Economic Darwinism

Natural History of Fire & Flood Cycles

Posted in Uncategorized by Economic Darwinism on August 14, 2010

In reference to the analogies presented in my previous article, please have a look at this article:

Natural History of Fire & Flood Cycles

While reading it, replace

  • “forest fire” with “recession”
  • “fire cycle” with “business cycle”
  • “ecosystem” with “economy”
  • “fire suppression” with “stimulus”
  • Etc

The following passage is so directly relevant to my point, I will reproduce it in its entirety (my highlights in bold):

Fire Suppression

As development has extended, or exploded as it has in some areas, into the chaparral environment, residents and government agencies have had to respond to the hazards associated with living in the urban/wildland interface. The majority of urban settlers who moved into these wildland areas are ignorant of the environment they are moving into and ill equipped to live in this wildland environment. Too often home buyers fail to realize that fire protection agencies may not be able to save their home from fire, and that agencies charged with building and safety and flood control may be powerless to save them from floods, mudflows, and landslides.

The primary response from government has been to initiation aggressive fire suppression and management in an attempt to eliminate fire from native lands. In spite of these aggressive fire suppression efforts large wildfires continue to consume vast acreages of chaparral in Southern California. After nearly a century of suppression, there has been increasing debate that fire control efforts have altered chaparral fire regimes in ways that magnify the threat of burning, erosion, sedimentation, and flooding at the urban/wildland interface (Pyne 1982). Fire suppression in Southern California appears to be producing older growth stands of chaparral which result in larger more intense fires. Younger chaparral stands (less than 20 years) are less likely to burn due to lower ratios of dead fuel to live fuels and reduced horizontal and vertical continuity of fuels. In northern Baja California where fire suppression has not been practiced to the extent it has in Southern California a mosaic pattern of differing age stands of chaparral appears to have developed resulting in smaller fire events of less intensity. Minnich (1983) comparing the chaparral fire regimes in southern California and Baja California found that in Baja California numerous small fire events fragment stands into a fine mixture of age classes, a process which appears to help preclude large fires. While the pattern of large fires in Southern California appears to be an artifact of suppression.

Fire suppression is extremely effective at the ignition stages of a fire and where climatic conditions are favorable. Therefore, fires occurring in Southern California in the summer during periods of higher humidity, lower wind speeds and temperatures are much more easily controlled. Most of Southern California’s major fires occur in the very late summer and fall periods during off shore wind conditions (Santa Ana Winds) which are characterized by high temperatures, low humidity and very high wind speeds. Fires in this type of severe weather conditions are extremely difficult and in many cases impossible to control. This type of weather scenario in conjunction with extensive areas of older chaparral stands result in fire magnitudes so great that entire watersheds are completely denuded of vegetation. This intense type of fire can even consume young moist stands of chaparral.

The extent of burned watershed can magnify flash-flood runoff behavior and high sediment yield in an exponential fashion (Minnich, 1989). Higher regional fire intensities may also result in more extensive hydrophobic soil impermeability and high runoff (Minnich, 1989). These adverse watershed impacts can be moderated by implementing a sustained-yield program of small to medium size planned burns to produce the stand mosaic similar to the Baja California chaparral model.

Prescribed burns adjacent to the urban wildland interface can present some challenging problems. The common complaints voiced by residents of these areas are the annoyance and potential health effects of the smoke, reduced visibility and potential danger of the controlled fire escaping and endangering their residences. Furthermore, air quality regulations, particularly in Southern California, severely limit the time of year these burns may occur. Given these constraints the prescribed burning near the urban wildland interface can be carried out only on a very limited basis. However, even on a limited basis prescribed burning in the urban wildland interface can be a valuable cost effective fire management tool for protection agencies.

The proximity of the Malibu/Santa Monica Mountains to the Los Angeles metropolitan region coupled with it’s coastal location, breath taking views, access to undisturbed natural areas, and sense of rural living make this a very desirable area. With proper land use planning, site planning, building codes and vegetation clearance it is possible to significantly reduce the threat of fire in the Chaparral community. However, the problem in the Santa Monica Mountains is there are literally thousands of existing legal undeveloped parcels comprising hundreds of acres of land area that are located in very remote, topographically constrained, and environmentally sensitive areas. These factors make it quite difficult to mitigate the threat of fire and adverse environmental impacts.

