The Great Recession, Stimulus Bill, and the US economy

Brad Plumer points to these two excellent graphics (from the Economic Report of the US President) that maps the impact of fourteen cases of banking/financial crises induced economic recessions from across the world.

1. The average increase in unemployment rate from the peak of the business cycle is 7.7 percentage points for the 14 cases, whereas in the Great Recession during 2007-09, the US economy suffered a 5.1 percentage points rise unemployment rate.



2. The average cumulative decline in real GDP from the business cycle peak for the 14 cases has been 10.2 percentage points and the average duration of recessions has been 6.6 quarters, measured as the number of quarters between the peak and trough of real output. In the Great Recession, the US economy suffered a 5.1 percentage points cumulative drop in real output and it has taken 6 quarters to regain the lost output.



There have been many studies which have examined the impact of the American Recovery and Reinvestment Act 2009 in shortening the recession and keeping unemployment rates from getting higher. This summary of nine economic studies on the stimulus bill reveals that six found a significant positive effect on growth and unemployment, while three found either a small or hard-to-predict effect. The US President's Council of Economic Advisers' most recent assessment of the ARRA found that, as of mid-2011, there would’ve been between 2.2 million and 4.2 million fewer Americans employed if the bill had never passed.

The graphics below, from the CEA report, highlight the impact of ARRA on the post-ARRA GDP and employment creation.




But the recession has surely taken a toll on the US economy. The graphic below shows that the Bush era tax cuts and lost revenues from the economic downturn are the major contributors to America's massive fiscal deficit.

The futility of monetary expansion

Given the strong opposition to any further expansion of its balance sheet, the US Fed has not gone ahead with a third round of quantitative easing but settled for the next best option of recalibrating its existing portfolio towards the longer end of the tenor spectrum.

The Fed's FOMC cited "significant downside risks" and announced that over the next nine months, it would sell $400 bn worth securities (treasuries and mortgage backed securities) with maturities below 3 years and purchase those with maturities longer than 6 years. With this, it hopes to twist the yield curve on longer term securities downwards without printing any more money and thereby further expanding its balance sheet.





While there is little doubt that it will have some impact in flattening the yield curve and lowering long-term rates, it is more or less certain that its impact is likely to be marginal. In fact, as witnessed by the steady flattening of the yield curve in the build up to the announcement, the markets may already have factored in its impact.

As an FT article suggested, though the lower long term rates will benefit home mortgage holders, their ability to take advantage of it remains questionable. It is estimated that about a quarter of borrowers have a mortgage worth more than their home and a half do not have the 20% of home equity needed to refinance at a lower rate. This effectively means that the two worst affected categories of mortgage holders will not be able to benefit from the flattening of the yield curve.

The lower long-term yields will also affect the profitability of banks, which traditionally borrow short-term and lend long. The flatter yield curves will dent their arbitrage margins. This will act as a further disincentive for them to lend in an uncertain economic environment.

Small businesses, the traditional engines of economic growth and job creation, especially in the aftermath of recessions, are badly credit constrained. Risk averse banks and financial institutions have been generally loath to lend to small businesses. As the plight of mortgage holders mentioned earlier shows, the battered household balance sheets have some distance to go before consumption can recover.

Most importantly, like the earlier quantitative easing programs, "operation twist" too will come up against the biggest problem facing monetary authorities and governments today - how to translate the dramatic expansion in monetary base and the resultant ultra-low long-term interest rates into increased credit ioff-take. In other words, monetary policies have not been able to make much headway with getting banks to lend, consumers to borrow, and businesses to invest. Except for a handful of the largest firms and financial institutions, credit remains squeezed.

This brings us to the fundamental issue which Paul Krugman and others have been higlighting, about the difficulty of squeezing much out of monetary policy when the economy is stuck in a liquidity trap and where aggregate demand is also in a deep slump. In a liquidity trap, since interest rates are touching the zero-bound (and therefore people do not have to sacrifice interest earnings to obtain liquidity), people are hoarding money not because of its liquidity value, but merely as a store of value. Worse still, since interest rates are close to zero, money and short-term treasuries become interchangeable and mere stores of value. This in turn means that conventional monetary policy actions that involve open market operations by swapping money for treasuries or expanding the money supply become ineffectual.

