More on the shape of the recovery (CNBC Interview)

Stretched V or U? The shape of the last three recessions.

Here is a nice chart from John Fernald at the San Francisco Fed that shows the path of GDP after the last three recessions, including the current one. Using the NBER dates to set the beginning of the recession you can see that the first quarters of the current one were similar to those of the previous two but that a year into the recession the economy accelerated its decline. This made the current recession much longer and deeper than the previous two.

Looking at the forecast for the next 6 quarters, the pace of recovery is not that different from what we have seen before but we start at a much lower level and this makes GPD to remain below the path of the 1990 and 2001 recessions for the quarters (and years) ahead.

Antonio Fatás

Healthcare and global imbalances

By now we all know that the global imbalances were created by excessive consumption in the US and high savings in China (and other countries). Indeed, if we recall that the current account balance is the difference between saving and investment, we will find that for the US over the past 20 years the increase in the current account deficit is almost entirely due to the increase in private consumption.

But what is exactly behind this increase? Do Americans spend more on cars, or toys from China, or is it something else? Here are the data:

As the graph below shows, consumption-to-GDP ratio stood at 62.71% in 1980Q1. The dramatic rise in consumption in the 1990s and early 2000s is clearly seen on the graph (the blue line). By 2009Q1 consumption-to-GDP ratio rose to 70.73%! When we look a little bit deeper, we realize that almost the entire increase is due to two factors: healthcare and education. Medical care plays the major role as its share in personal consumption expenditures rose from 10.2% to 18.3%. Education accounts for one percentage point in the increase in consumption.

Dealing with the rising costs of healthcare may indeed help not only resolve issues of healthcare provision in the US, but indirectly might be the most important tool for addressing global imbalances.

Ilian Mihov

Did economists ever get it right?

Paul Krugman has written a nice essay on the NY Times about How did economists get it wrong?. Other economists have written on the same topic: Eichengreen, Lane, Thoma, DeLong.

My reading of these articles is that there is a good deal of consensus around the following points:

1. Many (economists and non-economists) had expressed concerns prior to the crisis about economic imbalances such as excessive asset price appreciation or current account imbalances. They pointed out to the need of an adjustment, which could come in the form of a recession. As it has always been the case with recessions, forecasting the exact timing is not easy - it depends on how long imbalances are kept alive by markets, investors, policies (and luck).

2. There were several scenarios that were discussed prior to the crisis that could lead to a significant economic downturn. They involved a crash of the real estate market (which took place) and in some cases a reversal of capital flows as foreigners would stop lending to the US (or they would do so at much higher rates). This second scenario never materialized - the crash in real estate prices was enough.

3. Even among those who were concerned with the possibility of a crisis, very few understood the potential magnitude of the crisis, mainly because they could not foresee the collapse of the financial system that we witnessed a year ago. Here is a quote from Frederic Mishkin (who was a member of the Board of Governors, Federal Reserve 2006-08) in August 31 2007:

“The big gains in housing prices we have seen here and in many other countries have raised concerns about what might happen to economic activity if those price gains are reversed. Developments in the housing market can also affect credit markets. Furthermore, problems in the subprime mortgage market have led investors to reassess credit risk and risk pricing, thereby widening spreads in general and weakening the balance sheets for some financial institutions. Fortunately, the overall financial system appears to be in good health and the US banking system is well positioned to withstand stressful market conditions.”

Clearly, our knowledge of what was happening inside the financial system and the associated risk was very limited. This is a failure of regulation and we learned the lesson the hard way.

4. No doubt that some of the research that was done by economists (those in academia) did not provide any clue about what was about to happen. As Phil Lane argues in his article, this is partly a result of specialization, not all researchers are into the business of forecasting economic downturns. But there is also no doubt that some of the research in macroeconomics has been anchored in models that do no recognize enough failures in markets or deviations from rational behavior to produce or understand some of the phenomena that led to the current crisis. Part of this is because of ideological reasons (some want to believe that markets always work), part of this is because the "beauty" of dealing with simple models (the argument made by Krugman in his article).

