Saturday, November 29, 2008

Was the American Revolution the Product of a Boom-Bust Cycle?

Ronald W. Michener and Robert W. Wright say yes. According to this article, these authors have "worked for several years on a manuscript arguing that the American Revolution was a direct result of the economic malaise that followed the French and Indian War." So how exactly does their story unfold? From the article:
For the colonists, as for us, first came the boom. During the height of the French and Indian War, which lasted from 1754 until 1763, money flooded into the colonies, especially New York, where the British Army was headquartered. At the same time, the New York Legislature issued large numbers of bills of credit.

All that cash sloshing around resulted in lavish displays of wealth — notably by British officers, whose opulent living was emulated by the locals, especially in New York.

Housing prices soared during the war. But when credit tightened afterward — thanks in no small part to a prohibition on the issuance of paper money by the colonies under the Currency Act of 1764 — real estate owners who could not pay their debts lost their land.

[...]

At the core of the Wright-Michener argument is that this confluence of nasty economic circumstances was what produced the anger that found expression in rebellion against the Stamp Act and other British taxes. In other words, the core economic culprit was a boom-bust cycle; convinced that their future was no longer in their hands, the colonists could summon the ghost of John Locke, setting the stage for the arguments of Tom Paine and the Declaration.
I wonder if Niall Ferguson included this story in his new book.

Paul Krugman Versus Christina Romer

Paul Krugman is questioning whether the Great Depression was truly a monetary phenomenon. He apparently missed Christina Romer's article "What Ended the Great Depression?" where she shows that monetary developments were key not only to the economic recovery of 1933-1936 but also for the post-1938 recovery. These developments were what I would call unconventional monetary policy: FDR's devaluing gold, gold inflows from abroad, and Treasury choosing not to sterilize them. See here for more discussion of her findings--including a striking figure that shows what would have happened had there not been these monetary developments--and how it raises questions for the World War II-ended-the-Great-Depression story.

Update: See Josh's comments below and Zubin Jelveh's take on the numbers.

Wednesday, November 26, 2008

What Corporate Bond Yield Spreads Tell Us

Recently, a number of concerned observers took note of the rising cost of corporate borrowing by looking at real interest rates on AAA-rated and BAA-rated bonds. Let me add to their concern by looking at the BAA yield minus AAA yield spread. Whenever the spread between these two securities increases the market believes there to be a higher probability of default for the riskier BAA rated bonds. The spread may also increase as a result of the BAA securities becoming less liquid, either as a result of their increased riskiness or because of stress in financial markets. Since there are a large number of firms in these measures, the spread provides a good indicator of economy-wide stress facing firms. The spread, therefore, provide some insights into the overall state of the economy. The figure below graphs the spread and the officially dated NBER recession with gray bars. The data comes from the St. Louis Fed, has a monthly frequency, and runs through 11/24/08. (click on figure to enlarge.)

The figure shows that spread is now notably higher than it was during the 1973-1975 and early 1980s recessions. Moreover, the spread indicates corporate borrowing is now as stressed as it was during the second half of the Great Depression. So what does this mean for the real economy? To answer that question I took spread data for the entire period and plugged it along with the Fed's monthly industrial production series (also from St. Louis Fed) into a Vector Autoregression (VAR) with 13 lags (enough to eliminate serial correlation). Using the estimates from this simple VAR I was able to do a dynamic forecast of industrial production through the end of 2009. The figure below shows the results of this exercise. The blue portion of the line is the actual series while the red line is the forecast. (click on figure to enlarge.)


This simple bivariate model indicates the recession will last through August 2009. This implies that if the recession began in January 2008, then it should be a 20 month recession overall. This forecast assumes, though, the spread reaches a peak this month. If this assumption proves to be incorrect then the trough would be pushed back to a later date.

