There is a fascinating article in The Economist about how the world of derivatives has shaped up through the crisis.

I often encounter misconceptions about hedging. The one line that summarises the issue is this: The job of a hedging strategy is to combat extraneous economic exposure. Let me focus on currency exposure as an example, though the basic idea works in all aspects of hedging. A good currency hedge is one which neutralises the effect of currency fluctuations on the NPV of profit.

I have seen four major mistakes in the way people think about hedging:

1. Hedging seen as a way of eliminating currency risk in the translation of direct import/export proceeds. This is wrong because it's an incomplete picture of what happens to the profits of a company when the currency moves. A lot of finance practitioners are confused on this subject, particularly in India where RBI rules have had mistakes on these things for decades. (While RBI staff made mistakes, that was no reason for currency hedging consultants and such like to also make the same mistakes).
2. Hedging seen as a profit centre. This is wrong because the job of hedging is to eliminate exposure of the NPV of profit, not to make money. Suppose a company embarks on a currency hedging program. Half the time (ex-post) the hedge will appear to have made money and half the time (ex-post) the hedge will appear to have lost money. For a company which has very big currency exposure, ex-post, half the time there will be massive cash losses on the currency hedge. If top managers, directors or regulators do not understand this correctly, it's easy to jump into complaints about `massive losses on derivatives trading'. This emphasises the importance of seeing a hedging strategy and the economic exposure in an encompassing way. A person who closes out one element of an overall hedging strategy because that's generated a lot of cash outflow in recent days is, well, wrong.
3. Hedging away the core sources of profit. A refinery is a bet on the `crack spread', the gap between the price of crude oil and the price of petroleum products. The shareholder and owners of a refinery are inexorably speculators on the crack spread. If you don't believe that this spread will do well, don't build a refinery. For a refinery, this is core business risk, this is the source of profit. It is not an extraneous economic exposure. To try to hedge away this exposure is not correct.
4. Insecurities about imperfect hedges. Every now and then, a bright person complains that a proposed hedge has a substantial basis risk. The only perfect hedge is found in a Japanese garden. All realworld hedges are imperfect. The useful question is: Is an imperfect hedge better than no hedging?

The Economist article points out that with the upsurge in volatility, demand for derivatives has gone up, not down. Once most large firms of the world start doing balance-sheet scale hedging, derivatives positions will be much larger than they are today. The world needs bigger, not smaller, derivatives markets. We stumbled on our way to that world, and now have to figure out once again how we are going to get there.

In the world of OTC derivatives, firms face credit risk owing to contracts with banks and banks face credit risk owing to contracts with firms. In the good old days, these risks were mostly ignored, and OTC derivatives looked more attractive than exchange-traded derivatives (where posting collateral is unavoidable). Now, both sides are getting wary about what this involves. Banks have started charging higher prices for bearing this risk (either though a bigger price or through collateral requirement), and banks have started refusing to have exposures against certain firms. Both these phenomena should enlarge the footprint of exchange traded derivatives. All this flows logically but it was interesting seeing descriptions in the article about things actually shaping up this way.

Few topics are quite as polarizing as the “savings glut.” The very term is often considered an attempt to shift responsibility for the current crisis away from the United States.

That is unfortunate. It is quite possible to believe that the buildup of vulnerabilities that led to the current crisis was a product both of a rise in savings in key emerging markets, a rise that — with more than a bit of help from emerging market governments — produced an unnatural uphill flow of capital from the emerging world to the advanced economies, and policy failures in the U.S. and Europe.

The savings glut argument was initially put forward to suggest that the United States’ external deficit was a natural response to a rise in savings in the emerging world – and thus to defuse concern about the sustainability of the United States’ large external deficit. But it was equally possible to conclude that the rise in savings in the emerging world reflected policy choices* in the emerging world that helped to maintain an uphill flow of capital – and thus that it wasn’t a natural result of fast growth in the emerging world. This, for example, is the perspective that Martin Wolf takes in his book Fixing Global Finance. Wolf consequently believed that borrowers and lenders alike needed to shift toward a more balanced system even before the current crisis.