One thing that I find missing in all those articles is to know whether there was any difference between the current crisis and the previous ones. I am not sure there is much difference. Prior to the (mild) recession of 2001 we also witnessed very similar dynamics: many expressed concerns about the valuation of stocks (more so for tech stocks). But they called the crisis way before it happened. Once it happened, we all asked the question "How did we get it so wrong?". The difference with the current crisis is that this one is bigger, so more questions are being asked. Also, economic policy has played a much stronger role during the crisis, which has probably led to a stronger debate around economics.

It is also interesting to see that during the boom year, there was as much skepticism of economists' forecasts as today so even if some economists were getting it wrong, it is unclear how much they were driving market expectations or investment and spending decisions.

We will have to wait for the next crisis and see if things have changed or we just need to conclude that economists "will never get it right".

Antonio Fatás

Growth Forecasts Revised Upwards

For the last year and a half we have seen a worsening of forecasts of growth for most countries around the world. As we discussed in an earlier post, forecasts for GDP growth for 2009 had been revised downwards every single quarter starting in 2007Q4 until 2009Q1. Since then we have seen that these forecasts are becoming more stable and in the recent update by the OECD of their economic outlook we now see forecasts for the third quarter of 2009 being revised upwards - in some cases significantly. For example, the forecast for Germany was close to zero in June and it is now being revised to more than 4% (this are annualized growth rates). Below is a picture from this report.

Antonio Fatás

Government Debt. Going up (and then down?).

There is a growing debate about the increasing burden of government debt in advanced economies. As a result of the recession and the large stimulus packages, government debt is likely to increase over the coming years to levels that we have not seen in many decades. In the case of the US, the Congressional Budget Office expects government debt to go from 40.8% in 2008 to 68% of GDP in 2019 (more details here, this figure corresponds to the debt held by the public which is lower than the overall level of debt, as some of it is held by public institutions).

Is 68% too high? The debate is open and some think that while high debt in itself is not desirable, this is a number that we have seen before (Krugman has made this argument here). Others disagree and believe that this level of debt will impose a large burden on the economy (Hamilton makes the argument here).

Many countries (including the US after the second World War) have dealt with levels of debt as high or even higher than what we are likely to see over the coming years. In the US debate, there is a reference to the case of European countries that in the 90s saw levels of debt above 100% of GDP and "survive". What was their experience? Here is the picture from two of the "worst offenders": Belgium and Italy.

In both cases, the debt to GDP ratio increased above 110% of GDP. What did we learn from that experience? The good news is that countries can "survive" with such levels of debt. In fact, we need to realize that the burden that this debt imposed on the Italian or Belgian government budget was substantial because the interest rates were much higher than the rates that governments in advanced economies face today (more so the US government). Even with those high rates, levels of debt above 100% did not lead to insolvency and what we saw over the years that followed was a gradual reduction of those levels as a result of increased fiscal discipline and GDP growth.

The first piece of bad news is that the economic performance of these two countries was not great but it is hard to argue that government debt was the main reason for such a low performance. The second piece of bad news is that while the levels have been coming down, they have done so at a very low rate. The slope going up seems to be much faster than when it goes down.

Here are two other European countries that might provide a more optimistic perspective: Ireland and Sweden.

In both cases we see a much faster decline in the debt-to-GDP ratio. In Ireland, the ratio went from 105% to 25% over two decades. In the case of Sweden, the ratio decreased from 75% to 35% in about ten years. We know that high growth played a role, much more so in Ireland than in Sweden, but the trend is also a reflection of the efforts to bring discipline to the budget. The bad news is that these figures are likely to explode in the years ahead because of the current recession, a reminder once again, that the effect of the discipline of the last year might vanish quite soon.

Here is my reading of these experiences:

1. Advanced economies can live with high levels of debt-to-GDP ratios. The levels that European countries or the US are likely to see over the coming decades are manageable.

2. How easy will it be to manage the burden of the debt depends on interest rates and growth. An environment of low interest rates (the one we have seen so far) and healthy growth (to be seen) will make the lives of governments much easier.

