December NBNZ Business Outlook: Farewell inflation expectations

The National Bank Business Outlook for December came out the other day, and it was another horrible looking figure for business confidence.

Two key points for me, beyond what we have discussed earlier.:

  1. Own activity expectations are horrible,
  2. The inflation expectations measure collapsed.

The first covers the most important statistic in the series – own activity.  It was terrible, implying that businesses are feeling very negative for their own performance over the coming months.

The second statistic is an important one when thinking about inflation – it was inflation expectations.  This series is relatively stable, but it has now dropped sharply.  In conjunction with “pricing expectations”, and the “RBNZ inflation expectations numbers” this implies that core inflationary pressures are abating quickly.  Also note there was a strong decline in construction – component prices have held up building cost inflation, but this may now be a thing of the past.

Of course the main issue is the “relative price” adjustment between labour and goods – even if inflation goes to zero, if the value of labour has fallen as a result of this crisis we could still be heading towards excess unemployment.

How I learned to love the bubble

This fascinating article about experimental economists’ research into financial bubbles suggests that bubbles are a natural event on the way to equilbrium. The researchers set up an artifical market with identical assets, known dividends and a finite end period. With the value of the asset clearly defined in each period by the remaining dividend payments, the researchers expected prices to closely track the asset value.

Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then, as the [final] round nears, it crashes.
. . .
Based on future dividends, you know for sure that the security’s current value is, say, $3.12. But… you don’t know that I’m as savvy as you are. Maybe I’m confused. Even if I’m not, you don’t know whether I know that you know it’s worth $3.12. Besides, as long as a clueless greater fool who might pay $3.50 is out there, we smart people may decide to pay $3.25 in the hope of making a profit. It doesn’t matter that we know the security is worth $3.12. For the price to track the fundamental value, says Noussair, “everybody has to know that everybody knows that everybody is rational.”

Read more

No fiddling while Rome burns

Anyone who’s been concerned at the size of executive remuneration at financial firms will be excited to hear about Credit Suisse’s latest move. Rather than allowing its executives to fiddle as their mortgage backed security investments cause the balance sheets to go up in flames, CS is paying its executives bonuses in illiquid mortgage-backed securities.

I wonder if, given the risk associated with those assets, their bonuses will be correspondingly higher. I wouldn’t want to be the one explaining to shareholders that bonuses were surprisingly high this year, but it’s actually OK because…[drowned out by lynch mob]

ht: Megan McArdle

Cars and inventories

Chrysler has shut down production for a month, while Ford and GM have cut back substantially.  Some people feel that this is a disaster - and that it indicates we need government intervention, and fast!

But I’m confused.  Car inventories are at record high levels, and demand for cars is very poor – as a result, doesn’t it make sense to reduce the number of cars we produce?  Why should the government intervene to get industry to keep producing something people don’t want – I am very confused about this.

If anything, the decision to cut back production tells me that these firms are reacting sensibly to a drop in demand – why would we want to spoil their reaction to market signals?

Arnold Kling, asymmetric information, and the crisis

Arnold Kling from Econlog posts a passage from Michael Bordo approvingly. Specifically I enjoyed this part:

A key dynamic in the crisis stressed by Mishkin(1997) is information asymmetry, manifest in the spread between risky and safe securities, the consequences of which(adverse selection and moral hazard) are ignored in the boom and come into play with a vengeance in the bust.

So it appears they they both agree that asymmetric information is the key factor turning the current adjustment into a crisis (this is a belief that we share).

I would add one thing. Personally, I don’t just think it is “irrational exuberance” that leads to asymmetric information losing weight during a boom. I think that institutions form (reputations, organisations and the such) which appear to take care of the asymmetric information problem. However, when the downturn comes, and we discover that some of these institutions no longer exist/function we end up with a collapse.