From this point of view, the savings glut in the emerging world — as there never was much of a global glut, only a glut in some parts of the world — was in large part a result of product of policies that emerging market economies put in place when the global economy — clearly spurred by monetary and fiscal stimulus in the US — started to recover from the 2000-01 recession. China adopted policies that increased Chinese savings and restrained investment to try to keep the renminbi’s large real depreciation after 2002 – a depreciation that reflected the dollar’s depreciation – from leading to an unwanted rise in inflation. The governments of the oil-exporting economies opted to save most oil windfall – at least initially. Those policies intersected with distorted incentives in the US and European financial sector – the incentives that made private banks and shadow banks willing to take on the risk of lending to ever-more indebted households (a risk that most emerging market central banks didn’t want to take) to lay the foundation for trouble.

On one point, though, there really shouldn’t be much doubt: savings rates rose substantially in the emerging world from 2002 to 2007. Consider the following chart – which shows savings and investment in emerging Asia (developing Asia and the Asian NIEs) and the oil exporters (the Middle East and the Commonwealth of independent states) scaled to world GDP.

Investment in both regions was way up. But savings was up even more.

It is unusual for Asia and the oil exporters to show large surpluses at the same time. In 98 the fall in oil prices helped Asia and hurt the oil exporters; in 2000 the rise in oil prices helped the oil exporters and hurt Asia. And way back in 1980, Asia ran a deficit that helped offset the oil exporters’ surplus.

The main reason for the rise in emerging Asia’s savings is simple: China’s GDP rose relative to world GDP, and China’s savings rate rose relative to China’s GDP

The chart is from Stephen Green of StanChart; used with permission

The result was a very large increase in the aggregate savings of the emerging world – especially after 2003. The rise in the combined surplus of Asia and the oil exporters that followed the Asian crisis was around 0.5% of world GDP. The post 2003 “China boom” pushed the combined savings rate of the oil exporters and emerging Asia up another 1% of world GDP.

All my data, incidentally, comes straight from the IMF’s WEO data tables. All I did was to multiply the data on savings rates by regional GDPs and then scale the resulting dollar figure to world GDP in dollars.

That disaggregated data is almost as striking.

It shows, for one, that the “investment drought” argument applies far more to the Asian NIEs (Korea, Taiwan, Singapore, Hong Kong) than to the rest of Asia. Investment in some countries may not have recovered from the 1998 crisis, but the overall data is dominated by the huge rise investment in developing Asia (read China). Plotting the rise in billions of dollars – rather than as a share of global GDP – makes the scale of the rise in investment in developing Asia over the past few years clear.

Savings and investment in India both rose. And China went from a $1 trillion economy investing 30 to 35% of its GDP to a $4 trillion plus economy investing close over 40% of its GDP …

It is also striking that investment in the Middle East was essentially stagnant, in dollar terms, from say 1980 on. That meant that is was falling as a share of world GDP – and certainly falling relative to the Middle East’s population. Comparisons with the “boom” level of 1980 is a bit unfair, but it still isn’t hard to see why the region stagnated when oil prices stagnated.

And it also isn’t hard to see why the region boomed when oil prices soared, as the rise in oil revenue financed a boom in investment. The scale of that boom – in dollar terms – is rather impressive.

The net result: the global economy prior to the crisis was characterized both by high levels of both savings and investment in Asia and the oil exporters and by high levels of consumption and low levels of savings in the US.

In a global economy, a rise in savings relative to investment in one part of the world necessarily implies a fall in savings relative to investment in the rest of the world; sorting out why key macroeconomic variables change is always difficult.

Maybe this equilibrium was a function of excessive demand stimulus by the advanced economies in the aftermath of the last recession – and lax financial regulation that allowed households to over-borrow. High US and European demand allowed the emerging world to save more. Maybe it was a function of policies in the emerging economies, policies sometimes put in place to support undervalued exchange rates. That would explain why the growing US savings deficit didn’t put upward pressure on global interest rates and why the rise in the US external deficit didn’t lead to a rise in US real interest rates — something would have short-circuited the housing boom. Probably it was a mix of both. Emerging market savers (really their governments, as private savers weren’t exactly seeking out depreciating dollars) helped to provide Wall Street and the City the rope they (almost) used to hang themselves.

No matter. We don’t need to assign responsibility for the imbalances that marked the pre-crisis global economy to know that the chain of risk-taking that allowed emerging market savers to finance heavy borrowing by US households didn’t result in a stable system.

