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.

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.

Discouraged Workers and Unemployment...

According to the text, if discouraged workers are not counted as unemployed, the unemployment rate will be understated during recessions. Why is this? - Jane

The unemployment rate = 100* unemployment / (unemployment + employment). An increase in the number of discouraged workers decreases both the numerator and the denominator by the same amount. But because the numerator (unemployment) is much smaller than the denominator (unemployment + employment), in percent terms the numerator declines by more. Hence the measured unemployment rate falls.

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.")

The dire outlook for the US economy....

Back to my recurring theme of arguing that the US economy is heading for recession (last installment here), both Roubini and a Financial Times columnist argue that things are worse, and the economy is heading for a generalised systematic financial meltdown.

At some point, perma-bears like Roubini may overstate their case... and if Roubini doesn't, someone else will. Pessimism is like a commodity: there's a market for pessimistic economic projections. And the markets almost always overshoot. In this case, I'll be surprised if Roubini is not still calling for a worsening recession even once the economy starts to recover.

But, for the record, I think that point is still a long way off....

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......

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.

Housing wealth shock... US version

When the property bubble in Hong Kong burst, average Hong Kong apartment prices fell about 66% according to the official index between the peak (October 1997) and trough (July 2003) (for a graph, click here). The result of this was a long-term recession, deflation, and general economic malaise.

The United States is now epxeriencing a bursting property bubble. Few expect the correction to be as large as that experienced in Hong Kong, and to date prices have only dropped a few percentage points. But this may be just the beginning- see this news clip on YouTube for more. Expect a similar consequence for the US economy as HK's.

Thanks to Calculated Risk for the link.

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!

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....

Fed Rates and Exchange Rates....

One effect of the Fed rate cut has been a further fall in the value of the US dollar against most other currencies, as a direct result of the drop in relative returns on US fixed income assets.


To focus on just one currency pair, for the first time in 30 years, the Canadian Dollar looks set to surpass the US dollar (see graph above).

Given the increasing importance of oil and other commodity prices in driving the appreciation of the Canadian dollar, I think an abrupt fall in commodity prices is the only possibility of the Canadian dollar not surpassing the value of the US dollar in short order. (According to http://www.xe.com/, the Canadian dollar is currently trading at 0.9904 US Dollars).

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.

Labour Market Data

Some excellent anaylsis on the latest labour market data in the US from Econobrowser.....

Interest Rates and Recessions....

"Why do bond prices increase in a recession?" - Catherine

That's an excellent question! First not all bond prices necessarily increase.... it depends in part on the conduct of monetary policy, as we'll see.

But first lets step back and think about how bonds work. A bond is a financial asset that will pay out a fixed sum of money at some point in the future, along with a stream of interest payments until then. Without loss of generality, we'll ignore the interest payments, since they can be accounted for by appropriately adjusting the bond price. So we'll focus on a bond that pays only at maturity.

Suppose you hold such a bond. For the purpose of our example, we'll suppose that the amount paid at maturity is $1. Further, suppose that the bond has a market price today of $B. The return (or interest rate) on that bond until maturity can be easily computed as Int = (1-B)/B. That is, the return less what you paid for the bond, divided by what you paid. The point to notice is that the interest rate is inversely related to the bond price: an increase in B causes Int to fall, and vice versa.

So we've established that the bond price and the interest rate that the bond pays are inversely related. Now, in a recession bond prices may increase significantly, for at least two reasons:

1) "flight to quality." Uncertainty about the state of the economy may lead investors to be worried about holding too many equities or other risky assets, and instead wish to hold relatively low risk assets like bonds instead. If investors start buying bonds in large numbers, the demand for bonds rises, driving up the price of bonds. The increased price of bonds provides a windfall for existing bond holders, and results in interest rates falling (as per our formula above).

2) monetary policy. In many countries, the central bank sets monetary policy to try to stabilise the economy in response to shocks. In a recession, they seek to reduce the severity of the economy by cutting interest rates and stimulating demand. But if interest rates for some classes of assets start to fall, investors will re-allocate their investment portfolios to take advantage of the new lower interest rates. The end result will be that interest rates tend to fall across most classes of assets. Again, a fall in interest rates on bonds implies an increase in bond prices, and therefore a gain for existing bond holders.

Of the two effects outlined above, 2) is the most important, as the case of Hong Kong illustrates. Here the Currency Board mechanism ensures that monetary policy is committed to maintaining the fixed exchange rate, rather than stabilising the economy in response to shocks. So the central bank cannot cut interest rates in response to a recession.

Further, the fixed exchange rate ensures that interest rates remain similar between Hong Kong and the United States; otherwise arbitrage opportunities would open up (borrowing money at low interest rates in one economy to lend at higher interest rates in the other economy). Given the relative sizes of the Hong Kong and US economies, that means our interest rates will tend to fall when the US has a recession, regardless of what is happening in Hong Kong!

So if you think there's going to be a recession in Hong Kong, holding Hong Kong Dollar denominated bonds is unlikely to offer much protection, or prospective profits!

Timing The Coming US Recession.....

For quite a while now, I've been arguing that the US economy is on the brink of recession (see, for example, here, here and here). I have seen little to change my mind on this one, although I am surprised that the recession is taking so long to arrive! There are two possible responses to this:

1) I am wrong; the US is not on a path to recession
2) I am right; but the recession is still coming

I'll stick with 2) for now, but there is a very important lesson here about the ability of economics to predict the future. Even if I'm right, it is very difficult to predict the timing of economic corrections.

