In a previous set of papers, Oli Coibion, Michael LeBlanc and I examined the predictive power of energy futures post and paper.

In a new paper, Oli Coibion and I update our results regarding energy futures, and metal and agricultural commodities as well, through the end of August 2008, just before the financial crisis broke out in full force. From the paper:

This paper examines the relationship between spot and futures prices for commodities, including those for energy (crude oil, gasoline, heating oil markets and natural gas), precious and base metals (gold, silver, aluminum, copper, lead, nickel and tin), and agricultural commodities (corn, soybean and wheat). In particular, we examine whether futures prices are (1) an unbiased and/or (2) accurate predictor of subsequent spot prices. We find that while energy futures prices are generally unbiased predictors of future spot prices, there are certain notable exceptions. For both base and precious metals, the results are much less favorable to unbiasedness hypothesis. For precious metals and copper and lead, we strongly reject the null that β=1 at all three horizons. For the these other base metals, while we cannot reject that β=1, due to large standard errors. Finally, both corn and soybean futures have β close to 1, while wheat has β<1. Excepting oil and base metals, futures tend to outperform a random walk specification in out of sample forecasts.

The regression we run is:

s_t - s_t-k = β ₀ + β ₁ (f _t|t-k - s_t-k) + ε _t

Where s_t is the log spot price at time t, f_t|t-k is the log futures price at time t-k that matures at time t. The resulting β coefficients at the three month horizons are displayed in Figure 2.

Despite the bias in futures, along a RMSE dimension, futures outperform a random walk for most commodities, except for base metals (the out of sample period is 03M01 to 08M07). That being said, the outperformance relative to a random walk is seldom statistically significant.

Through the course of the crisis, it became increasingly clear that many firms lacked adequate capital and liquidity to protect themselves as well as the financial system as a whole.

Professor Blinder elaborated:

the real leverage problems arose with (a) investment banks that operated (under a different regulatory regime [from commercial banks]) with 30 times leverage and more, and (b) gimmicks such as thinly-capitalized SIVs and conduits that (legally) avoided capital requirements...

Both Bernanke and Blinder further called attention to the problems with procyclical capital requirements. Standard capital requirements become looser when times are good, but that is exactly when it's most feasible and desirable for them to strengthen the equity cushion. Blinder advocated reverse convertible debentures proposed by Mark Flannery and the Squam Lake Working Group on Financial Regulation as a way to implement countercyclical capital requirements.

Though a conceptually different issue from equity capital, Blinder also favored requiring both mortgage originators and mortgage securitizers to retain 5% of any assets they create.

(2) Compensation. Blinder observed: "Pay plans that are structured in such a 'heads I win, tails I don't lose' way create powerful incentives for traders to go for broke gambling with OPM ('other people's money')." In his spoken remarks he added, "They did go for broke, and a lot of them achieved that objective."

Here were Bernanke's observations on the subject:

flawed compensation practices at financial institutions also contributed to the crisis. Compensation, not only at the top but throughout a banking organization, should appropriately link pay to performance and provide sound incentives. In particular, compensation plans that encourage, even inadvertently, excessive risk-taking can pose a threat to safety and soundness. The Federal Reserve has just issued proposed guidance that would require banking organizations to review their compensation practices to ensure they do not encourage excessive risk-taking, are subject to effective controls and risk management, and are supported by strong corporate governance including board-level oversight.

(3) Derivatives. Though Bernanke did not say much about the explosion of financial instruments such as credit default swaps and their role in propagating the crisis, Blinder highlighted the desirability of changes:

While the regulation of derivatives is fraught with peril, it is not hard to improve upon what we have now-- which is practically nothing. I have argued for years that the most important step the government could take would be to push as much derivatives trading as possible into organized exchanges....

The Treasury White Paper (p. 48) proposes to subject OTC derivatives to a "robust regime" of regulation that includes "conservative capital requirements," margins, reporting requirements, and "business conduct standards."

(4) Resolution mechanism. Finally, both Bernanke and Blinder stressed the need for a mechanism to supervise the liquidation of failing systemically important financial institutions. Blinder advocated:

we could develop a new resolution mechanism, perhaps patterned on what the FDIC now does with small banks (often before the bank's net worth goes negative), that would enable the authorities to wind down a systemically-important financial institution (including a non-bank) in an orderly fashion-- rather than just throwing it to the Chapter 11 wolves. This last idea is among the key ingredients of the Treasury's reform plan, has substantial support in Congress, and may well become law. If so, it would have several desirable effects.