* Policies that increased savings in China include a tight fiscal policy and the reforms that increased the profitability of the SOEs, creating a new source of business savings. No comparable reform was put in place to have the SOEs pay dividends (or to use the dividends to support say a social safety net), so the rise in business savings in effect freed up household savings to be lent abroad (with a lot of help from the state banks and the PBoC). Policies that reduced investment include the rise in the banks’ reserve requirement — which meant that Chinese banks had one of the lowest loan to deposit ratios in the emerging world going into the global slump — and more generally the restraints on bank lending. The governments of most oil-exporting economies also saved a large fraction of the oil windfall, especially in 2004 and 2005. Over time discipline waned a bit, but the rise in spending and investment didn’t quite keep pace with the rise in oil prices.

There comes a time when, however alluring is the limelight, and however strong your thrust for action, you’d better opt for a graceful exit.

The exit of former Fed Chairman Alan Greenspan has been anything but graceful, made all the more frustrating by his stern refusal to leave.

Greenspan’s latest foray into the stage comes in the form of an op-ed piece in the Financial Times last week, which is so full of blunders that I’m embarrassed on behalf of the FT for publishing it without first doing even a Wikipedia check.

Worse… Greenspan’s thesis reveals either a mind that (for all its former greatness) can no longer think; or an ex-Fed Chairman who so misunderstood how the financial system works that it’s no wonder at all that we got into this mess!

So the first blunder comes early on when Greenspan talks about what he sees as a virtuous circle of rising stock markets, leading to improved credit conditions, higher lending and the resumption of economic activity… which in turn supports higher stock prices and so on.

While the idea that improved confidence can generate a virtuous circle has merits, what is questionable is Greenspan’s road to get there: The “newly created equity” in banks’ balance sheets as the prices of banks’ stocks go up.

Well that’s plain wrong. Regulatory capital, which is what matters for a bank’s ability to increase its lending, is not marked to market but at the price paid up originally to purchase equity in a bank. (Regulatory capital also includes other stuff, like retained earnings, which again are not marked to market but at the price when they were booked).

In other words, the increase in stock prices does NOT provide a “capital buffer that supports the debt issued by financial and non-financial companies” and does NOT “supply banks with the new capital that would allow them to step up lending.”

If there is one way higher stock prices help is if banks actually see it as an opportunity to raise new capital and expand their operations. Indeed, some banks have done so recently, but the main motivation was their urge to pay back the TARP money and rid themselves of the government’s watch. So new private capital replaced old government capital, without a meaningful improvement in banks’ ability to lend.

The Maestro goes on… “the rising market value of existing corporate assets (proxied by stock prices) relative to their replacement cost would spur new capital investment. […] A prolonged recovery in global equity prices would thus assist in the lifting of the deflationary forces that still hover over the global economy. I recognize that I accord a much larger economic role to equity prices than is the conventional wisdom. From my perspective, they are not merely an important leading indicator of global business activity, but a major contributor to that activity, operating primarily through balance sheets.”

Greenspan’s perspective is not entirely new—as a matter of fact, it’s out of date! The idea that companies’ investment decisions are driven by the difference between the market value of capital and the replacement cost of capital (a ratio economists call “Tobin’s q”) was floated a long time ago.

But research has questioned the extent to which investment actually responds to that ratio. Indeed, it has found that investment is better predicted by fundamentals that determine expectations for future profits and the discount rate.

Of course, one would think (/hope) that these fundamentals are closely interlinked with the current level of stock prices! But to the extent that stock prices can deviate from “fundamentals”, it’s the latter that tend to drive investment decisions and not so much the former.

Blunders aside, what I found most interesting is Greenspan’s almost-agnostic stance on why stock markets are up in the first place. The only explanation he offers is the “human propensity to swing between euphoria and fear, which, while heavily influenced by economic events, has a life of its own. In my experience, such episodes are often not mere forecasts of future business activity, but major causes of it.”

So that’s all it takes, sounds like... a slight push by the invisible hand and… boom! Fear gives way to euphoria, markets go up, business activity surges and.. you know the rest! OK, perhaps I’m over-interpreting here but I’m just struck by Greenspan’s silence on the role of the government’s (very visible) hand in getting the markets out their self-inflicted abyss.

If anything, Greenspan’s central point later on is a warning against the potential unraveling of this virtuous circle of rising markets/rising activity, due to government actions that lead to unsustainable budget deficits and inflation.