There are also a number of very poorly planned subdivisions which were divided in the late 1920s and 30s with lot sizes of less than an acre and many more typically 5,000 to 10,000 sq. ft. in size. These subdivisions were primarily designed for weekend cabin type of use. However, today the expensive homes built on these parcels are occupied on a year round basis. There are approximately 6,000 of these ill-conceived small parcels in the Santa Monica Mountains. These subdivisions have very narrow winding roads which cannot accommodate fire equipment and are for the most part very heavily wooded with both natural and exotic plant species. These types of subdivisions are disasters just waiting to happen.

Proper site design on a large parcel can reduce fire danger to some extent, however, in these small lot subdivisions it is impossible in many cases to significantly reduce the fire hazards given the very steep site topography, lack of adequate water supply, proximity to other structures and limited access for fire equipment.

Given that the threat of fire alone has not provide an adequate basis to prohibit development on these parcels and given the more rigorous requirements placed on regulatory agencies by recent court decisions regarding constitutional takings of private property, these parcels are and will continue building out. Furthermore, as most of us know today regulatory agencies are facing even more severe limitations and restrictive requirements regarding regulation of private property. Therefore, the over simplified argument, which is voiced quite often is “just deny all development of homes on these parcels” is just not realistic or legally justifiable.

In order to reduce the buildout of these subdivisions and remote environmentally sensitive parcels the California Coastal Commission developed the Transfer of Development program in the Malibu/Santa Monica Mountains Area of the Coastal Zone. Simply the Transfer of Development program requires that any time a new parcel is created through the subdivision process, the equivalent development rights on designated small lot subdivision lots or remote environmentally sensitive parcels have to be retired. In theory, the newly created subdivisions are located in areas more suitable for this type of development. To date 924 substandard lots have been retired in small lot subdivisions and some 800 acres of remote environmentally sensitive parcels have been retired. Making the Malibu/Santa Monica Mountains Transfer of Development program one of the most successful in the United States.

Prescribed Fire Economics

Posted in Uncategorized by Economic Darwinism on August 14, 2010

I enjoyed Market Talks quote of the day:

I wish free money was really free and that there was a painless way to move from severe recession and high leverage to robust and sustainable economic growth, but there is no short cut.

– Kansas City Fed President Thomas Hoenig, arguing the Fed needs to raise interest rates.

It seems everyone is looking for a painless solution. Even Felix Salmon comments about  “causing unacceptable amounts of pain” in his half-supportive half-opposed article on Santelli’s righteous (and right on) recent rant.

If we let housing find its bottom naturally, true, many financial institutions will cease to exist. True, we may look back at 2008 as the “good ol’ days” before things got really ugly.

But at this point, letting things get ugly is exactly what we need for the long run. Let the fittest businesses survive.

The analogy I like to use is a technique often used in forest management, i.e prescribed burns.

Imagine a world completely fearful of the tiniest of forest fires. Whenever a fire broke out, even a mild one, the entire Federal (Forest) Reserve  was called out to extinguish it. Years and even decades go by without even a single lost home due to forest fire. People started talking about a Great (Forest Fire) Moderation. Some even proclaimed that the forest fire cycle that used to be standard reading material in many, now obviously obsolete, forest management textbooks for years had been defeated by the Federal (Forest) Reserve.

The mantra became, “Let all vegetation flourish!” Never fear. If natural selection has lead certain vegetation populations to dwindle in the past, we’ll have none of that. Come one and all. Prosper in the new age of forest fire management where forest fires no longer exist.

Guess what happens? The forest floor becomes flush with vegetation (read fuel). All around, as far as the eye can see, nothing but flourishing vegetation (read fuel). Forest Rangers are happy. Politicians are happy. Everyone is happy.

But one day, there is a particularly strong wind. The Federal (Forest) Reserve has not yet figured out how to control the weather unfortunately. A fire breaks out and quickly spreads. At this point, the brush is so dense providing a never ending supply of fuel. Similar to the critical neutron mass of a nuclear reaction, the fire spreads exponentially. Soon, there is an inferno far larger than the world has ever seen.

Monetary policy should not be about avoiding forest fires at all costs. Monetary policy should be about prescribed burns. Let the vegetation that is unfit for survival perish. It is better to have a controlled burn now and then than to have an uncontrollable inferno.

