Are We Out of the Woods Yet?

We learned today that the economy contracted far more than expected--6.1% on annualized basis versus and expected 4.6%-- in the first quarter of 2009. While some observers find this continued plunge troubling, others like Jim Hamilton and Calculated Risk find some comfort that the underlying numbers are moving in a manner consistent with the economy reaching a bottom. Specifically, they note that historically consumption starts to recover in the later part of the recession even as nonresidential investment is falling--something that happened this past quarter. I hope their assessment is correct.

There are, however, reasons to be cautious. First, it may be asking too much to use past U.S. historical patterns to infer what is happening today with the U.S. economy. This is because the current recession, unlike many of the past ones, is truly global in nature and is far more pronounced than any other post-World War II global recession. Given that there are still many problems with the global economy--banking problems in Western Europe, collapse of global trade, large output gap in global economy, China's discomfort with holding dollar reserves--it would not take much (say a swine-flu pandemic?) to cause further declines in the world economy and , in turn, the U.S. economy. Second, there is still the big bank insolvency problem lurking in the United States. As discussed here and in many other places, the U.S. government has yet to forcefully address this problem. (Though David Leonhardt indicates today there may be progress on this front.) It needs to be done, but at the same restructuring large parts of the banking system--that is making bank creditors take a hit--could create another severe credit crunch. Finally, there is always the chance of a deflationary spiral taking hold in the United States as U.S. domestic demand continues to collapse as seen in this figure (Click on figure to enlarge):


More declines in nominal spending like this is a sure way to let loose deflationary expectations. Although we are not there yet, Rebecca Wilder notes that in many places nominal wages are headed down. Again, I hope this past quarter was indeed the bottom, but until we know for sure Ben Bernanke needs to keep his helicopter running around the clock.

Steve Hanke on the Fed's Policies

Steve Hanke makes the case that the Fed's misreading of the deflationary pressures in the early-to-mid 2000s caused it to overreact at the time:

One of our problems is the Fed's preoccupation with the risk of deflation. Fixated on this risk in 2002 and 2003, Greenspan pumped out dollars, cutting the Fed funds rate down to 1%. The easy credit boom continued, inflating asset prices...

What the Fed has failed to realize is that most deflations are good ones, not bad ones. During the last two centuries there have been many deflations throughout the world. Almost all of them have been good ones precipitated by technological innovation, rising productivity, global capital flows and sustained economic growth. If farm mechanization cuts the price of wheat, you get a rising living standard. This is good.

Instead of lowering interest rates seven years ago, the Fed should have raised them. This would have blunted the credit boom that led to the bubble. The most visible excess was a buildup in debt relative to GDP and a deterioration of debt quality. Combined government, corporate and household debt is now 250% of annual GDP, double what it was a generation ago. A lot of the debt on both corporate assets and houses is junk. It can be repaid only by refinancing on the back of ever higher asset prices.

As readers of this blog know, I take a similar view on the deflationary pressures at that time. However, I have also argued there were a number of factors that came together--not just loose monetary policy--to create the perfect financial storm. Still, a good look at the evidence indicates the Fed's approach was highly distortionary at the time.

Going Negative Can Be Good...

According to a staff report from the Federal Reserve. From the Financial Times we learn the following:

The ideal interest rate for the US economy in current conditions would be minus 5 per cent, according to internal analysis prepared for the Federal Reserve's last policy meeting.

The analysis was based on a so-called Taylor-rule approach that estimates an appropriate interest rate based on unemployment and inflation.

A central bank cannot cut interest rates below zero. However, the staff research suggests the Fed should maintain unconventional policies that provide stimulus roughly equivalent to an interest rate of minus 5 per cent.

Fed staff separately estimated what size and type of unconventional operations, including asset purchases, might provide this level of stimulus. They suggested that the Fed should expand its asset purchases by even more than the $1,150bn (€885bn, £788bn) increase policymakers authorized at the last meeting, which included $300bn of Treasury purchases.

[...]

Still, many Fed officials expect they may well keep rates near zero for another 18 months to two years and some might see value in making this more explicit...

Wow--expanding its money creation beyond the additional $1.15 trillion and keeping interest rates at zero another 18 months. Now that is some real anti-deflationary firepower. It also makes it incredibly challenging for the Federal Reserve to reverse itself once the recovery takes holds, more so than I previously imagined. As The Economist noted in a recent article, a "messier, more political future awaits" the Federal Reserve once this crisis is over.

Only One Recession-Proof Industry Left

Can you find it in the table below? (Click on figure to enlarge.)



Yes, the government sector has taken a hit leaving the education and health services sector--okay, that is technically two sectors but I am using the BLS categories--as the only one that continues to grow. Below is a figure showing the cumulative percent change in these sectors since the start of the recession (Click on figure to enlarge):

The Second Derivative

A Banana Republic?