It is difficult not to share this concern. But even the most ardent market believers (and I consider myself one) should recognize that market confidence has recovered in part because of a bombardment of government policies:

Policies to backstop key segments of financial markets and contain tail risks (e.g. the Fed’s credit easing facilities); policies generating expectations (rightfully or not) of higher future growth than otherwise projected (e.g. rate cuts and quantitative easing); and, importantly, policies to eliminate investors’ uncertainty about the government’s course of action, esp. vis-à-vis the financials (e.g. the stress tests and the stated decision to refrain from nationalizing any major bank).

So why does this all matter? It matters because the key to the right course of action is a correct diagnosis. And, at this point, a belief in a self-fulfilling circle of market bliss and economic prosperity, which can only be interrupted by government stupidity, is pretty naïve.

Markets are up because of a sense of relief that last winter's horror show will not continue. A relief supported by government actions, as well as real economic data that point to a slower pace of contraction than earlier feared. Whether markets have moved ahead of themselves is another question, and one asked every single second within the investment community.

Given this diagnosis, for me the best indicator of a sustainable macroeconomic recovery is neither the stock market nor the usual economic indicators that people talk about (house prices, employment, ISM and so on).

Rather, it’s the withdrawal of the government’s intervention in the economy: The elimination of the Fed’s funding/backstop facilities; the withdrawal of quantitative easing without rattling the markets; the full emancipation of financial firms (for their equity, debt and asset prices) from government support.

As for Greenspan, well, it’s really time to stop the blabber, get off the stage and maybe revise his memoirs. Failing that, leading financial newspapers should just stop giving him a platform.

On the same day that the worst economic growth numbers in the U.K. in 51 years, we also get some news that the British economy may be stabilising. Well, at least house prices seem to be stabilising as Nationwide reported a 0.9% increase in house prices in UK June. That is the third rise in four months and takes the annual decline to only 9.3% over June of 2008.

Nationwide Chief Economist Martin Gahbauer notes that the 3-month average house price change is up for the first time in eighteen months.

"The three month on three month rate of change – a smoother indicator of the short-term price trend – turned positive for the first time since December 2007 to stand at 0.9%, up from -0.4% in May. If the pattern of price movements seen in the first half of the year is repeated over the second half, then prices could show only a small single digit fall for 2009 as a whole. This would represent a stark shift from trends seen at the turn of the year, when most indicators were pointing to a repeat of the large declines seen in 2008".

Part of the reason prices have stabilised is the huge shadow inventory that has been taken off the market as prices declined, reducing residential property inventory. How long this lasts is anyone’s guess. But Gahbauer is cautious.

"While it is encouraging to see that prices are no longer seeing steep falls, there are still many obstacles in the way of a genuine and sustainable price recovery. To begin with, abnormally low supply levels are unlikely to last forever, as the recent price increases should make previously hesitant sellers feel more confident about marketing their properties. Additional supply is also likely to come from homeowners who see their financial position impacted by higher unemployment and lower incomes. With the stock of property available for sale likely to eventually increase, house purchase demand will need to rise more convincingly from current levels to prevent a possible relapse in price levels".

Part of the reason that Gahbauer is awaiting further evidence has to do with the high cost of housing relative to income in the UK. We are still at levels unseen in the last 25 years, suggesting that house prices are still too high.

Nevertheless, three months in four is a good counter-trend to be taken seriously. To the degree this data is confirmed by the Halifax when it reports, we should start to consider that the U.K. is the first of the large housing bubble markets (Spain, the U.S., Ireland and the U.K.) to stabilise.

Source House Price Rise Continued in June - Nationwide

Related Reading:

Ricardo's Law: House Prices and the Great Tax Clawback Scam

Coins of England and the United Kingdom 2009

How Britain Got the Blues: The Transmission and Reception of American Blues Style in the United Kingdom (Ashgate Popular and Folk Music Series)

Residential Property Management: Over 50 Forms & Bonus Real Estate Dictionary!

Coins of England and the United Kingdom 2002 (Standard Catalogue Brit Coins)

Summertime is conference season, especially for those of us who don't live close to a major airport hub. The first conference I attended was the NBER's International Seminar on Macroeconomics, co-organized by Lucrezia Reichlin and Ken West. The conference was broken up into several sections: Financial Crises, International Economic Puzzles, Exchange Rates and Financial Development. Lot's of interesting papers, and plenty of stimulating discussion. I can't do justice to the proceedings, but I can provide the summaries of the papers.

