US Recession...

Here's some excellent analysis on the US business cycle by James Hamilton. The news is bad.....

Walmart and the Recession....

The US appears to be in recession, but not everyone is suffering. Yesterday we argued that the effects of the recession on China, for example, depend on the kinds of goods and services that China exports to the United States. If these exports are mostly necessities, there will be minimal effects.

Walmart may also buck the trend, as this Slate article suggests.....

China Trade and US Recession...

"If the US experiences a recession, might that not be good for China's exports? After all, China exports low-priced goods, and US households may consume more of these during a recession" - DuOo

You raise a good point. During a recession, consumption of luxury goods falls dramatically, while consumption of necessities may barely change. Thus depending on the kind of goods China is exporting, a US recession may not necessary hurt China's economy. I expect that a US recession will negatively impact on China, for two reasons:

1) There's a difference between low priced goods and necessities. Yes, demand for necessities is relatively resillient during a recession, but necessities are items like food and medicine. These are not the largest part of Chinese exports to the United States. Instead China's exports are mostly made up of consumer goods that, while (relatively) cheap, are not essential consumption items to US households.

2) China's exports are increasingly in the "luxury" and durable goods sector, which are highly vulnerable to the business cycle. There are very few cars, for example, that do not contain some parts that were made in China. An anecdote that I heard recently from a friend in the watch industry is that the mechanisms in nearly all "Swiss" watches are made in China. The watch is still assembled in Switzerland, so that it can still be claimed to be "Swiss" for marketing reasons, but much of the actual manufacturing is now taking place in China.

For these reasons, I expect that a US recession will negatively impact on China.

The US Recession will be Bad....

.... by Martin Feldstein, Harvard Professor and current head of the NBER, the organisation that dates US recessions. See this link on Calculated Risk for more.

Here's an earlier take by me on the US business cycle.

Winners and Losers...

At every stage of the business cycle, there are both winners and losers. The standard example I use is bankruptcy lawyers. They do well when the economy is tanking, but risk requiring their own services when the economy is doing very well! The linked Freakonomics article considers the winners and losers of the housing crisis in the United States.

The Great Moderation

Here's an excellent discussion on the Freakonomics blog on "The Great Moderation," and why the probability of recession in the US may be overstated.

I'm not convinced.... a large housing correction as we are now seeing in the US has always predicted a recession in the past (see this post on the Calculated Risk blog, for example). I don't think the mechanism will be any different this time around.

Yes, the evolution of the economy and improved macroeconomic policy may have resulted in an increased ability of the economy to adjust to a range of different shocks, but that doesn't mean that it can avoid recessions under all circumstances! If the shock is big enough (as the current one appears to be), we'll still get a recession.

The Coming Recession...

According to the Economist, one accurate measure of past recessions is the number of times the news media includes the term "Recession." And guess what's happened to the number of times you can find "Recession" in print in the US lately? See this link for more.

(There's actually a formal name for counting the number of times a particular word appears in print, and using this frequency as an explanatory variable. It's called "Textual Analysis" or "Content Analysis.")

Multipliers...

When there is a shock to the economy, it is generally thought to have a multiplied effect on the economy. Some households enjoy higher income, they spend it, increasing the income for other households, who in turn spend it, and so on. The size of the multiplier is finite because there are leakages: some of the increase in income may be saved, used to pay taxes, or used to buy imports, and is therefore not available as income to others.

How big are these multipliers? Menzie Chinn provides some estimates at Econbrowser.

Housing Prices and Recession...

I keep harping on about the fall in house prices in the US leading to a recession- my last installment was here.

CalculatedRisk have a careful assessment of the argument here, and essentially agree. If you don't have time to read the whole article, this graph illustrates it nicely. Housing values were recently at an all-time high as a percentage of GDP, and so mortgages still are. As house prices start to fall, those mortgages are going to stay at their stratospheric levels, implying that net wealth of households is falling far more dramatically (in percentage terms) than the fall in house prices alone would suggest. And we know the influence of the wealth affect on consumption, and therefore GDP......

Oil, Gold, Exchange Rates, and Inflation....

Does the rapid appreciation of the price of oil and gold signify increased inflation? Here's a careful analysis by James Hamilton on Econbrowser.

Has the Fed lost the plot?

