature provides an important benchmark, but may be too strong for some applications. This paper reviews some recent research that has emphasized methods for analyzing models of learning, in which expectations are not initially rational but which may become rational eventually provided certain conditions are met. Many of the applications are in the context of popular models of monetary policy. The goal of the paper is to provide a largely non-technical survey of some, but not all, of this work and to point out connections to some related research.

 

MARCH/APRIL 2006 Vol. 88, No. 2

Entrepreneurship and the Policy Environment

The authors examine how the government-policy environment effects entrepreneurship, specifically if marginal income tax rates and bankruptcy exemptions influence rates of entrepreneurship. Previous work has shown both policies are positively related to entrepreneurship, but these authors show a U-shaped relationship with marginal tax rates and an S-shaped relationship with bankruptcy exemptions.

Human Capital Growth in a Cross Section of U.S. Metropolitan Areas

Growth of human capital (change in the fraction of a metro area's college-educated labor force) is typically seen as generating desirable outcomes (e.g., economic growth). With a sample of >200 U.S. metro areas for 1980, 1990, and 2000, the author explores why some economies have more human capital than others and finds two significant correlates: population and the existing stock of college-educated labor. If population and human capital growth are positively associated with education, these results suggest that larger, more-educated metro areas should have the fastest rates of growth. The evidence supports this conclusion.

Macroeconomic News and Real Interest Rates

Economic news affects the perceptions of investors, forecasters, and policymakers about the economy. The authors evaluate the responses of the yield of 10-year TIIS to nearly 3 dozen macroeconomic announcements and find that the real long-term interest rate responds to surprises in a handful of key macroeconomic indicators (e.g., labor productivity growth).

Using Cyclical Regimes of Output Growth to Predict Jobless Recoveries

Gaps between output and employment growth are often attributed to transitional phases as the economy adjusts to shifts in productivity. But cyclical factors can also drive a wedge between output and employment growth. This article shows that one measure of cyclical dynamics (expected output loss from a recession) helps predict the gap between output and employment growth in the coming 4 quarters and implies that a weaker-than-expected rebound can partially mute employment growth relative to output growth.

 

JANUARY/FEBRUARY 2006 Vol. 88, No. 1

The Fed's Monetary Policy Rule

This article was originally presented as a speech at the Cato Institute, Washington, D.C., October 14, 2005.

On the Size and Growth of Government

The size of the U.S. federal government, as well as state and local governments, increased dramatically during the 20th century. This paper reviews several theories of government size and growth that are dominant in the public choice and political science literature. The theories are divided into two categories: citizen-over-state theories and state-over-citizen theories. The relationship between the 16th Amendment to the U.S. Constitution and the timing of government growth is also presented. It is likely that portions of each theory can explain government size and growth, but the challenge facing economists is to develop a single unifying theory of government growth.

The Evolution of the Subprime Mortgage Market

This paper describes subprime lending in the mortgage market and how it has evolved through time. Subprime lending has introduced a substantial amount of risk-based pricing into the mortgage market by creating a myriad of prices and product choices largely determined by borrower credit history (mortgage and rental payments, foreclosures and bankruptcies, and overall credit scores) and down payment requirements. Although subprime lending still differs from prime lending in many ways, much of the growth (at least in the securitized portion of the market) has come in the least-risky (A–) segment of the market. In addition, lenders have imposed prepayment penalties to extend the duration of loans and required larger down payments to lower their credit risk exposure from high-risk loans.

Are the Causes of Bank Distress Changing? Can Researchers Keep Up?

Since 1990, the banking sector has experienced enormous legislative, technological, and financial changes, yet research into the causes of bank distress has slowed. One consequence is that traditional supervisory surveillance models may not capture important risks inherent in the current banking environment. After reviewing the history of these models, the authors provide empirical evidence that the characteristics of failing banks have changed in the past ten years and argue that the time is right for new research that employs new empirical techniques. In particular, dynamic models that use forward-looking variables and address various types of bank risk individually are promising lines of inquiry. Supervisory agencies have begun to move in these directions, and the authors describe several examples of this new generation of early-warning models that are not yet widely known among academic banking economists.

Replicability, Real-Time Data, and the Science of Economic Research: FRED, ALFRED, and VDC

This article discusses the linkages between two recent themes in economic research: “real time” data and replication. These two themes share many of the same ideas, specifically, that scientific research itself has a time dimension. In research using real-time data, this time dimension is the date on which particular observations, or pieces of data, became available. In work with replication, it is the date on which a study (and its results) became available to other researchers and/or was published. Recognition of both dimensions of scientific research is important. A project at the Federal Reserve Bank of St. Louis to place large amounts of historical data on the Internet holds promise to unify these two themes.

 


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