Figure 1: Legend: Each observation represents average equity market correlation coefficient in a group of 16 countries, for a four-year panels, 1890-2001. The sixteen countries in our dataset are Australia, Belgium, Canada, Denmark, Finland, France, Germany, Great Britain, Italy, the Netherlands, New Zealand, Norway, Spain, Sweden, Switzerland, and the United States. "Uncorrected" is the equity market correlation of a pair of countries, and is taken from Global Financial Data. The Forbes-Rigobon volatility adjusted equity correlation is proposed in Forbes and Rigobon (2002), and used here. Source: D. Quinn and H.-J. Voth, "Free Flows, Limited Diversification: Openness and the Fall and Rise of Stock Market Correlations, 1890-2001". In the abstract to "Free Flows, Limited Diversification: Openness and the Fall and Rise of Stock Market Correlations, 1890-2001", Dennis Quinn and Hans-Joachim Voth write:

Using a new dataset on capital account openness, we investigate why equity return correlations changed over the last century. Based on a new, long-run dataset on capital account regulations in a group of 16 countries over the period 1890-2001, we show that correlations increase as financial markets are liberalized. These findings are robust to controlling for both the Forbes-Rigobon bias and global averages in equity return correlations. We test the robustness of our conclusions, and show that greater synchronization of fundamentals is not the main cause of increasing correlations. These results imply that the home bias puzzle may be smaller than traditionally claimed.

The abstract to "The Default Puzzle: Underwriters and Sovereign Bond Markets 1815-2007", by Marc Flandreau, Juan H. Flores, Norbert Gaillard, Sebastian Nieto-Parra reads:

We provide a comparison of salient organizational features of primary markets for foreign government debt over the very long run. We focus on output, quality control, information provision, competition, pricing, charging and signaling. We find that the market set up experienced a radical transformation in the recent period and interpret this as resulting from the rise of liability insurance provided by rating agencies. Underwriters have given up their former role as gatekeepers of liquidity and certification agencies to become aggressive competitors in a new speculative grade market.

Romaine Ranciere and Aaron Tornell summarize their paper, "Systemic Risk-Taking and the US Financial Crisis", thus:

The recent macroeconomic experience of the US resembles the boom-bust cycles of emerging markets more so than the tame postwar US business cycles. We present a model in which a feebdack loop between credit and prices generates the boom and the bust, and accounts for several stylized facts that characterize of the US experience.

The next section of the conference departed from the issues of crises, and moved onto puzzles. The first puzzle tackled was a prominent one in international finance, namely the Feldstein-Horioka finding that saving and investment are highly correlated, despite the fact that capital mobility is widely perceived to be high (see additional discussion here).

In "The Feldstein-Horioka fact", Domenico Giannone and Michele Lenza, write:

This paper shows that general equilibrium effects can partly rationalize the high correlation between saving and investment rates observed in OECD countries. We find that once controlling for general equilibrium effects the saving-retention coefficient remains high in the 70's but decreases considerably since the 80's, consistently with the increased capital mobility in OECD countries.

The next paper addressed the reason for the famous Meese-Rogoff finding that ex post historical simulations using structural models cannot outperform a random walk (see discussion here). From the abstract of the paper "Can Parameter Instability Explain the Meese-Rogoff Puzzle?" by Philippe Bacchetta, Eric van Wincoop and Toni Beutler:

The empirical literature on nominal exchange rates shows that the current exchange rate is often a better predictor of future exchange rates than a linear combination of macroeconomic fundamentals. This result is behind the famous Meese-Rogoff puzzle. In this paper we evaluate whether parameter instability can account for this puzzle. We consider a theoretical reduced-form relationship between the exchange rate and fundamentals in which parameters are either constant or time varying. We calibrate the model to data for exchange rates and fundamentals and conduct the exact same Meese-Rogoff exercise with data generated by the model. Our main finding is that the impact of time-varying parameters on the prediction performance is either very small or goes in the wrong direction. To help interpret the fndings, we derive theoretical results on the impact of time-varying parameters on the out-of-sample forecasting performance of the model. We conclude that it is not time-varying parameters, but rather small sample estimation bias, that explains the Meese-Rogoff puzzle.

(This paper is closely related to a very interesting paper "On the Unstable Relationship between Exchange Rates and Macroeconomic Fundamentals", by Bachetta and van Wincoop). My comments are here [ppt], while my update (with Cheung and Fujii) of the Meese-Rogoff exercise is here [pdf].