Tuesday, November 25, 2008

Monetary Policy Ended the Great Depression...

and not fiscal policy, according to Christina Romer in her 1992 JEH paper. Tyler Cowen recently referenced this article--amidst the New Deal debate ragging between Alex Tabarrok, Eric Rauchway, Paul Krugman, and others--and I want to follow up by noting a few more details from its conclusions. First, Romer found that fiscal policy was inconsequential not only in the early -to-mid-1930s, but also as late as 1942. Her results call into question the traditional view that World War II-driven fiscal policy ended the Great Depression. Second, Romer shows that it was monetary developments that ended the Great Depression, both in the mid- and late-1930s. In her own words:
The money supply grew rapidly in the mid- and late 1930s because of a huge unsterilized gold inflow to the United States. Although the later gold inflow was mainly due to political developments in Europe, the largest inflow occurred immediately following the revaluation of gold mandated by the Roosevelt administration in 1934. Thus, the gold inflow was due partly to historical accident and partly to policy. The decision to let the gold inflow swell the U.S. money supply was also, at least in part, an independent policy choice. The Roosevelt administration chose not to sterilize the gold inflow because it hoped that an increase in the monetary gold stock would stimulate the depressed economy.(p. 781)
So a defacto easing of monetary policy was the source of the 1933-1937 recovery as well as the one after 1938.

To make these findings more concrete, Romer performed some counterfactuals to demonstrate what would have happened had there not been expansionary macroeconomic policies. She does this by showing the actual path of real GNP and its path under non-expansionary policies. The difference between the two series show the importance of the expansionary policy that took place during this time. First she shows the impact of fiscal policy:Note there is no meaningful difference between these series. Hence, there was no real expansionary fiscal policy, even as late as 1942. Next, she shows the effect of monetary policy:
Here there is a significant difference. Romer concludes "real GNP would have been approximately 25 percent lower in 1937 and nearly 50 percent lower in 1942 than it actually was if the money supply had continued to grow at its historical average."

So much for the World War II story. But wait, Romer does notes that World War II can still be credited in a different way for ending the Great Depression:
However, Bloomfield's and Friedman and Schwartz's analyses suggested that the U.S. money supply rose dramatically after war was declared in Europe because capital flight from countries involved in the conflict swelled the U.S. gold inflow. In this way, the war may have aided the recovery after 1938 by causing the U.S. money supply to grow rapidly. Thus, World War II may indeed have helped to end the Great Depression in the United States, but its expansionary benefits worked initially through monetary developments rather than through fiscal policy.

Once again we are reminded that monetary policy matters.

Update: To be clear, Romer does not say fiscal policy could not be effective only that it was not really tried. See Mark Thoma for more on this point.

Monday, November 24, 2008

Niall Ferguson

Niall Ferguson must never tire. He produces books so rapidly one wonders whether he ever sleeps. Ferguson's latest book is the The Ascent of Money. According to the cover, Ferguson shows that "finance is in fact the foundation of human progress. What’s more, he reveals financial history as the essential backstory behind all history." I love the implication: one cannot be a real historian unless one understands finance and economics. With such a ringing endorsement of my profession I am looking forward to getting a copy. There is also this interesting interview with Ferguson regarding his new book:



PBS will be airing a series to accompany this book in January. If you want a taste of Ferguson's writing without buying one of his books, take a look at his recent article in Vanity Fair titled "Wall Street Lays Another Egg."

More on the Business Cycle and the Church

I just presented a paper this past weekend looking at the dynamic response of religious participation and religious giving to economic shocks. This paper follows an earlier one where I found a strong countercyclical component to religious participation by evangelical Protestants and a slightly procyclical component for mainline Protestants. Economic theory provides good motivations for these results. Given my interest in this field of economics--yes, I am macroeconomist dabbling in the economics of religion--I was pleased to find the following video clip on CNN. It shows people turning to church as a means to smooth their consumption over this business cycle.


Saturday, November 22, 2008

Liquidity Premium Sign of the Times

The Cleveland Fed used to provide TIPS-based expected inflation estimates that accounted for the TIPS liquidity premium. No more. (Click on figure to enlarge)

Thursday, November 20, 2008

Donald Kohn on Excess Reserves & the 2003 Deflation Scare

This past Wednesday I was able to attend the CATO Institute's 26th Annual Monetary Policy Conference. They had a number of interesting speakers, but the keynote speaker was Federal Reserve Vice Chairman Donald L. Kohn. He gave the first talk of the conference and then took questions from the audience. His talk was an interesting one where he reevaluated whether the Fed should attempt to check asset bubbles. Here, however, I want to focus on two of the comments he made after the talk.