• The TBTF doctrine would morph into “too big to be put into Chapter 11," but not "too big to be seized and its management thrown out." That change alone would go a long way toward reducing moral hazard.
• Taxpayers would (mostly) be relieved of the burdens of costly bailouts....
• Regulators would no longer have to keep large "zombie banks" (and non-banks) on life support for fear of the systemic consequences of shutting them down.

Bernanke endorsed this reform as well:

the Congress should create a new set of authorities to facilitate the orderly resolution of failing, systemically important financial firms.... In light of the experience of the past year, it is clear that we need an option other than bankruptcy or bailout for such firms.

A new resolution regime for nonbanks, analogous to the regime currently used by the Federal Deposit Insurance Corporation for banks, would permit the government to wind down a failing systemically important firm in a way that reduces the risks to financial stability and the economy. Importantly, to restore a meaningful degree of market discipline and to address the too-big-to-fail problem, it is essential that there be a credible process for imposing losses on the shareholders and creditors of the firm. Any resolution costs incurred by the government should be paid through an assessment on the financial industry and not borne by the taxpayers.

One detail I'd stress is the need for integration of the approaches to items (3) and (4) above. One of the problems that makes bankruptcy messy for these institutions is that outstanding derivatives contracts can assume a life of their own, sucking assets out of the firm as the market moves against the firm's bets and in practice giving these contracts seniority over conventional debt. From the perspective of society's best interests I don't think such seniority can be justified. I agree with the assertion in Blinder's spoken remarks that the economic costs of the latest recession exceed the cumulative potential efficiency benefits of what he referred to as "fancy finance."

I would propose that instruments such as the credit default swaps entered into by any systemically important financial institution should be subject to a regulatory stop-loss provision. In a standard clearinghouse mechanism, each party delivers collateral against the possibility of the market moving against their original bet. If the market moves too much, the loser either must add collateral or their position is wiped out. If the institution continues to deliver new margin capital, it can become like the compulsive gambler doubling down as the firm's equity cushion essential for financial stability bleeds away. Like the referee protecting a staggering boxer, the regulator needs the authority to declare "no mas" on an institution's commitment of new capital to such positions.

Bernanke concluded with the following:

we cannot lose sight of the need to reorient our supervisory approach and to strengthen our regulatory and legal framework to help prevent a recurrence of the events of the past two years.

To which I would only add, Amen!

CA ≡ (T-G) + (S-I)

Where CA is the current account, (T-G) is the consolidated government budget balance, and (S-I) is the private sector saving-investment balance. Figure 1 depicts the profound shifts that have occurred in these components (normalized by nominal GDP).

Note that I've omitted the statistical discrepancy which makes these items add up exactly.

How much of the recent shift in the net private saving is due to changes in personal saving (as opposed to corporate behavior)? Actually quite a bit. Of the 2.6 ppts shift in net private saving since 08Q1, 2.9 ppts is accounted for by the shift in personal saving.

How persistent will this shift in the personal saving rate be? This is the big question, in terms of the rebalancing issue (keeping in mind that the national saving identity is a tautology). Deutsche Bank provides an interesting set of calculations, which indicates how long it will take to hit the 20 year average net wealth/disposal personal income ratio.

Peter Hooper, Torsten Slok and Christine Dobridge write:

To try to gauge historical norms that households may aim for we appeal once again to average values that have prevailed over time. The 20-year average of household net worth is 533% of income. On this basis, net worth has returned about half way to its historical norm from the low reached in Q1. Chart 6 shows two prospective paths of adjustment back to the 20-year average, a 3-year path and a 5-year path. To follow these paths, we assume that households use half of their saving to pay down debt, and the other half to purchase assets. We also assume that income grows at 1% a year and asset values grow at the same rate. In order to rebuild wealth in three years then, households would need to raise their saving rate to 7% immediately and to 8% by 2012. In order to rebuild wealth in 5 years, however, households would need only a 2% to 3% saving rate. The saving rates implied by this wealth calculation are lower than the rates implied by the debt calculation. This is because net worth has risen since Q1 because of the rebound in the stock market. Net worth-toincome looks to have been about 500% in Q3; households have already made good progress towards their wealth target.