"I am afraid that the Fed Reserve, which regards its loose monetary policy can overcome potential recession, has missed the point. The underlying problem with US' economy is the unbelievable deficit! With high deficit and high oil price, I am reminded of the stagflation of 1970s. What do you think?" - Wallace

The Federal Reserve is in a tight spot. Their objective is to try to ensure that the US economy grows as fast as possible without generating excessive inflation. If the economy starts to slow, they cut interest rates, while if the economy grows too fast, they raise rates.

That's the theory, in the simplest possible terms. But the reality is much more complicated. We can think of the economy as consisting of many different key indicators, that all suggest different monetary policy responses. For example, if we were to focus on the latest employment numbers, GDP release, or inflation data, they were relatively strong, suggesting that a reduction in interest rates is definitely not required at the current point in time, and runs the risk of fueling further increases in the inflation rate. In sharp contrast, if we focus on one key aspect of the economy, the stock of wealth tied up in housing, this is dropping in value very quickly, and will most likely lead to a significant drop in consumption and a recession in the coming months. (I know I've been making this argument for some time now, but I still believe it to be true!).

Add to the mixture the fact the monetary policy acts on the real economy (e.g. GDP) with a lag of 6-12 months, and on the nominal economy (i.e. inflation) with a lag of 12-18 months, and you end up with a central bank that has to worry about what is going to happen in the future, rather than the present.

And just to make things even more confusing, the current subprime mortgage meltdown has effectively tightened monetary policy, as banks require higher interest rates to offset their increased risk aversion as a large part of their portfolio has gone up in smoke. To some extent, the cuts in interest rates have simply offset this recent phenomena. To illustrate this, consider the following graph, containing the prime rate, the effective federal funds rate, and the yield on BBA-rated bonds (all data taken from FRED). While the first two series have seen falls in interest rates since May of 50 basis points, the BBA yields are actually higher!



So coming back to the question, I think there is a risk of stagflation (when the economy's growth rate slows and inflation increases) if the central bank cuts rates too much, but there's also a risk of a serious recession (if house prices continue to fall dramatically, and consumers cut back on their consumption). On balance, we could argue about whether the central bank has done too little or too much, but we will never know for sure until after the fact, and by then it is too late to do anything about it!

On the real issue being the budget deficit, this is indeed a problem going forward for the United States, but not directly related to the monetary policy dilemma that the Federal Reserve faces. (In the margin, an expansionary fiscal policy requires a relatively contractionary monetary policy to offset its inflationary effects). And of course, moving to a contractionary fiscal policy would only make matters worse if the US economy does enter a recession.

Good or bad news about the economy?

Just a few days back, the latest employment data for the US was released, and the data was surprisingly good, as this Bloomberg story reports. But how exactly should we interpret a single piece of evidence? The data is volatile, and as a result, there are lots of conflicting pieces of evidence, as Nouriel Roubini discusses here. The rational thing to do is to take moving averages through the data, to drop out some of the volatility (and if we have 12 month moving averages, drop out any distortions caused by seasonal factors or- more likely- poor adjustment for seasonality), and then interpret the smoothed data, as James Hamilton proposes here. The conclusion? The news is not good.

US recession round-up....

Some recent posts on the coming US recession....

Here is the insightful Nouriel Roubini taking stock of the dire state of the US economy, and the path it is on to recession.

Here is James Hamilton explaining why the oil price is so high. It's a simple case of supply and demand. We've got lots of the latter, and not quite enough of the former.

In the past, any major rise in oil prices has lead to a recession- no questions asked. Hamilton continues here with why the economy need not be as sensitive to the price of oil as it was in the past, which may be cause for a little optimism.

And his fellow Blogger, Menzie Chinn, continues here with a roundup of recessionary causes, and the historical inability of growing trade to keep the US economy out of recession.

Why have a currency board?

"Notwithstanding the fact that the currency peg is very political, are there any compelling reasons why the HKD should not be "unpegged" from the USD, particularly in view of expected further depreciation of the greenback?"



That's an excellent question! To answer it, first we need to take a slight detour, into the world of currency unions. A currency union is a form of monetary policy where two or more countries use the same money- for example, the Euro area, or Ecuador and the US- who both use USD. There is a substantial amount of evidence that countries in currency unions benefit economically from large increases in trade, investment flows, and output (see the links on this page put together by Andy Rose at UC Berkeley, and my own modest contribution published in Pacific Economic Review that you can view here).