The graphic below highlights the near complete lack of responsiveness of monetary aggregates to the massive expansion in monetary base. Though the monetary base has exploded, the M2 money supply and its velocity have hardly budged, just as inflation has remained anchored to the bottom.



Clearly, as the graphic below shows, this massive infusion of money has found its way into the safety of bank's reserves.



It is amply clear that the present economic problems cannot be solved just by increasing the supply of money. Nineties Japan and Depression era US provides ample evidence of the futility of such expansion. In the circumstances, the solution lies in boosting aggregate demand. Monetary policy can only work at the margins in preventing the situation from getting worse.

No lessons learnt - The UBS ETF scam

The $2 bn loss incurred by the rogue UBS trader Kweku Adoboli is surely another big blow to the confidence of the embattled European banking sector. It is also a reiteration of the fact that financial market regulators and governments have learnt little from the bitter lessons of the sub-prime mortgage meltdown.

Adoboli headed the Exchange Traded Funds (ETF) trading desk, which packaged ETF-based derivatives and transacted its trades for clients, and which are typically hedged to minimize risks. But Adoboli did not always hedge them, thereby exposing the bank to huge swings.

ETFs track financial indices and its value arises from either directly from an underlying index fund or a derivative with the index fund as the counterparty. It is the later which makes ETF's risky. If the counterparty suffers a huge loss, leaving it without the funds to service the derivative contract, then the ETF owner suffers huge losses.

Further, depending on the complexity of the packaging of the underlying index funds, the risk is dispersed far and widely across, making it difficult to accurately locate and price risk. In recent years, as ETFs have gained popularity, investment banks have even been packaging ETF derivatives to create "synthetic" ETFs (the counterparty is another set of derivatives). In this regard, it is similar to the complex and highly opaque Collateralized Debt Obligations (CDOs) and synthetic CDOs constructed by splicing and dicing and then packaging pools of mortgage loans.

The risks from activities of traders like Adoboli go beyond these. His 'Delta One' trading desk effectively conducted both client and proprietary trading. Investor clients were promised certain benchmark returns, with the excess returns going to the bank (and those in the trading desk), an incentive for the traders to take extra risk, often leveraging their employer's (bank's) balance sheet. Sometimes, even as banks sell ETF's to their clients, they themselves form the derivative counterparty (positions often taken with their proprietary capital), thereby creating the potential for deeply undesirable conflicts of interests.

Adoboli is only the latest in the long history of such rogue traders - Tomonori Tsurumaki of Sumitome, Nick Leeson of Barings, and Jérôme Kerviel of Société Générale - who caused huge losses to their employers and clients. Incidents such as these lend further weight to the argument that even the best monitoring cannot firewall a determined trader who tries to systematically mislead his employer, even over long periods of time. This naturally revives calls about separating commercial and investment banking operations in big financial institutions. An editorial in FT succinctly sums up the need of the hour,

"The narrow lesson is that derivatives can conceal risk as well as manage it. The broad lesson is that inherently risky investment banking must not be allowed to contaminate utility banking or the wider economy. It is a call to speed up efforts to increase investment banks’ capital buffers and the ease with which they can be resolved if the buffers are worn through. If this is done, the risks investment banks take on and the gains and losses that ensue are largely a matter between banks and their shareholders – provided that shareholders are not defrauded or misled."

The final report of the Independent Commission on Banking, appointed by the British Government to improve stability and competition in the British banking system, and headed by John Vickers, which was released a few days before, has much the same to say. It calls for ring-fencing investment and deposit taking retail banking and alos higher capital buffers for investment banks to limit systemic risks.

Ring-fencing will limit the taxpayer guarantees to individual and business depositers and will not cover the risks taken by traders within the investment bank. Today, the deposit insurance guarantee within the large universal banks (that combines all activities, not spearated from each other), acts as an effective public subsidy for their private investment banking activity. As Martin Wolf has argued, ring-fencing, and not outright separation (as was the case during the Glass-Steagall era in the US, which was replaced with the Gramm-Leach-Bliley Act in 1998), will retain the benefits of a single management - like an investment bank bailing out its failing retail banking division.