In the final section, the first paper presented was by Kathryn M. E. Dominguez, entitled " International Reserves and Underdeveloped Capital Markets". From the abstract:

International reserve accumulation by developing countries is just one example of the puzzling behavior of international capital flows. Capital should flow to where its return is highest, which ought to be where capital is scare. Yet recent data suggest the opposite -- net capital flows from developing countries to industrialized countries. This paper examines the role of financial market development in the accumulation of international reserves. In countries with underdeveloped capital markets the government's accumulation of reserves may substitute for what would otherwise be private sector capital outflows. Effectively, these governments are acting as financial intermediaries, channeling domestic savings away from local uses and into international capital markets, thereby offsetting the effects of domestic financial constraints that lead to excessive private sector exposure to potential capital shortfalls.

For a slightly different perspective on reserve accumulation, see this post.

Next, in "The Nontradable Goods' Real Exchage Rate Puzzle", my colleague Lukasz Drozd, and Jaromir Nosal write:

This paper studies empirically and theoretically the decomposition of the real exchange rates into tradable and nontradable components, in the spirit of Engel (1999). Empirically, using an extended decomposition, we find that the contribution of the relative price of nontradable goods to local nontradable output to the overall real exchange rate movements is at best modest. Theoretically, we argue that this finding is a puzzle for the standard models in which the law of one price holds, and fluctuations of the real exchange rate for tradable goods are fully accounted for by the relative price movements of the differentiated home and foreign tradable goods. Specifically, we find that, in the best case scenario, the standard model overshoots the contribution of non-tradable goods to the overall real exchange rate fluctuations by a factor of two.

The final paper, by Lone Christiansen, Alessandro Prati, Luca Antonio Ricci, Stephen Tokarick, and Thierry Tressel, tackled a difficult issue, namely "Assessing External Equilibrium in Low Income Countries". From the abstract:

This paper investigates empirically the external performance of low income countries, as measured by the real exchange rate, the current account, and the net foreign assets. The paper focuses on indicators which are specific to low income countries, such as the quality of policies and institutions, the special financing access, and the role of shocks. It also offers a metric for linking the external indicators via a calibration of trade elasticities.

The paper builds upon the research program at the Fund which uses the macroeconomic balance approach to inferring norms in current account balances; this approach is closely related to the methodology implemented in Chinn and Prasad (JIE, 2003) (discussed in this post.)

The final segment involved a panel discussion on "Monetary Policy in a Low Interest Rate Environment," chaired by Athanasios Orphanides (the Governor of the Central Bank of Cyprus). The participants were:

• Huw Pill, European Central Bank
• Vincent Reinhart, American Enterprise Institute
• Volker Wieland, Goethe University Frankfurt
• John Williams, Federal Reserve Bank of San Francisco

This was a fascinating panel discussion, which covered among other things quantitative easing/credit easing, whether QE can occur even above the zero interest rate bound, and the lessons from Japan's (successful) experience in QE without inflation.

Some representative pieces here: For Pill; for Reinhart; for Volker; and for Williams.

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Originally published at Econbrowser and reproduced here with the author's permission.

The labor market is almost surely the key to this recovery; renewed income growth would allow households to spend (i.e., add to the C of Y = C + I + G + NX), while at the same time, save in order to mend overly indebted balance sheets. And the consumer is key to this recovery, as residential investment - usually a big driver of growth during the recovery - is likely to be sluggish for some time (see this VOX article on credit-less recoveries, hat tip reader Steve C.)

So lets analyze the claims numbers. The labor cycle is still in the "contracting" phase; and except for April 2009, massive job loss has helped to pull down wages and salaries since August 2008. Going forward, initial claims suggest that the job loss is likely to slow.

The chart illustrates the 4-week moving average of initial unemployment claims as reported by the Department of Labor. Robert Gordon (see Econbrowser post from April 2009) noticed a pattern that is quite evident in the chart above: for each recession, the 4-week moving average is a good predictor of the recession's end. We will see if that happens this time.

But there is another thing to note here as well: once claims do peak, they tend to fall rather quickly. Therefore, history suggests that claims should start to drop off sharply in the second half of 2009 (coming months).

On the other side of the fence sits the stock of claimants, or continued claims. There was a big hoopla a couple of weeks ago, pointing to the exhaustion rate or the final claims numbers as evidence that people were simply going without benefits and not employed, rather than actually finding work. This is not true - well the not finding work part might be - there are plenty of benefits to be had.