So currency unions are good- but what's that got to do with Hong Kong, with doesn't have a currency union, but a currency board? It's hard to say anything definitive, as there just aren't enough cases of currency boards to undertake the kind of empirical studies linked to above. But I think it is a reasonable conjecture that the same benefits that accrue to currency unions also accrue to currency boards. Both fix the exchange rate in a way that is politically costly to reverse; the main difference between them is that in one case, the countries retain different notes and coins from each other, and in the other case they do not. If my conjecture is correct, Hong Kong benefits from higher capital flows (important for the establishment of the growing international finance centre here), higher trade flows (one of the corner stones of the Hong Kong economy), and higher economic growth.



That doesn't mean that a currency board is without costs. Since the exchange rate cannot adjust to absorb shocks, other variables do instead- including output and unemployment. Our business cycles may be more volatile, but that may be a price that is worth paying.

Hong Kong Tax Cut Harmony....

Continuing yesterday's post, William Pesak of Bloomberg agrees that Hong Kong's tax cut is a bad idea- although he adds some additional reasons to my argument about macroeconomic instability: (1) instead of cutting taxes, the government could have used it's largese to try to reduce inequality, and (2) the government should focus less on competing with Singapore (Hong Kong's closest competitor in the low-tax stakes in Asia), and more on forward planning- figuring out what Hong Kong needs for future growth.

(2) is obvious: planning is good-provided such planning is focused solely on trying to ensure that Hong Kong has all the essential ingredients in place to allow for future growth. Here I'm thinking of physical infrastructure, and ensuring Hong Kong is an attractive location for human capital to locate. On the first one, the CE's announcement included some important news: expansions to the subway trains and highways to improve mobility. On the second one, there was further good news: new green-field sites for international schools (places in which are currently significantly over-subscribed, and are limiting the relocation of expats to Hong Kong). But there's still room for more. In my opinion, the greatest issue in making Hong Kong a more attractive location for human capital is the air quality- which is affecting the quality of life of all Hong Kong residents.

But forward planning is not necessarily a great idea, depending on what it entails. If it includes trying to determine which sectors will be the "winners" in the future evolution of the economy, as in Singapore, then Hong Kong may be better off without it. Think of the unpopular and unprofitable Hong Kong Disneyland and the mis-allocation of resources involved in the Cyberport project as the results of this type of planning. The private sector should be left to make these decisions.

Regarding (1), inequality in Hong Kong may be high by international standards, but is it too high? That's a difficult question to answer.... although from the point of view of contributing to economic stability, a large increase in government spending to increase equality (by spending on public housing, education, and health care, for example) may be just as destabilising as a tax cut! Someone receives that increase in government spending as income, contributing to overheating of the economy. Stability would be greater if the government increased such spending during a recession rather than the current boom.

For more of Pesek's column, see here.

Hong Kong's fiscal policy is cyclical?

Further to my previous post, the Hong Kong government has responded to the healthy fiscal situation by announcing a tax cut. But is that a good idea? To answer that, we need to think about the role of Government policy.

In an ideal world, the government (and central bank) can use fiscal (and monetary) policy to try to smooth the economy over the business cycle. For Hong Kong, monetary policy cannot be used for this purpose, since it is effectively dedicated to maintaining the currency board system. That just leaves fiscal policy.

For fiscal policy to be a stabilising force in the economy, we'd like to see a relatively contractionary policy when the economy is booming, and an expansionary policy when the economy is contracting. That is, the government should be using it's policy to actively work in the opposite direction of the private sector to stabilise the overall performance of GDP.

Part of this work is automatic. In a recession, welfare payments and unemployment benefits automatically increase, spurring an expansionary fiscal policy, and this is further re-inforced by decreases in taxes as individuals experience pay decreases, and may even drop to lower tax rates due to the progressive tax system. We call these factors "automatic stabilisers" in the economy.

But the effect of the automatic stabilisers will result in the government tending to run a deficit in times of recession, and a surplus in times of rapid growth. And herein lies the rub.

For politicians trying to determine when and how to adjust taxes, they'll tend to cut taxes when the economy is booming, since they have a healthy surplus, and raise taxes when the economy is contracting, since they have an "unhealthy" deficit. This works against the automatic stabilization of the economy, and is in fact destabilizing.

It is easy to see this at work in Hong Kong. The following graph plots government revenue and spending- excluding transfers to and from funds- for Hong Kong over the past 12 years. First, we can see that revenue is far more cyclical than spending, with the government always running a surplus in the first quarter, and a deficit in the third quarter. This is simply due to the timing of tax payments.