Testimony of Chairman Ben S. Bernanke: July 18, 2007

Posted in Uncategorized by Economic Darwinism on July 26, 2009

For Yves Smith:

Testimony of Chairman Ben S. Bernanke
Semiannual Monetary Policy Report to the Congress
Before the Committee on Financial Services, U.S. House of Representatives
July 18, 2007

Chairman Bernanke presented identical testimony before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, on July 19, 2007

Chairman Frank, Ranking Member Bachus, and members of the Committee, I am pleased to present the Federal Reserve’s Monetary Policy Report to the Congress.  As you know, this occasion marks the thirtieth year of semiannual testimony on the economy and monetary policy by the Federal Reserve.  In establishing these hearings, the Congress proved prescient in anticipating the worldwide trend toward greater transparency and accountability of central banks in the making of monetary policy.  Over the years, these testimonies and the associated reports have proved an invaluable vehicle for the Federal Reserve’s communication with the public about monetary policy, even as they have served to enhance the Federal Reserve’s accountability for achieving the dual objectives of maximum employment and price stability set for it by the Congress.  I take this opportunity to reiterate the Federal Reserve’s strong support of the dual mandate; in pursuing maximum employment and price stability, monetary policy makes its greatest possible contribution to the general economic welfare.

Let me now review the current economic situation and the outlook, beginning with developments in the real economy and the situation regarding inflation before turning to monetary policy.  I will conclude with comments on issues related to lending to households and consumer protection–topics not normally addressed in monetary policy testimony but, in light of recent developments, deserving of our attention today.

After having run at an above-trend rate earlier in the current economic recovery, U.S. economic growth has proceeded during the past year at a pace more consistent with sustainable expansion.  Despite the downshift in growth, the demand for labor has remained solid, with more than 850,000 jobs having been added to payrolls thus far in 2007 and the unemployment rate having remained at 4-1/2 percent. The combination of moderate gains in output and solid advances in employment implies that recent increases in labor productivity have been modest by the standards of the past decade.  The cooling of productivity growth in recent quarters is likely the result of cyclical or other temporary factors, but the underlying pace of productivity gains may also have slowed somewhat.

To a considerable degree, the slower pace of economic growth in recent quarters reflects the ongoing adjustment in the housing sector.  Over the past year, home sales and construction have slowed substantially and house prices have decelerated.  Although a leveling-off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders’ inventories to rise further relative to the pace of new home sales.  Accordingly, construction of new homes has sunk further, with starts of new single-family houses thus far this year running 10 percent below the pace in the second half of last year.

The pace of home sales seems likely to remain sluggish for a time, partly as a result of some tightening in lending standards and the recent increase in mortgage interest rates.  Sales should ultimately be supported by growth in income and employment as well as by mortgage rates that–despite the recent increase–remain fairly low relative to historical norms.  However, even if demand stabilizes as we expect, the pace of construction will probably fall somewhat further as builders work down stocks of unsold new homes.  Thus, declines in residential construction will likely continue to weigh on economic growth over coming quarters, although the magnitude of the drag on growth should diminish over time.

Real consumption expenditures appear to have slowed last quarter, following two quarters of rapid expansion.  Consumption outlays are likely to continue growing at a moderate pace, aided by a strong labor market.  Employment should continue to expand, though possibly at a somewhat slower pace than in recent years as a result of the recent moderation in the growth of output and ongoing demographic shifts that are expected to lead to a gradual decline in labor force participation.  Real compensation appears to have risen over the past year, and barring further sharp increases in consumer energy costs, it should rise further as labor demand remains strong and productivity increases.

In the business sector, investment in equipment and software showed a modest gain in the first quarter.  A similar outcome is likely for the second quarter, as weakness in the volatile transportation equipment category appears to have been offset by solid gains in other categories.  Investment in nonresidential structures, after slowing sharply late last year, seems to have grown fairly vigorously in the first half of 2007.  Like consumption spending, business fixed investment overall seems poised to rise at a moderate pace, bolstered by gains in sales and generally favorable financial conditions.  Late last year and early this year, motor vehicle manufacturers and firms in several other industries found themselves with elevated inventories, which led them to reduce production to better align inventories with sales.  Excess inventories now appear to have been substantially eliminated and should not prove a further restraint on growth.

The global economy continues to be strong.  Supported by solid economic growth abroad, U.S. exports should expand further in coming quarters.  Nonetheless, our trade deficit–which was about 5-1/4 percent of nominal gross domestic product (GDP) in the first quarter–is likely to remain high.