The first comment had to do with the policy of paying interest on excess reserves. Someone from the audience asked him if this policy was counterproductive since it discouraged banks from lending at the very time they should be encouraged to lend. Kohn's answer was that these excess reserves would still be sitting at the banks even if the Fed were not paying interest on them. I find this view hard to accept. Surely some of these excess reserves are being held because of the interest payments. Why would any bank lend excess reserves to another one when the bank is guaranteed the federal fund rate target by the Federal Reserve? If you want to see the potential downside to this policy look no further than the Fed's 1936-1937 monetary policy.

The second comment is one that Kohn shared with me directly. As I was leaving the auditorium after one of the talks I saw that Kohn was right behind me. I took advantage of this opportunity by asking him a question that went something like this: "You mentioned that the low inflation in 2003 indicated economic weakness and, thus, justified the accommodative monetary policy at that time. Couldn't one also view the low inflation in a more benign manner by interpreting it as the result of the rapid productivity gains rather than weak aggregate demand?" His answer was "No. Productivity was not growing. Moreover, unemployment was growing at the time." I appreciate him answering my question, but have to respectfully disagree with his response. Here is why: (1) data shows productivity was growing and (2) the weak labor market--called at the time the "jobless recovery"--can easily be understood as a response to rapid productivity gains. One could also make the argument that the weak labor market conditions were the result of the Fed's low interest rates creating an inordinate substitution of capital for labor.

These next three figures make my case. The first figure shows productivity--as measured by non-farm business labor productivity--did see an acceleration in its year-on-year (Y/Y) growth rate around 2003:


The figure also shows the ex-post real federal funds rate (ffr) relative to Y/Y the productivity growth rate. Assuming there were no significant changes in intertemporal preferences and population growth rates, this first figure suggests the Fed was pushing its policy rate down as the natural rate--which is a function of intertemporal preferences, population growth rate, and productivity growth rate--was increasing.

The next figure shows the Y/Y growth rate of nominal spending--measured by final nominal sales to domestic purchasers--against the nominal ffr. The year in question, 2003, is highlighted by the two dashed lines. This figure indicates nominal spending or aggregate demand was not collapsing in 2003. The ffr, on the other hand was being pushed to down to 1%.


So productivity was increasing and aggregate demand was not collapsing. What about the weak labor market? As mentioned above, one story is that the "jobless recovery" was simply the consequence of the productivity gains. Another story is that the existing low ffr was pushing the cost of capital down and encouraging an inordinate substitution of capital for labor by 2003. In either case, there is no justification for further lowering of the ffr in 2003. The figure below sheds some light on this view. It graphs real gross private domestic investment against total nonfarm employment with the year 2003 again delineated.


This figure shows a sharp increase in investment spending in 2003 while employment remained more or less flat. Firms, therefore, were building up their capital stock while avoiding new additions to labor. I suspect monetary policy was a key reason for this development. For those who are interested, I was able to ask a similar question to Ben Bernanke back when he was a Fed governor. See his response here.

Update: The ever insightful ECB points out that the figure above that uses real gross domestic private investment reflects both residential and non-residential investment. Clearly, my capital substitution story hangs on non-residential investment recovering while labor remained flat. Real non-residential investment is graphed below with nonfarm employment:


This figure shows that non-residential fixed investment was recovering in 2003 while employment remained flat. However, it did not recover as sharply as gross domestic private investment overall.

Wednesday, November 19, 2008

Larry White on How the Fed Contributed to the Housing Boom

I have made the case here many times that the Fed's monetary policy in the early-to-mid 2000s was inordinately loose, and as a result, helped create the housing boom. Two channels through which this accommodative monetary policy affected the housing sector is that it (1) encouraged households to take on excessive leverage and (2) created a "search for yield" environment where investors looked at investment options they normally would ignore (e.g. subprime MBS). Larry H. White in this new paper adds another channel:
The Fed’s policy of lowering short-term interest rates not only fueled growth in the dollar volume of mortgage lending, but had unintended consequences for the type of mortgages written. By pushing very-short-term interest rates down so dramatically between 2001 and 2004, the Fed lowered short-term rates relative to 30-year rates. Adjustable-rate mortgages (ARMs), typically based on a one year interest rate, became increasingly cheap relative to 30-year fixed-rate mortgages. Back in 2001, non teaser ARM rates on average were 1.13 percent cheaper than 10-year fixed-mortgages (5.84 percent vs. 6.97 percent). By 2004, as a result of the ultra-low federal funds rate, the gap had grown to 1.94 percent (3.90 percent vs. 5.84 percent). Not surprisingly, increasing numbers of new mortgage borrowers were drawn away from mortgages with 30-year rates into ARMs. The share of new mortgages with adjustable rates, only one-fifth in 2001, had more than doubled by 2004. An adjustable-rate mortgage shifts the risk of refinancing at higher rates from the lender to the borrower. Many borrowers who took out ARMs implicitly (and imprudently) counted on the Fed to keep short-term rates low indefinitely. They have faced problems as their monthly payments have adjusted upward. The shift toward ARMs thus compounded the mortgage-quality problems arising from regulatory mandates and subsidies.
Read the whole paper here.