The next graph demonstrates the (sometimes) destabilising nature of Hong Kong fiscal policy. The budget deficit as a percent of GDP, with the seasonal fluctuations smoothed out, (left hand axis) is plotted against the growth rate of real GDP (right hand axis).


In 2003/2004, for example, the government was running a large deficit, in large part due to SARS. The growth rate was also negative. What did the government do? They raised tax rates. (See page 20 here for details). That may have helped to lower the deficit, but it also helped to exascerbate the recession that hit Hong Kong.

Fast forward to the present time, and we have the same mistake being made, in reverse. The Hong Kong economy is booming- real GDP grew 6.9% last quarter- and the Government is running a large surplus. So now the Government cuts taxes, potentially fueling a further over-heating of the economy.

My preference would be for the government to limit any tax cuts so that they definitely do not need to be raised next time there's a downturn, or a SARS, or a birdflu, or a crash in mainland equity markets, or a..... I'm not being pessimistic here, but the reality of business cycles is that booms are followed by slumps. They always have been, and they always will be. And Governments should plan for them.

But in the meantime, if the government wishes to decrease my tax bill, I won't be saying no!

The HKMA is On Top of Things....

The Hong Kong Monetary Authority, Hong Kong's de facto Central Bank, is on top of things... literally! In fact, being housed in the top 11 floors of IFC2, the world's 7th tallest building (and Hong Kong's tallest.... at least until the new ICC building going up across the harbour adds a few more floors).

Of course that's just a play on words, and an excuse to post a photo taken from the 84th floor of IFC2 (below). I'm currently spending a few hours a week at the Hong Kong Institute for Monetary Research, an institute funded by the HKMA, writing a paper on Hong Kong's deflation.

Hong Kong has a unique experience of deflation, as the graph below shows. Out of all developed economies, none other has experienced as large and persistent a deflation in recent times as Hong Kong- Japan is included in the graph as a comparison. I am using this unique Hong Kong data to improve our understanding of the business cycle.





The reason why this data is unique to Hong Kong is in large part due to Hong Kong's monetary policy. With a currency board, the central bank cannot respond to a negative shock by loosening monetary policy, so the economy experiences the full force of the shock. Additionally, the exchange rate cannot adjust (that's what the currency board is designed to keep fixed); prices must adjust in their stead for Hong Kong to regain competitiveness after a negative shock. In the case of Hong Kong's deflation, there were actually four negative shocks in quick succession that resulted in continuous deflation for 68 months (from November 1998 until June 2004): a massive wealth shock, as the property bubble burst (residential real estate lost 70% of this value peak-to-trough), the Asian Financial Crisis, the dot-com bubble bursting, and SARS all contributed to Hong Kong's deflationary experience.

And here's the promised picture from the 84th floor, looking towards Sheung Wan, on one of those all-too-rare days in August when the pollution levels were low, and you realise that there are islands visible on the horizon that you haven't seen for years! (Click on the photo to enlarge).

Sports, sentiment, and cycles....

I can't sit here, as a native-born Kiwi (New Zealander) and not make a comment on the shocking result in the Rugby World Cup in the early hours of the morning, HK time. Completely against expectations, the world's top rugby team, and the most successful in the history of the sport, lost to France in the quarter-finals. There are many things I'd like discuss (like the refereeing), but I'll leave that to the experts. The fact is, based on current form, the All Blacks (as the NZ team are called) should have won by a large margin.

Let me first address the apparent contradiction of the top team failing to win the World Cup, and then get on to the macroeconomic implications of sports, and implications for China.

Rugby teams have different styles of play. Some are flamboyant, occasionally producing amazing results, but in the long run are likely to disappoint (like hedge funds); others play excellent, exciting rugby, win more often than not, but sometimes suffer major lapses (like equities); and others are dead boring, able to grind out a modest return under most circumstances, but fail to inspire in the long run (like bonds).

Of these three types, I'd characterise the All Blacks as the top equities fund of world rugby. For over 100 years, they have out-performed all other funds across all asset classes on average, but they've had significant set-backs along the way, in particular failing to win some crucial games at world cups! But maybe that's just a result of the structure of the world cup. To win, a team must beat three competitors on three consecuative weekends in sudden-death matches. Winning two by a large margin is irrelevant if you lose the remainder.

Consider the analogy of investing. Suppose your objective was to have the highest return in three consecuative pairwise comparisons with randomly selected alternative funds. Would the top equities fund win? There's a good chance of that if all the competitors were also equity funds. But the probability drops as the investment strategies of the opposition diverge from equities. For example, equities may have out-performed bonds consistently for as long we we've had data (and have now started out-performing hedge funds as well), but I'd expect equities to beat bonds in three consecuative periods (months, say) with a probability of less than 50%, since bonds consistently outperform equities in a falling market.