3. There is no need to pay back the debt within the next "x" years. What matters is to keep the level of debt-to-GDP ratio under control. [Of course, there is an issue of fairness that I am ignoring, about which generation should pay for the current expenditure]

4. Having said that, we need to plan for the next crisis, even if we are still trying the get out of the current one. The real fiscal discipline shows up during good times when government manage to save the necessary resources to pay for the extra spending and the reduced taxes that the next recession will bring. In many countries, including the US, the high projected levels of debt are a result of the consequences of the current recession but also the inability of previous administrations to bring the level of debt down when growth was high.

Antonio Fatás.

Fed’s Exit Strategy

After the reappointment of Ben Bernanke, discussions about the exit strategy from the massive increase in liquidity intensified again. On Squawk Box of the CNBC Asia channel one guest expressed his doubt that the Fed will be able to withdraw the liquidity because they are holding a lot of illiquid assets.

The Fed has more levers to control money supply than just open market operations and I will discuss them below, but let’s focus first on the balance sheet.

The inflationary danger arises from the fact that banks (depository institutions) hold over 819bln in deposits at the Fed (the second line in the liabilities side). If these institutions withdraw their deposits at the Fed and start lending out, there will be inflation. In order to reduce inflationary pressures, the Fed should be able to withdraw money from circulation. In normal times, the operation is very simple – the Fed officials sell some of Fed’s assets on the open market. By doing this, the Fed gets back cash and thus money supply in the economy goes down. To be able to perform this operation, however, the Fed must have liquid assets.

If we look at the asset side, we will see that the Fed has over 600bln in mortgage backed securities. Clearly, these are not good candidates for an open market operation. But in addition, there are at least three items that can be quickly sold or cancelled – US Treasury securities ($736bln), Term Auction Credit (credit with short maturity of about $220bln), and Commercial Paper facility of about $50bln. The last two items are part of credit facilities that the Fed can cancel easily once commercial banks start lending. The total amount is above 1trillion. In short, the Fed has enough balance sheet instruments to counteract the potential conversion of bank deposits into money.

Consolidated Balance Sheet of All Federal Reserve Banks (August 20, 2009) (Billions of USD)

Assets		Liabilities and capital
Gold US Treasury Securities Mortgage-backed Securities Term Auction Credit Commercial paper Other portfolio holdings Liquidity swaps Other assets	11 736 609 221 53 61 69 304	Banknotes Deposits of deposit. institutions US Treasury Other Capital	871 819 240 83 51
Total	2064	Total	2064

But these balance sheet tools do not exhaust the ammunition of the Fed to counteract any raise in inflation. Let me enumerate here some of the possible actions:

1. Open market operations (as described above).

2. Closing down of lending facilities (as described above)

3. Change in reserve requirements. What matters for inflation is the increase in broad measures of money. The Fed can raise required reserves ratios and by doing this they can reduce dramatically the speed at which money enters the economy. Required reserve ratios are used rarely because they are a very powerful tool (too powerful, one might say) in the control of money supply.

4. Change in the interest rate paid on the deposits of commercial banks. The Fed currently pays interest to banks that deposit their money in the Fed. If they increase this rate, the process of conversion of deposits into currency will slow down.

5. Issuance of central bank bonds. Currently the Fed does not have the authority to issue bonds (why would they borrow money, if they can print money?). But for the purposes of controlling money supply, they may ask the Congress to authorize them to issue bonds if they run out of Treasury bonds (i.e. they use all of them in open market operations) and they still need to reduce money supply further. This is a less conventional tool, but it has been used in China since 2003. Indeed this is how the People’s Bank of China sterilizes the effect of capital inflows and trade surpluses on money supply.

Armed with all these instruments, it is clear that, technically at least, the Fed possesses the levers to control the supply of money, so that rate of inflation does not increase above their (implicit) target persistently.

If you want to monitor the balance sheet of the Fed, it is published weekly on the following site: http://www.federalreserve.gov/releases/h41/Current/ (scroll down to where you see “Consolidated Statement of Condition of All Federal Reserve Banks”.)

Below is my interview for CNBC Asia from August 26, 2009, about the reappointment of Ben Bernanke as the chairman of the Fed (I know that I am biased). I also discuss Fed’s exit strategy briefly.

Ilian Mihov