This set of calculations suggests at least a few years of relatively muted consumer behavior. The key factor is the rate at which households seek to reestablish their target net worth/income ratios.

It's interesting to contrast this perspective with that the "Blame it on Beijing" view, which holds Rest-of-World excess saving as the driver. I believe that when considering the US economy -- which is about three times as large as that of China (according to IMF WEO data) -- one can reasonably argue that what happens here is at least as important as what happens in East Asia (in contrast to some observers, I take Chairman Bernanke's recent speech, focusing on raising US national saving, as a welcome return to thinking about the primacy of US factors [speech text]).

The first interpretation of what went wrong is that financial markets were pricing risk correctly in 2006 but began to overprice risk in 2007. Keister and McAndrews analyzed a situation in which banks out-of-the-blue stop lending to each other, while Gorton interpreted events in terms of a classic bank run, in which the liquidation value of entities is feared to have fallen below their short-run liabilities, creating an incentive for lenders to refuse to renew short-term credit. In the benign version of this theory, the troubled entities would in fact be solvent if it were not for the "fire-sale" prices at which distressed assets must be sold in such an environment. If allowed to proceed unchecked, these fears could prove self-fulfilling and result in a rapid collapse of credit.

In terms of appropriate policy responses to this problem, I would distinguish between actions that might have helped if implemented earlier in the decade and options that were available if we begin the analysis in the fall of 2007. If we are looking at what might have been done years earlier that could have helped, the obvious answer is to consider regulatory reforms that might have prevented financial markets from reaching a point at which the liquidation spiral could be set off in the first place. Bank panics are not an inevitable result of private financial intermediation. The key principle for avoiding them is to ensure that the liabilities of financial institutions consist not just of short-term borrowing, but also of equity contributed by the owners. As long as this equity cushion exceeds potential liquidation losses, there is no incentive for short-run creditors to rush to get their cash back, and no insolvency for the bank in the event that the bank does experience a run. It was a regulatory failure to allow an explosion of off-balance sheet entities that borrowed short and lent long but were immune from bank capital requirements.

On the other hand, if we ask what policy options were available after we had entered the fall of 2007, this particular policy prescription is of no help, as the horses were already out and the barn had no capital. Since there are profound negative externalities from simply watching asset prices and lending collapse, there would seem to be a clear case for the Fed to fulfill the function of lender of last resort, lending and buying assets where others won't until the panic subsides and rational valuations return, and trying to do so in such a way that otherwise solvent enterprises were shielded from a panic bankruptcy.

An alternative perspective is that risk was incorrectly priced in the years leading up to the crisis with rationality only returning in 2007-2008. During 2004-2006 there was $2.7 trillion in new subprime and alt-A mortgage debt generated; (Ashcraft and Schuermann). Much of this was extended without documentation of the borrowers' income, little or no money down, negative amortization, and called for huge increases in the borrowers' monthly payments a few years into the loan. Yet somehow through the magic of securitization, this debt was repackaged into tranches that overwhelmingly received AAA credit ratings.

Such massive capital flows only made sense if one believed that house prices would continue to expand rapidly. Because this process was funneling such huge sums into the U.S. housing market, for a while house prices did just that, more than doubling between 2000 and 2005 according to the Case-Shiller 20-city house price index. U.S. household mortgage debt tripled in a little over a decade. According to this second interpretation, when house prices inevitably came crashing down, they brought with them defaults not just on the hybrid subprime and alt-A mortgages, but also put many otherwise sound borrowers underwater.

If it is claimed that the run-up in house prices and mortgage debt were a horrible miscalculation, what were the market failures that produced it? There is a long list of contributing factors. The originate-to-distribute model left the loan originators and securitizers with profits and lesser-informed buyers with the losses, creating agency problems; (Ashcraft and Schuermann). Intra-firm compensation schemes left decision-makers personally with the upside and stockholders with the downside, inducing excessive risk-taking; (Diamond and Rajan; Bebchuk and Spamann). The public-private GSEs Fannie Mae and Freddie Mac were woefully undercapitalized, giving private players the upside and the taxpayers the downside, and perhaps emboldening private securitizers to take even bigger risks (Hamilton). Both the compensation and procedures of the ratings agencies may have contributed to inaccurate perception of the safety of MBS (Ashcraft and Schermann), as did the mistaken perception that entities like AIG had the ability to insure against aggregate default risk. Moral hazard problems induced from the (ex post correct) belief that the U.S. government would absorb the downside on such gambles may have been another factor inducing excessive risk-taking.