In this context, Matt Taibi raises an important point about inherently risk-taking investment banking traders and the apparent incompatibility of their activities with the need to protect the interests of retail depositers and tax payers. He argues that there is little distinction between rogue traders and most investment bankers, in so far as both have the freedom to take excessive risks with their client's money and bear limited direct and immediate responsibility to their clients' interests. He writes scathingly about the adverse consequences of the legal end to separation of retail and investment banking and the inherent risk-taking nature of investment bankers,

"the brains of investment bankers by nature are not wired for "client-based" thinking... it just defies common sense to have professional gamblers in charge of stewarding commercial bank accounts... Investment bankers do not see it as their jobs to tend to the dreary business of making sure Ma and Pa Main Street get their $8.03 in savings account interest every month... investment bankers by nature have huge appetites for risk...

The influx of i-banking types into the once-boring worlds of commercial bank accounts, home mortgages, and consumer credit has helped turn every part of the financial universe into a casino... They’re not "rogue" for the simple reason that making insanely irresponsible decisions with other peoples’ money is exactly the job description of a lot of people on Wall Street... they don’t call these guys "rogue traders" when they make a billion dollars gambling.

The only thing that differentiates a "rogue" trader like Barings villain Nick Leeson from a Lloyd Blankfein, Dick Fuld, John Thain, or someone like AIG’s Joe Cassano, is that those other guys are more senior and their lunatic, catastrophic decisions were authorized... if you're a well-groomed 60 year-old CEO who uses his authority to ignore quality control and internal audits in order to make disastrous trades that could sink the company, you get a bailout, a bonus, and heroic treatment in an Andrew Ross Sorkin book... rogue companies are protected at every level of the regulatory structure and continually empowered by dergulatory legislation giving them access to our bank accounts."

Felix Salmon's makes this excellent case for separating or atleast ring-fencing retail/commercial and investment banking activities,

"When you’re hiring people for the UBS trading floor, you’re hiring men who love to win, congenital risk-takers. And then you surround them with risk-management protocols designed to keep them under some semblance of control. There’s a natural tension there. And if you take the hundreds of thousands of risk-takers working on trading floors in London and Hong Kong and New York and Paris, it’s a statistical inevitability that one or two of them will go rogue every year or so.

Risk-managment protocols are important, but they can never be foolproof, because they’re run by humans. So we really shouldn’t let investment bankers — by which I mean risk-hungry traders with access to billions of dollars of balance sheet — anywhere near the systemically-important balance sheets of our largest commercial banks. Losses like the $2 billion at UBS are manageable. But they’re small beer compared to the entirely legitimate losses made by the likes of Morgan Stanley’s Howie Hubler during the financial crisis. He managed to lose $9 billion, and get paid millions for doing so."

More on the Dark Age - overcoming the obsession with mathematical models?

John Kay argues that the fundamental challenge for economics profession today is to abandon its exclusive focus on deductive model-based approach with its focus on rigour and consistency (and expressed exclusively with the tools of mathematics) and embrace elements of real-world observations based inductivism which also draws heavily from cross-disciplinary research (which are not exactly amenable to being reduced to mathematical models). He writes,

"Consistency and rigour are features of a deductive approach, which draws conclusions from a group of axioms – and whose empirical relevance depends entirely on the universal validity of the axioms. The only descriptions that fully meet the requirements of consistency and rigour are completely artificial worlds... deductive reasoning is the mark of science: induction – in which the argument is derived from the subject matter – is the characteristic method of history or literary criticism.



But this is an artificial, exaggerated distinction. Scientific progress – not just in applied subjects such as engineering and medicine but also in more theoretical subjects including physics – is frequently the result of observation that something does work, which runs far ahead of any understanding of why it works. Not within the economics profession.



There, deductive reasoning based on logical inference from a specific set of a priori deductions is 'exactly the right way to do things'. What is absurd is not the use of the deductive method but the claim to exclusivity made for it. This debate is not simply about mathematics versus poetry. Deductive reasoning necessarily draws on mathematics and formal logic: inductive reasoning, based on experience and above all careful observation, will often make use of statistics and mathematics.



Economics is not a technique in search of problems but a set of problems in need of solution. Such problems are varied and the solutions will inevitably be eclectic. Such pragmatic thinking requires not just deductive logic but an understanding of the processes of belief formation, of anthropology, psychology and organisational behaviour, and meticulous observation of what people, businesses and governments do.