In the case of the current business cycle, there remains clear evidence that the market is on a path to correction. The essential story is the same as I have mentioned before. The US has enjoyed several years of economic growth as a result of increasing asset prices- especially in the real estate sector. Households have used some of this increased perceived wealth to increase their consumption, by withdrawing equity from their homes. With consumption making up 70% of GDP in the US, this feeds through into increased economic growth.

But there are some risks to this process: now real estate prices, which have been pushed up artificially by easy access to credit (see here), have started falling. The whole process that pushed up economic growth in the past goes into reverse, and before we know it, the US is in recession.

But how long does it take for this process to work its way through the economy? Well, that all depends on how quickly individuals respond to decreased real estate wealth by reducing their consumption. And that is very difficult to predict, although there is some evidence of this effect now- see, for example, this story on CNN.

If it were easy to predict the timing of economic events, then we'd know exactly when to take leveraged positions in US Government bonds (since the Federal Reserve Board will cut interest rates if the US enters a recession, increasing the value of existing bonds), and Macroeconomics would be a recipe for making money. But alas, Macroeconomists are poor at predicting timing. Or, as an Economist for a major international bank recently remarked to me, "there's a big difference between being right and being able to make money." From the point of view of making money, timing is everything.

Predicting Financial Crises....

Financial crises are rare events that seem to creep up on us, and then unleash a torrent of turmoil, laying financial waste to the macroeconomic environment. They seem unpredictable - in part because the final trigger of a crash may be something seemingly minor, and of little real financial consequence it its own right. Yet our inability to predict them doesn't stop analysts from trying. At any given point in history, there are sure to be some predicting a crisis just around the corner!

Sometimes it's a useful thought experiment to consider the state of the macroeconomy and try to figure out risks to its continued growth, and growing imbalances that might lead to future crises. It forces us to spell out our underlying model of the macroeconomy, and the implicit assumptions we make about financial markets.

For your bedtime reading, Mark Gilbert outlines one such thought experiment in the context of a story on Bloomberg here.

Related Reading: "Why Stock Markets Crash."

Monetary Policy and Dragon Slaying

The objectives of monetary policy are very different in different economies. For example, Singapore seeks to stabilise the exchange rate against a basket of other currencies. Many central banks seek to maintain the inflation rate on consumer goods in the low single-digits (referred to as "inflation targeting"). The Federal Reserve in the United States seeks to "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," although in recent years its behaviour has looked much like an inflation targeter.

Stepping back, each of these objectives is chosen based on an over-arching concern that monetary policy should increase stability in the economy. Because economies have different structures, different objectives may be appropriate for different economies, and at different times.

To understand why "inflation targeting" is so popular today, a little history is helpful. The 1970's were a disastrous period of monetary policy. Inflation rates increased into the high teen's in many developed economies, reducing economic stability. Inflation targeting was an appropriate and timely foil to this problem. It was pioneered by one of the worst performing central banks in the developed world over this period, the Reserve Bank of New Zealand, but was quickly adopted by other countries as a transparent way to maintain stable inflation at minimal cost to the real economy.

So the inflation dragon has been slayed; does that mean that central banks can relax, knowing that they are achieving their objectives? Unfortunately, the answer is "no." While price stability is important, it is just one element in achieving a stable economy. Further, there is increasing evidence that slaying the inflation dragon has allowed another, potentially more ominous dragon, to grow in its absence.

What I am talking about here is asset price bubbles. Low and stable inflation over a decade or more has ensured that consumers and investors at large have come to expect low inflation in the future. They know that if the inflation rate jumps, the central bank will quickly respond by increasing interest rates, stabilising inflation. Thus, not worried about surprise inflation, they are content with moderate wage increases, sustaining low inflation as an equilibrium.

With little inflationary pressure, central banks have been able to increase the money supply (or equivalently lower real interest rates) below historical levels. The resulting cheap credit and excess liquidity has led to increased demand for assets, pushing up equities and real estate prices in many countries. To some extent, this is an appropriate outcome: lower real interest rates imply that the opportunity cost of owning equities or real estate is lowered, encouraging higher real prices. My concern is that this process has gone too far, and the prices of many assets now exceed fundamental levels. And when asset price bubbles develop, they must eventually burst.

Examples of possible asset price bubbles vary by country. In the US, UK, Australia, New Zealand, Spain, etc, I would point to real estate as a probable bubble, and one that is starting to burst in the US at least (see my earlier posts here, here, and here). For China, the bubble appears to be equities (see my earlier posts here and here).

Suppose that the arguments I'm making here are correct. Because boom-bust cycles are disruptive for the real economy, monetary policy is not achieving its ultimate objective of economic stability, regardless of its effectiveness at stabilising prices or exchange rates.

What should we do about it? That's the million dollar question! In principle, existing monetary policy tools could be used to try to prevent asset price bubbles developed, but that may require extreme changes in interest rates, which themselves would be destabilising. I'd also be very skeptical of the ability of any central bank to correctly detect bubbles in the long run. That is because it is not always clear whether a rapid increase in asset prices represents a bubble.

But there are some simple first steps that a central bank could take. For example, if inflation is benign but asset prices are roaring ahead, the central bank should be hesitant at cutting rates, and maybe should raise rates at the margin.

These are just my preliminary thoughts on this important topic. I think that this is one of the potential big new areas where central bank behaviour is likely to change in the coming decade, although I have no idea at this point what form such changes are likely to take. I'll blog more on this topic in the near future.....