Economic Letter

The optimal proportion of financial wealth placed in stocks versus risk-free bonds changes over an investor’s life and is very sensitive to the long-run correlation between stock returns and labor income. If this correlation is assumed to be high, then the optimal proportion of stock is hump-shaped and approximately zero for young agents, in contrast to the claims of financial advisers and most academic models.

The recession that began in late 2007 severely reduced state tax revenue and increased demand for many public services. In the near term, institutional and political factors limit the options states have for cutting spending and raising taxes. Aid to states in the federal economic program is winding down next year and the situation is likely to get worse before it gets better. Painful budgetary choices lie ahead for many states, though the drag on the national economy should be modest.

Financial institutions are increasingly using economic capital models to help determine the amount of capital they need to absorb unexpected losses. These models typically aggregate capital based on business-level analysis. However, important challenges surround this aggregation as well as other aspects of these models. Supervisors could use these capital calculations when they assess capital adequacy, but they need to be aware of these modeling issues.

As the financial crisis has receded, the Federal Reserve has scaled back its extraordinary provision of liquidity. Eventually, the Fed will remove all remaining monetary stimulus by raising the federal funds rate and shrinking its balance sheet. The timing of such renormalizations depends crucially on evolving economic conditions.

Many central banks conduct monetary policy according to an inflation targeting framework, which requires that some measure of inflation be chosen as the target. One approach would be to use an index of goods and services whose prices are market determined and not subject to frequent, idiosyncratic, and transitory changes. That could be an index based on the personal consumption expenditures prices of services and durable goods, excluding nondurable goods, similar to but distinct from the U.S. core personal consumption expenditures price index.

The enormity of the recent financial shock was not fully apparent until well into the crisis. One result was that banks did unusually low levels of pre-reserving against eventual loan losses. Much of that underreserving was related to the extraordinary decline in real estate values that led to outsized losses on mortgage loans. This experience highlights the limitations of the bank provisioning process and the need to guard against worse-than-expected economic conditions through higher capital levels.

Economic recoveries from the past two recessions have been much more gradual than the rapid V-shaped recoveries typical of earlier downturns. Analysis of the factors that determine economic growth rates indicates that recovery from the most recent recession is likely to be faster than from the two previous recessions, but slower than earlier V-shaped recoveries.

The single most important proposition in economic theory, first stated by Adam Smith, is that competitive markets do a good job allocating resources. Vilfredo Pareto’s later formulation was more precise than Smith’s, and also highlighted the dependence of Smith’s proposition on assumptions that may not be satisfied in the real world. The financial crisis has spurred a debate about the proper balance between markets and government and prompted some scholars to question whether the conditions assumed by Smith and Pareto are accurate for modern economies.

This conference examined how the recent economic crisis has changed residential and development environments in many parts of the world. For example, the crisis has reduced home ownership and created pressure to increase neighborhood density in the United States. And, at least temporarily, it slowed migration in China to export-oriented urban areas.

The conference was sponsored by the Center for the Study of Innovation and Productivity and was held at the Federal Reserve Bank of San Francisco November 18, 2009.

During the current labor market downturn, unemployment duration has reached levels well above its previous highs. Analysis of unemployment data suggests that extended unemployment insurance benefits have not been important factors in the increase in the duration of unemployment or in the elevated unemployment rate.