The belief that models are not just useful tools but are capable of yielding comprehensive and universal descriptions of the world blinded proponents to realities that had been staring them in the face. That blindness made a big contribution to our present crisis, and conditions our confused responses to it."

The central challenge as the mainstream in the profession see it is to develop a model (preferably one that can be simulated on a computer) of the economy which is not only able to explain why events happen as they do but also make reasonably accurate predictions of them. Kay explores the various possible interpretations that have sought to correct the obvious flaws in the standard DSGE models, consequent to the soul-searching that followed the sub-prime crisis and its aftermath.



In response to the crititicism of the Lucasian DSGE model, its Chicago supporters have sought to make it even more complex in order for it to be more realistic! They have introduced more parameters to represent the complex problems that abound in the real world, which takes into account market frictions and transaction costs. Another response has come from those like Joe Stiglitz who while retaining many of Lucas assumptions have introduced greater importance to information imperfections (for example, Ricardian equivalence's assumptions of households having information about future budgetary problems is now questioned).



Some others, from the complexity economics school, have put forward agent-based modelling solutions, based on specific behavioural and other heuristics generally observed in the real-world. All these solutions satisfy the "requirement" of being mathematical and computer simulatable. However, questions about their real-world effectiveness remain.



Without offering any specific model, John Kay argues in favor of a less mathematics based approach. He writes,

"Another line of attack would discard altogether the idea that the economic world can be described by any universal model in which all key relationships are predetermined. Economic behaviour is influenced by technologies and cultures, which evolve in ways that are certainly not random but that cannot be fully, or perhaps at all, described by the kinds of variables and equations with which economists are familiar. The future is radically uncertain and models, when employed, must be context specific."

The crux of the debate is that all conventional approaches to explaining and forecasting macroeconomic phenomena assume that it has to be contained in a logically consistent and theoretically sound model. It assumes that it is possible to collapse all the different (and there are a maddening array of them) scenarios into this one comprehensive model.



Therefore, the supporters of the Lucasian school try to formulate a single model that can satisfactorily explain all the different types of economic recessions. Accordingly, it seeks to use the same model, with its standard set of assumptions, to explain aggregate demand slumps caused by as widely varying factors as the routine ones (say, monetary policy induced) to those spawned by banking crisis and resultant balance sheet damages.



The result is a failure to satisfactorily explain the present balance sheet recession, especially in conditions of persistent high unemployment rates and zero nominal interest rates. In response, the freshwater economists have either adopted a postion of ostrich like denial or have tried to tinker with the existing models, introducing newer parameters and assumptions to explain market frictions, and in the process drawing them further away from reality.



What if there is no such magic model that can be formulated? Is it possible to forecast macroeconomic outcomes with any great degree of accuracy, beyond estimating the broad trends? What if the degree of relevance of each assumption varies widely across different contexts, to be so irrelevant at certain times as they are relevant at other times, and in which case the model itself should assume a completely different character? More importantly, is there really a need to have a universal, one-size-fits-all model?

Manias and Panics!

Charles Kindleberger in a picture!







(HT: Kaltoons via Paul Krugman)

"Great Contraction", not "Great Recession"?

Carmen Reinhart and Ken Rogoff, the foremost historians of financial market crises, have consistently cautioned against any misplaced optimism for a quick recovery from the depths of the sub-prime crisis. They have pointed to historical evidence to argue that it takes typically more than four years for an economy hit by a deep financial crisis to just recover to the same pre-crisis per capita income level. The evidence so far, for most macroeconomic indicators, has pretty much squared up with their findings.







Though they have opposed contractionary policies to reduce public debts in the US, they have also questioned the effectiveness of large fiscal stimulus. They reject the arguments of those advocating expansionary policies who blame the current state of the US economy to inadequate fiscal stimulus spending. They argue that this policy approach can be useful in combating a "recession", but not a debt-driven "contraction". In such financial meltdown induced contractions, the major problem is debt-laden consumers and businesses.