Of course that doesn't completely explain the Rugby World Cup: with one victory in 5 world cups, the most dominant team is running at a lowly 20% success rate! But at least it's a start.

The semi-finals of the cup include England (bonds) versus France (hedge fund) and the winner of South Africa (equities)/Fiji (hedge fund) versus the winner of Scotland (underperforming bonds)/Argentina (inexperienced hedge fund). As with investments, it's impossible to be sure what the outcome will be.

But lets get on to the macroeconomics of sport, since this is supposed to be a macroeconomics blog! New Zealand has a small population that is completely rugby obsessed. This obsession starts at birth, and aflicts nearly all members of the population, whether they've ever picked up an oval ball or not. Perhaps more so than in any other country, the performance of the national rugby team affects the mindset, optimism, and outlook of the population.

So what happens when the national team losses unexpectedly? National mourning and stunned disbelief. But maybe more. How about a recession?

Remember that expectations and optimism play a major role in the consumption and savings decisions of consumers. In the case of New Zealand, the current phase of the business cycle would suggest that this is particularly so. As with the United States until recently, the economy has been booming, largely on the basis of the "feel good" factor. This has fueled increases in house prices to historically unprecedented levels, which has in turn fueled large increases in consumption spending and investment (in new houses), driving the economy to new heights. The end result is unsustainable, with the current account deficit at worse than 8% of GDP, and record household debt levels.

This ponzi scheme of inflated real estate prices driving excessive consumption must at some point come tumbling down. Could a shock to expectations, in the form of the worst ever performance of the All Blacks at a world cup trigger such a correction? Time will tell.

Coming closer to home, the Chinese market is a "bubble of bubbles" according to some commentators. Hype about the coming olympics may be helping to drive up asset prices above fundamental levels. What happens when the olympics is over, especially if China fails to impress with a record medals haul? It's the final straw that breaks the camel's back, and the smallest pin that bursts the largest bubble....

The Fed Finally Cuts....

So the US Federal Reserve Board have finally cut interest rates by 50 basis points (that's half a percent). Despite increasing evidence of a coming recession from many fronts- falling house prices, increasing housing foreclosures, decreasing demand for durable goods including cars, weak labour market data, and dropping wholesale inflation rates- the Fed held off on interest rate cuts due to concerns that inflation was uncomfortably high.

Now that they have cut, economists are divided, with some believing that the fed has not done enough, and others believing that they've done too much, and inflation will now increase.

For my part, I'm in the "not enough" camp. The melt-down of the housing sector is gaining momentum, and I expect to see increasing evidence of the fall in house prices feeding into lower consumption figures. As demand falls back further, I think the inflationary concerns will take care of themselves.

(For further insights on the Fed rate cut, check out Nouriel Roubini and James Hamilton).

When the US has a cold, the rest of the world catches... ?

If the US has a recession, what will be the effect on the rest of the world? This question has bounced around for some time now.

In one corner are the optimists. The lack of demand from the US will be largely replaced by an increase in demand from Asia, they argue, so that the world economy will continue to grow unabated. It's a nice story, but seems a little optimistic in my view. For a start, the largest Asian economies- Japan and China- look unlikely to take up any slack from the US. The latest macro news from Japan was weak- GDP decreased 1.2% last quarter.

For China's part, a substantial increase in domestic consumption would be required for it to provide much imputus to global growth. Increased consumption is the flip-side of decreased savings.... and China's disproportionate savings rate is due to deeper structural problems, which show no likelihood of abating any time soon. In an economy with poor quality, expensive, inadequate health care, rational consumers will always tend to oversave... the alternative is the possibility of premature death, for want of effective health care.

So if Asia can't replace a lack of demand from the US, what about Europe? Europe is already running on all cylinders, and significantly outperforming the US economy at the moment- despite a much lower population growth rate that would normally result in lower economic growth on average. To expect more from Europe may be to expect too much.

The bigger concern is that a recession in the United States might have serious negative consequences for Asia, leading to a further slowdown in world growth. Both Japan and China depend heavily on exports to the US for their own domestic economic health, lending credence to this argument. If so, hang on for a rollercoaster ride of an economy for the next couple of years!

For a related viewpoint, see Menzie Chinn's analysis here.