Monday, November 17, 2008

Another Economic Prophet: Peter Schiff

I have labeled Nouriel Roubini and Andy Xie as certified economic prophets for calling the financial crisis ahead of time. Let me add Peter Shiff to the list. He too warned of the looming financial crisis. What is really remarkable is that he made this call many times despite the intense ridicule he received from the naysayers. See him get scorned below:




I admire Peter Schiff's resolve. Thanks to my student Adam Alderman for the pointer.

Wednesday, November 12, 2008

Did the "Great Moderation" Contribute to the Financial Crisis?

Since the early-to-mid 1980s there has been a pronounced drop in macroeconomic volatility. This development has been called the "Great Moderation" and can be seen in the figure below. This figure shows the rolling 10-year average real GDP growth rate along with one-standard deviation bands. These standard deviation bands provide a sense of how much variation or volatility there has been around the 10-year average real GDP growth rate. The figure shows a marked decline in the real GDP volatility beginning around 1983. (Click on figure to enlarge)

Solid line = 10 year real GDP growth rate rolling average
Dashed line = 1 standard deviation

Something I have been wondering lately is whether this "Great Moderation" contributed to the financial crisis by creating complacency about macroeconomic conditions. Is it possible that policymakers, investors, and others came to believe that improvements in macroeconomic stability were a given and, as a result, let their guard down? Thomas Cooley believes this may be the case:
There is another, deeper possible link between the Great Moderation and the financial crisis that is worth thinking about, because it may help to inform the financial regulation of the future. The idea is simply that the decline in volatility led financial institutions to underestimate the amount of risk they faced and overestimate the amount of leverage they could handle, thus essentially (though unintentionally) reintroducing a large measure of volatility into the market.

Financial institutions typically manage their risk using what they call value at risk or VaR. Without getting into the technicalities of VaR (and there is a very long story to be told about the misuse of these methods), it is highly likely that the Great Moderation led many risk managers to drastically underestimate the aggregate risk in the economy. A 50% decline in aggregate risk is huge, and after 20 years, people come to count on things being the same.

Risk managers are supposed to address these problems with stress testing--computing their value at risk assuming extreme events--but they often don't. The result was that firms vastly overestimated the amount of leverage they could assume, and put themselves at great risk. Of course, the desperate search for yield had something to do with it as well, but I have a hard time believing that the managers of Lehman, Bear Stearns and others knowingly bet the firm on a systematic basis. They thought the world was less risky than it is. And so, the Great Moderation became fuel for the fire.
So as much as the Great Moderation has been praised, it may turn out to be a key contributor to the biggest financial crisis since the Great Depression.

Sunday, November 9, 2008

The Challenges Ahead

Nouriel Roubini reminds us of the challenges facing President-elect Obama over the next few years:
Obama will inherit [an] economic and financial mess worse than anything the U.S. has faced in decades: the most severe recession in 50 years; the worst financial and banking crisis since the Great Depression; a ballooning fiscal deficit that may be as high as a trillion dollar in 2009 and 2010; a huge current account deficit; a financial system that is in a severe crisis and where deleveraging is still occurring at a very rapid pace, thus causing a worsening of the credit crunch; a household sector where millions of households are insolvent, into negative equity territory and on the verge of losing their homes; a serious risk of deflation as the slack in goods, labor and commodity markets becomes deeper; the risk that we will end in a deflationary liquidity trap as the Fed is fast approaching the zero-bound constraint for the Fed Funds rate; the risk of a severe debt deflation as the real value of nominal liabilities will rise given price deflation while the value of financial assets is still plunging.

[...]

So let us not delude each other: the U.S. and global recession train has left the station; the financial and banking crisis train has left the station. This will be a long and severe and protracted two year recession regardless of the best intentions and good policies of the new U.S. administration. It will take a lot of hard work and sound policies to clean up this mess and reduce the length and severity of this economic contraction.
Expect a few more gray hairs from out next President.