As to possible prescriptions, Kenneth Rogoff advocates policies that "catalyze debt workouts and reductions" and "moderate inflation". He writes,

"Governments could facilitate the write-down of mortgages in exchange for a share of any future home-price appreciation. An analogous approach can be done for countries. For example, rich countries’ voters in Europe could perhaps be persuaded to engage in a much larger bailout for Greece (one that is actually big enough to work), in exchange for higher payments in ten to fifteen years if Greek growth outperforms....



The only practical way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years... inflation is an unfair and arbitrary transfer of income from savers to debtors. But... such a transfer is the most direct approach to faster recovery. Eventually, it will take place one way or another, anyway..."

This line of analysis, with its focus on reducing the debt exposure, is similar to the "balance sheet recession" analysis of Richard Koo. He argues that the sub-prime meltdown had left the balance sheets of households and financial institutions in tatters. The financial market bailout program, TARP, and the extraordinary quantitative easing measures have effectively backstopped the losses of financial institutions.



However, there have been nothing similar to bailout households, especially those facing foreclosures and negative equity with their housing mortgages. The result is that consumers, whose consumption forms 70% of the US GDP, remains subdued, even deepressed. The knock-on effect on business investments and the labour market is there to see. As Ken Rogoff suggests, some form of partial and conditional write-downs of certain mortgages, and tax cuts that could be used to pay-off debts, would be the most appropriate fiscal expansion measures for such times.



Update 1 (5/8/2011)



Larry Summers makes the point that tax receipts over the next decade would be about $1 trillion lower — and debt that much larger — if economic growth were shaved by half a percentage point a year. This is about the same amount that the debt deal bill passed by the US Congress claims it will save.



Update 2 (15/8/2011)



The biggest restraint on consumer spending in the US has been the debt hangover. Since August 2008, when household debt peaked at $12.41 trillion, it has declined by about $1.2 trillion, according to an analysis by Moody’s Analytics of data from the Federal Reserve and Equifax, the credit agency. A large portion of that, though, was simply written off by lenders as borrowers defaulted on loans. However, the proportion of after-tax income that households spend to remain current on loan payments has fallen, from close to 14 percent in early 2007 to 11.5 percent now.







Still, household debt as a percentage of GDP remains high, far higher than its pre-nineties rate. It is reasonable to argue that the economy cannot achieve true health until debt levels decline, even with the ultra-low rates and the commitment to keep them low till atleast mid-2013.

The evolution of a financial asset bubble

(HT: Chris F Masse, Via MR)

Mapping and disseminating the risk topography

It is now widely acknowledged that arguably the biggest contributor to the sub-prime financial market crisis was a failure to anticipate and act on the build-up of risks across the sector. This constitutes failures at two levels - having access to information on the evolution of various cross-sectional risks with time and then acting appropriately to mitigate these emerging risks.

Robert Shiller points to a 2010 paper by Donald L. Kohn, Matthew J. Eichner and Michael G. Palumbo, who argue that the underlying themes were similar to previous crises,

"Although the instruments and transactions most closely associated with the financial crisis of 2008 and 2009 were novel, the underlying themes that played out in the crisis were familiar from previous episodes: Competitive dynamics resulted in excessive leverage and risktaking by large, interconnected firms, in heavy reliance on short-term sources of funding to finance long-term and ultimately terribly illiquid positions, and in common exposures being shared by many major financial institutions."

Taking cue from this, they point to the need for policy makers to have "better and earlier indications regarding these critical, and apparently recurring, core vulnerabilities in the financial system". In particular with the sub-prime crisis, they point to two information failures. One was the failure to anticipate "the underlying credit risk associated with the rapid growth of home mortgages and a consequent increase in the vulnerability of borrowers to a downturn in home prices or incomes". The other was the inability to assess the growth of financial vulnerability outside the traditional banking sector because of "a greater reliance on short-term funding for longer-term financial instruments". They emphasise the need to fill up these data gaps and have real-time information on them to have a comprehensive early warning system in place.