It was not too long ago Paul Krugman was calling the United States a banana republic with nukes. Although he made this statement in jest, Simon Johnson and James Kwak have been arguing in print and on their blog that the United States has, in fact, all the characteristics of an emerging market economy with respect to its financial sector. Acording to Johnson and Kwak, the U.S. financial sector is oversized, politically influential, and as a result is preventing the necessary restructuring needed for the U.S. economy to start recovering. Martin Wolf agrees with much of their assessment:

Unquestionably, we have witnessed a massive rise in the significance of the financial sector. In 2002, the sector generated an astonishing 41 per cent of US domestic corporate profits... In 2008, US private indebtedness reached 295 per cent of gross domestic product, a record, up from 112 per cent in 1976, while financial sector debt reached 121 per cent of GDP in 2008. Average pay in the [financial] sector rose from close to the average for all industries between 1948 and 1982 to 181 per cent of it in 2007

Martin Wolf, however, questions their claim that the reason the problems in the financial sector have not be forcefully addressed is because of its political influence. I too agree the financial sector is bloated and effectively insolvent. However, I am with Martin Wolf in being skeptical of the political influence of Wall Street view. My own take on why there has been a lack of meaningful action in financial sector--mainly fixing the insolvency problems with the big banks through restructuring--is the fear of creating another systemic credit crisis.

Johnson and Kwak in their most recent blog posting direct us to this article by Desmond Lachman, someone who has spent 30+ years following emerging markets. Lachman has seen many emerging market crises and knows them well. Lachman is someone you take seriously. Here is some of the article:

Back in the spring of 1998, when Boris Yeltsin was still at Russia's helm, I led a group of global investors to Moscow to find out firsthand where the Russian economy was headed. My long career with the International Monetary Fund and on Wall Street had taken me to "emerging markets" throughout Asia, Eastern Europe and Latin America, and I thought I'd seen it all. Yet I still recall the shock I felt at a meeting in Russia's dingy Ministry of Finance, where I finally realized how a handful of young oligarchs were bringing Russia's economy to ruin in the pursuit of their own selfish interests, despite the supposed brilliance of Anatoly Chubais, Russia's economic czar at the time.

At the time, I could not imagine that anything remotely similar could happen in the United States. Indeed, I shared the American conceit that most emerging-market nations had poorly developed institutions and would do well to emulate Washington and Wall Street. These days, though, I'm hardly so confident. Many economists and analysts are worrying that the United States might go the way of Japan, which suffered a "lost decade" after its own real estate market fell apart in the early 1990s. But I'm more concerned that the United States is coming to resemble Argentina, Russia and other so-called emerging markets, both in what led us to the crisis, and in how we're trying to fix it.

[...]

The parallels between U.S. policymaking and what we see in emerging markets are clearest in how we've mishandled the banking crisis. We delude ourselves that our banks face liquidity problems, rather than deeper solvency problems, and we try to fix it all on the cheap just like any run-of-the-mill emerging market economy would try to do. And after years of lecturing Asian and Latin American leaders about the importance of consistency and transparency in sorting out financial crises, we fail on both counts: In March 2008, one investment bank, Bear Stearns, is bailed out because it is thought to be too interconnected with the rest of the banking system to fail. However, six months later, another investment bank, Lehman Brothers -- for all intents and purposes indistinguishable from Bear Stearns in its financial market inter-connectedness -- is allowed to fail, with catastrophic effects on global financial markets.

In visits to Asian capitals during the region's financial crisis in the late 1990s, I often heard Asian reformers... complain about how the incestuous relationship between governments and large Asian corporate conglomerates stymied real economic change. How fortunate, I thought then, that the United States was not similarly plagued by crony capitalism! However, watching Goldman Sachs's seeming lock on high-level U.S. Treasury jobs as well as the way that Republicans and Democrats alike tiptoed around reforming Freddie Mac and Fannie Mae -- among the largest campaign contributors to Congress -- made me wonder if the differences between the United States and the Asian economies were only a matter of degree.

Maybe we are closer to being a banana republic than I realized.

Far From Over

Floyd Norris writing in the NY Times reminds us that the problems in the U.S. financial sector are far from over:

The loans went to borrowers who might never before have been allowed to borrow. When they found repayment difficult, they were permitted to refinance their loans, generating fees for the lenders and postponing the ultimate reckoning. Then the credit markets turned and both the borrowers and lenders were in deep trouble.

So it went with the subprime mortgage crisis. And so it is now going with corporate loans and bonds. It appears that defaults on leveraged loans and corporate bonds will soon rise to levels not seen since the Great Depression.

Read the rest here. The problems with corporate debt can be seen in the figure below which shows the difference between interest rates on BAA-rated corporate bonds and AAA-rated corporate bonds. Since the BAA-rated securities are riskier, the spread between these two yields provides a glimpse into the market's assessment of corporate risk. (Click on figure to enlarge.)

Can the U.S. financial system handle more shocks?