Will the Euro Survive?

I was a little puzzled last week after reading Wolgang Munchau's column in the FT. He noted that some of the European countries outside the Eurozone--specifically Denmark, Hungary, Iceland--are now wishing they were members and probably will become so in the near future. Based on these developments he argued the global financial crisis should actually lead to an enlargement of the Eurozone. While his argument makes sense in the case of the few countries mentioned above, what about the broader Eurozone? Does not the global financial crisis add more stress to the viability of the Eurozone? In a reply to Munchau, Desmond Lachman says yes:
Sir, Wolfgang M√ľnchau seems to be very wide of the mark in asserting that the present global financial crisis will lead to the early expansion of the eurozone... For, as the marked widening in interest rate spreads on Italian and Spanish government bonds would suggest, the more pressing question raised by the crisis is not so much whether the eurozone will expand but rather whether or not the euro can survive in its present form.

In 1998, when the euro was launched, Milton Friedman famously warned that the euro would be truly tested by the first major global economic recession. He issued this warning in the belief that, lacking labour and product market flexibility, Europe was not an optimum currency area in the sense that was the case of the U.S. economy.

Judging by October's alarming plunge in global equity prices and the virtual freezing up in global credit markets, there can be little doubt that Europe, along with the United States, is at the start of its worst economic recession in the postwar period. And judging by the bursting of Spain's outsized housing market bubble and by the precarious state of Italy's public finances, there can be little doubt that Spain and Italy will be the two major European economies that will be put to the severest of tests as the global recession deepens.

For in order to cope with their respective problems, Spain and Italy will need low interest rates and weak currencies that continued euro membership clearly precludes.
In short, Lachman is questioning whether the Eurozone in its current form is an optimal currency area and, thus, whether it can truly survive. Apparently, so are some investors thinking this way. Over at intrade.come there is a contract on whether "any country using the Euro to announce their intention to drop it on/before December 2010." Here is the latest figure--where price equals probability-- from the contract (click figure to enlarge):


Currently the probablity of say Spain or Italy leaving the Euro is between 30-35%. Although not very high, it is a sizable increase from when the contract was introduced in early 2008. So what is the future of Euro?

Update: Here is a related post from Naked Capitalism. Here are some papers from a conference on the future of the Euro hosted by The Economist magazine and CATO.

Thursday, November 6, 2008

An Impressive Recession Indicator

Add this metric to your list of recession indicators: the year-on-year change in civilian unemployed - 15 weeks and over. Whenever this measure exceeds 0% for a sustained period there has been a recession. This pattern can be seen in the figure below, where NBER-dated recessions are in gray bars (click on figure to enlarge):


The consistency of this pattern is remarkable. Thanks to Robin G. Brown, one of my students, for pointing this relationship out to me.

Wednesday, November 5, 2008

More Excess Reserve Buildup Ahead

Bloomberg reported yesterday that the Federal Reserve is encouraging more hoarding of excess reserves by banks shoring up its efforts to "sterilize" its injections of liquidity to the banking system:
Nov. 5 (Bloomberg) -- The Federal Reserve boosted the interest rate it pays banks for the excess cash they keep on deposit, aiming to prevent its record injection of funds into the financial system from affecting its monetary policy.

``The rate on excess balances will be set equal to the lowest Federal Open Market Committee target rate in effect during the reserve maintenance period,'' the Fed said in a statement. The federal funds target stands at 1 percent.
The WSJ's RTE blog also noted this development and reported the Federal Reserve believes this move "would help foster trading in the funds market at rates closer to the FOMC’s target federal funds rate." In response, a perplexed reader named "confused" left the following comment at the RTE blog:
Why? The entire point to flooding the market with liquidity was to get inter-bank and bank-corporation lending started again. If that leads to a traded fed-fund rate less than the target rate, that just means the excess liquidity still needs time to work. This move seems to completely negate the prior efforts. I ask again: why???
Great question from "confused." Here are my thoughts on this matter.

Update: A reader in the comments section directs us to FT.com/Alphaville where Sam Jones provides further insight on this development. He argues we are in a liquidity trap, the Fed now recognizes it , and as a result it may cut back on sterilizing its liquidity injections. I hope Sam is correct. What do you think?