The authors also argue that merely collecting data, even analyzing them, would not serve much purpose. It is critical that the analysis focus on the relevant areas - specific instruments and their transactions - and then it should be rendered in the most effective manner to evoke the desired response among all the relevant stakeholders. In this context, as a large number of researchers have argued, the presence of automatic stabilizing mechanisms (like say, dynamic capital buffers and reserve requirements) can eliminate the risk of stakeholders not acting (for whatever reasons) even when faced with information on emerging risks. They write,

"More fundamental, in our view, is the need to use data in a different way — in a way that integrates the ongoing analysis of macro data to identify areas of interest with the development of highly specialized information to illuminate those areas, including the relevant instruments and transactional forms... We can easily imagine specifying ex ante a program of data collection that would look for vulnerabilities in the wrong place, particularly if the actual act of looking by macro- or microprudential supervisors causes the locus of activity to shift into a new shadow somewhere else."

In this context, in a recent working paper, Markus K. Brunnermeier, Gary Gorton, and Arvind Krishnamurthy have sought to identify the kinds of risk measurements of leverage and liquidity that should be collected and how it should be interpreted in terms of modern financial theory to provide real-time decision support for financial market participants. They conceptualize and design a risk topography that outlines a data acquisition and dissemination process that informs policymakers, researchers and market participants about systemic risk. They write,

"Our approach emphasizes that systemic risk (i) cannot be detected based on measuring cash instruments, e.g., balance sheet items and income statement items; (ii) typically builds up in the background before materializing in a crisis; and (iii), is determined by market participants’ response to various shocks. We propose that regulators elicit from market participants their (partial equilibrium) risk as well as liquidity sensitivities with respect to major risk factors and liquidity scenarios. General equilibrium responses and economy-wide system effects can be calibrated using this panel data set."

This is one such excellent data reresentation technique that maps the build-up of co-related risks. HSBC researchers use heat maps to identify the changes in correlations between different categories of asset classes.

Re-thinking macroeconomic policies - a graphical summary

The sub-prime mortgage crisis and the Great Recession have questioned several underlying assumptions of modern macroeconomics. Paul Krugman famously called it the "Dark Age of Macroeconomics" and many standard macroeconomics text books are currently undergoing wholesale revisions in the light to these experiences.

What should be the role of Central Banks, especially in ensuring financial stability? What are the policies and instruments that can be deployed by central banks? What should be the optimal inflation target? What are the exit routes available for central banks from extraordinary monetary accommodation? Do central banks have a role in stabilizing output, that goes beyond interest rate changes, especially when faced with deep recessions?

What regulations are required to ensure greater stability and improve the crisis-resilience of banks? What can be done to contain the build up of systemic risks and limit the contagion effects of deleveraging and resultant liquidity crisis? How do we mitigate the moral hazard concerns arising from financial bailouts? What type of financial market regulations are required to limit the possibility of asset bubbles?

What are the fiscal policy options for governments faced with an economic recession and zero-bound in interest rates? How should fiscal policy be organized during such recessions? Which policies deliver the greatest bang for the buck? How can we swiftly deploy stimulus measures in the face of political paralyses and gridlocks? Should governments restrain from stimulating the economy, when faced with zero-bound recessions, with short-term fiscal measures for fear of deficits and debts?

What is the role of global macoreconomic imbalances in causing and sustaining asset bubbles? What is required to prevent the build up of such imbalances? How should cross-border financial flows be regulated? What is the optimal capital account policy for emerging economies? What sort of international monetary system is required to satisfactorily resolve cross-national financial crises?

I have tried to consolidate the learnings from events of the last three years and the post-mortems and other research that has gone into more satisfactorily understanding and explaining macroeconomic policy making. The result is this graphic. While I must admit that it is highly simplified (all such beautiful flow-charts are meant to simplify complex policy eco-systems), it only seeks to broadly highlight all the different elements of a post-crisis macoreconomic policy framework.

It is clear that the mandate of central banks have to expand beyond inflation targeting and include financial market stability. And when faced with deep recessions, central banks have a credit policy role, whence it could become a lender, buyer, and insurer of last resort. Fiscal policy becomes critical when monetary policy loses traction and when interest rates are at the zero-bound. Its main instruments are automatic stabilizers and discretionary spending measures. The specific instruments of each policy, as indicated in the chart, are illustrative and is meant to merely guide discussion.



(Please click on the graphic to enlarge)

In fact, the IMF recently brought together some of the world's leading economists to a conference where the Fund and participants urged a wholesale re-examination of macroeconomic policy principles. See also this concise presentation by Olivier Blanchard.