For the most part, financial markets have remained supportive of economic growth.  However, conditions in the subprime mortgage sector have deteriorated significantly, reflecting mounting delinquency rates on adjustable-rate loans.  In recent weeks, we have also seen increased concerns among investors about credit risk on some other types of financial instruments.  Credit spreads on lower-quality corporate debt have widened somewhat, and terms for some leveraged business loans have tightened.  Even after their recent rise, however, credit spreads remain near the low end of their historical ranges, and financing activity in the bond and business loan markets has remained fairly brisk.

Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy’s underlying trend.  Such an assessment was made around the time of the June meeting of the Federal Open Market Committee (FOMC) by the members of the Board of Governors and the presidents of the Reserve Banks, all of whom participate in deliberations on monetary policy.  The central tendency of the growth forecasts, which are conditioned on the assumption of appropriate monetary policy, is for real GDP to expand roughly 2-1/4 to 2-1/2 percent this year and 2-1/2 to 2-3/4 percent in 2008.  The forecasted performance for this year is about 1/4 percentage point below that projected in February, the difference being largely the result of weaker-than-expected residential construction activity this year.  The unemployment rate is anticipated to edge up to between 4-1/2 and 4-3/4 percent over the balance of this year and about 4-3/4 percent in 2008, a trajectory about the same as the one expected in February.

I turn now to the inflation situation.  Sizable increases in food and energy prices have boosted overall inflation and eroded real incomes in recent months–both unwelcome developments.  As measured by changes in the price index for personal consumption expenditures (PCE inflation), inflation ran at an annual rate of 4.4 percent over the first five months of this year, a rate that, if maintained, would clearly be inconsistent with the objective of price stability. 1 Because monetary policy works with a lag, however, policymakers must focus on the economic outlook.  Food and energy prices tend to be quite volatile, so that, looking forward, core inflation (which excludes food and energy prices) may be a better gauge than overall inflation of underlying inflation trends.  Core inflation has moderated slightly over the past few months, with core PCE inflation coming in at an annual rate of about 2 percent so far this year.

Although the most recent readings on core inflation have been favorable, month-to-month movements in inflation are subject to considerable noise, and some of the recent improvement could also be the result of transitory influences.  However, with long-term inflation expectations contained, futures prices suggesting that investors expect energy and other commodity prices to flatten out, and pressures in both labor and product markets likely to ease modestly, core inflation should edge a bit lower, on net, over the remainder of this year and next year.  The central tendency of FOMC participants’ forecasts for core PCE inflation–2 to 2-1/4 percent for 2007 and 1-3/4 to 2 percent in 2008–is unchanged from February.  If energy prices level off as currently anticipated, overall inflation should slow to a pace close to that of core inflation in coming quarters.

At each of its four meetings so far this year, the FOMC maintained its target for the federal funds rate at 5-1/4 percent, judging that the existing stance of policy was likely to be consistent with growth running near trend and inflation staying on a moderating path.  As always, in determining the appropriate stance of policy, we will be alert to the possibility that the economy is not evolving in the way we currently judge to be the most likely.  One risk to the outlook is that the ongoing housing correction might prove larger than anticipated, with possible spillovers onto consumer spending.  Alternatively, consumer spending, which has advanced relatively vigorously, on balance, in recent quarters, might expand more quickly than expected; in that case, economic growth could rebound to a pace above its trend.  With the level of resource utilization already elevated, the resulting pressures in labor and product markets could lead to increased inflation over time.  Yet another risk is that energy and commodity prices could continue to rise sharply, leading to further increases in headline inflation and, if those costs passed through to the prices of non-energy goods and services, to higher core inflation as well.  Moreover, if inflation were to move higher for an extended period and that increase became embedded in longer-term inflation expectations, the re-establishment of price stability would become more difficult and costly to achieve.  With the level of resource utilization relatively high and with a sustained moderation in inflation pressures yet to be convincingly demonstrated, the FOMC has consistently stated that upside risks to inflation are its predominant policy concern.

*  *  *

In addition to its dual mandate to promote maximum employment and price stability, the Federal Reserve has an important responsibility to help protect consumers in financial services transactions.  For nearly forty years, the Federal Reserve has been active in implementing, interpreting, and enforcing consumer protection laws.  I would like to discuss with you this morning some of our recent initiatives and actions, particularly those related to subprime mortgage lending.

Promoting access to credit and to homeownership are important objectives, and responsible subprime mortgage lending can help advance both goals.  In designing regulations, policymakers should seek to preserve those benefits.  That said, the recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards and, in some cases, by abusive lending practices and outright fraud.  In addition, some households took on mortgage obligations they could not meet, perhaps in some cases because they did not fully understand the terms.  Financial losses have subsequently induced lenders to tighten their underwriting standards.  Nevertheless, rising delinquencies and foreclosures are creating personal, economic, and social distress for many homeowners and communities–problems that likely will get worse before they get better.