The chart illustrates the total uninsured on the regular state programs plus the emergency benefits program (EB) plus the emergency unemployment compensation program (EUC-2008). By including the number of people that are collecting benefits under the EB and EUC-2008 programs, the total stock of claimants tallies closer to 9 million rather than the 6.1 million (not seasonally adjusted) claiming under the regular program.

I had a talk with Scott Gibbons (the DOL contact on the release). A person can claim unemployment insurance benefits for up to 79 weeks (around 1.5 years) depending on which state he/she resides and whether the claims are completed in 2009 or 2010. My point is: there is a pretty big safety net out there right now.

Of course, all of those people are searching for jobs. And the initial claims numbers support big payroll declines for probably months to come. 2009 is still going to be rocky, even if GDP growth returns in the second half of the year.

Mark Thoma links to a medical paper that brings up the issue that few people want to talk about: at what point is the cost of medical care to extend life not justified? Like Thoma, I don’t have a great answer, except to point out that in a world of scarce resources, the answer cannot be that any effort to extend life by any small amount is always a good idea. (And as David Leonhardt explained, our health care system is certainly constrained by scarce resources, whether we like it or not.)

I just have one observation and one recommendation.

The observation is that our political and legal systems already put price tags on life routinely. If you die on the job, the workers’ compensation system calculates how much your life was worth; if you are killed as a result of someone else’s negligence, the tort system does the same. In either case, the calculation is primarily based on your expected earnings for the rest of the life; in other words, young high-earners are worth more than old poor people. And for virtually everyone, the number you end up with is much less than the value implied by the cancer treatment discussed in the paper Thoma cites.

I’m no fan of that system. I’m just surprised that as a society we can be so brutal and inegalitarian in one sphere and so touchy in another (health care, where the thought that any life-extending treatment might be too expensive is probably considered morally abhorrent by most people).

The recommendation is that if you are interested in this issue, you should listen to Dr. Robert Martensen on Fresh Air. Martensen is not only a doctor and a bioethicist, but at the time of the interview I believe (my memory might be failing me) he was dealing with the imminent death of one of his parents, and the medical choices involved.

Buried in the late wire news on Friday – and therefore barely registering in the newspapers over the weekend – Treasury announced the rules for pricing its option to buy shares in banks that participated in TARP.

The Treasury Department said the banks will make the first offer for the warrants. Treasury will then decide to sell at that price or make a counteroffer. If the government and a bank cannot agree on a fair price for the warrants, the two sides will have the right to use private appraisers.

This is a mistake.

The only sensible way to dispose of these options is for Treasury to set a floor price, and then hold an auction that permits anyone to buy any part – e.g., people could submit sealed bids and the highest price wins.

In Treasury’s scheme, there is significant risk of implicit gift exchange with banks - good jobs/political support/other favors down the road – or even explicit corruption. For sure, there will be accusations that someone at Treasury was too close to this or that bidder. Why would Treasury’s leadership want to be involved in price setting in this fashion?

Treasury apparently sees corruption as an issue about personalities (i.e., WE aren’t ever corrupt) rather than about institutional structure. For example, if you create an arrangement that easily permits corruption, such as through nontransparent decision making or negotiation around warrant pricing, you set up incentives to be corrupt. Either existing people change their behavior, or new people will seek appointment in order to participate in corruption.

This is also a point, by the way, that Treasury has been making for years through its representatives at the International Monetary Fund – including during the Clinton Administration, when the same people were running U.S. economic policy as now. It’s a good point and never easy for countries-with-potential-corruption to hear. It applies as much to the United States as to anywhere else.

Treasury will argue the disposal of warrants is a one-off event, but this is not a plausible line: it is part of a much longer series of nontransparent decisions over finance. The attitude that “we can be nontransparent because we will never be corrupt” creates reputational risk for both Treasury and participating banks. If extraordinary support for the financial sector lasts several years, we will likely have at least one time-consuming and damaging investigation into all the details of these settlements.

In any crisis, technical mistakes are made due to high pressure, lack of information, and political considerations; this is unavoidable. But this proposed pricing for TARP warrants looks like a pure unforced error, and should be quietly overriden by the White House – hopefully, senior congressional leaders will quickly make this point behind the scenes.

There is obviously unappealing midterm election risk in this pricing scheme and making a correction now – before major banks have participated – would be relatively straightforward.

(Primer on option pricing, applied to warrants; background on how we got here)