The Federal Reserve is responding to these difficulties at both the national and the local levels.  In coordination with the other federal supervisory agencies, we are encouraging the financial industry to work with borrowers to arrange prudent loan modifications to avoid unnecessary foreclosures.  Federal Reserve Banks around the country are cooperating with community and industry groups that work directly with borrowers having trouble meeting their mortgage obligations.  We continue to work with organizations that provide counseling about mortgage products to current and potential homeowners.  We are also meeting with market participants–including lenders, investors, servicers, and community groups–to discuss their concerns and to gain information about market developments.

We are conducting a top-to-bottom review of possible actions we might take to help prevent recurrence of these problems.  First, we are committed to providing more-effective disclosures to help consumers defend against improper lending.  Three years ago, the Board began a comprehensive review of Regulation Z, which implements the Truth in Lending Act (TILA).  The initial focus of our review was on disclosures related to credit cards and other revolving credit accounts.  After conducting extensive consumer testing, we issued a proposal in May that would require credit card issuers to provide clearer and easier-to-understand disclosures to customers.  In particular, the new disclosures would highlight applicable rates and fees, particularly penalties that might be imposed.  The proposed rules would also require card issuers to provide forty-five days’ advance notice of a rate increase or any other change in account terms so that consumers will not be surprised by unexpected charges and will have time to explore alternatives.

We are now engaged in a similar review of the TILA rules for mortgage loans.  We began this review last year by holding four public hearings across the country, during which we gathered information on the adequacy of disclosures for mortgages, particularly for nontraditional and adjustable-rate products.  As we did with credit card lending, we will conduct extensive consumer testing of proposed disclosures.  Because the process of designing and testing disclosures involves many trial runs, especially given today’s diverse and sometimes complex credit products, it may take some time to complete our review and propose new disclosures.

However, some other actions can be implemented more quickly.  By the end of the year, we will propose changes to TILA rules to address concerns about mortgage loan advertisements and solicitations that may be incomplete or misleading and to require lenders to provide mortgage disclosures more quickly so that consumers can get the information they need when it is most useful to them.  We already have improved a disclosure that creditors must provide to every applicant for an adjustable-rate mortgage product to explain better the features and risks of these products, such as “payment shock” and rising loan balances.

We are certainly aware, however, that disclosure alone may not be sufficient to protect consumers.  Accordingly, we plan to exercise our authority under the Home Ownership and Equity Protection Act (HOEPA) to address specific practices that are unfair or deceptive.  We held a public hearing on June 14 to discuss industry practices, including those pertaining to pre-payment penalties, the use of escrow accounts for taxes and insurance, stated-income and low-documentation lending, and the evaluation of a borrower’s ability to repay.  The discussion and ideas we heard were extremely useful, and we look forward to receiving additional public comments in coming weeks.  Based on the information we are gathering, I expect that the Board will propose additional rules under HOEPA later this year.

In coordination with the other federal supervisory agencies, last year we issued principles-based guidance on nontraditional mortgages, and in June of this year we issued supervisory guidance on subprime lending.  These statements emphasize the fundamental consumer protection principles of sound underwriting and effective disclosures.  In addition, we reviewed our policies related to the examination of nonbank subsidiaries of bank and financial holding companies for compliance with consumer protection laws and guidance.

As a result of that review and following discussions with the Office of Thrift Supervision, the Federal Trade Commission, and state regulators, as represented by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators, we are launching a cooperative pilot project aimed at expanding consumer protection compliance reviews at selected nondepository lenders with significant subprime mortgage operations.  The reviews will begin in the fourth quarter of this year and will include independent state-licensed mortgage lenders, nondepository mortgage lending subsidiaries of bank and thrift holding companies, and mortgage brokers doing business with or serving as agents of these entities.  The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations of and improved enforcement for nondepository mortgage lenders.  Working together to address jurisdictional issues and to improve information-sharing among agencies, we will seek to prevent abusive and fraudulent lending while ensuring that consumers retain access to beneficial credit.

I believe that the actions I have described today will help address the current problems.  The Federal Reserve looks forward to working with the Congress on these important issues.


Footnotes

1. Despite the recent surge, total PCE inflation is 2.3 percent over the past twelve months. Return to text

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2007 Testimony