If this perspective is the correct one, we can again distinguish between policies that would have made sense earlier in the decade and policies that were realistic options once we entered the crisis phase in 2008. If the above list of contributing market failures is correct, obviously addressing these with regulatory reforms before we reached the crisis point would have been the first-best option. On the other hand, if we condition on previous policy mistakes and ask what could have been done with options available in the fall of 2008, I disagree with those who reason that the way to correct the moral hazard problem is to hang tough in this situation and simply watch the losers go down. There are huge macroeconomic externalities from the resulting collapse of credit, which is why the government claiming it will not bail out the gamblers is not a credible strategy. Instead, this perspective suggests that the key policy question once we find ourselves in the fall of 2008 is how to allocate the necessary capital losses among lenders, stockholders, and the taxpayers in a way that minimizes the disruptive externalities of a credit collapse. If this is the correct perspective, the primary effect of targeted liquidity measures is simply to allocate these potential losses to the Federal Reserve. It is far from clear that this is the appropriate way for a democratic society to answer the question of who should bear the losses.

I laid out the two perspectives above as diametrically opposed views. I nevertheless believe that the correct interpretation of events would acknowledge that each account contains some truth. It is hard to deny that there was some degree of misallocation of capital in the explosion of house prices and mortgage debt or that the resulting real estate price collapse was a key cause of the devaluation of securities and loss of bank equity that precipitated the banking panic phase. The remarks I presented at the Jackson Hole conference in August 2007 laid out precisely this scenario. We might disagree on how much of that $2.7 trillion in new subprime and alt-A debt represented a malfunctioning capital market, and characterize the middle ground between the two views in terms of choice of a number between 0 and 2.7. If that number is big enough, it may be that no realistically feasible level of bank equity would have been sufficient to assure solvency in the face of a deterioration of confidence, and there is certainly the potential for fire-sale asset price deterioration and a necessary role for the Federal Reserve to fulfill its role of lender of last resort. But obviously from this hybrid perspective, the Fed is performing a combination of liquidity provision and residual loss absorption through these operations, and would want to undertake the latter only with extreme care and thoughtfulness.

Participants in this session were asked to address two basic questions. The first is whether the Fed's targeted liquidity operations were necessary and effective. My answer is probably yes, though I would have a hard time persuading someone if they were not already convinced of that. The second question is whether such operations should be considered an important part of central banks' arsenal of tools in the future. To that my answer is categorically no. From virtually any perspective of our current problems, it would have made far more sense to address these problems with proper regulatory supervision prior to the crisis instead of targeted liquidity operations after the crisis unfolds.

You can view my complete set of comments prepared for the conference here.

Global macroeconomic imbalances -- massive borrowing by some countries and massive lending by others -- drove the financial boom and bubble that eventually burst into the current crisis. There is now nearly universal agreement that such imbalances cannot be sustained, and that the former deficit and surplus nations need to move toward macroeconomic balance.

However, rebalancing requires a fundamental reorientation of some of the world's major economies, a reorientation that will lead to major economic, social, and political tensions. Foreign borrowing by the deficit countries fed an orgy of consumption that was wildly popular so long as it continued; but the accumulated foreign debt that has resulted will now begin to impose sacrifices that will be just as wildly unpopular. Nations that have relied on foreign borrowing to fuel government and household spending will have to cut back drastically. They face a reduction in real wages, in consumption, in the standard of living. At the same time, nations that have relied on exports as the engine of economic growth will have to figure out how to power their economies without relying on foreign markets. These political economies dominated by powerful export interests face fundamental challenges to those interests, as their export orientation may no longer be sustainable.

In deficit and surplus nations alike, the attempt to adjust to a new international economic reality will almost certainly lead to major conflicts within nations and among nations. What are these conflicts likely to be, and what do they say about prospects for the future? For guidance, one turns to history and theory. First, this paper reviews some of the extensive historical record on how the world economy, and the countries within it, has attempted to redress macroeconomic imbalances. Then it explores what theory says about the adjustments necessary to rebalance, and how this is likely to play out in national and international political economies.

For some related commentary, see our joint work in this examination of the causes of the ongoing financial and economic crisis in this post (and this article).

...recent research questions the claim that the financial panics themselves contributed to their contemporaneous and severe employment downturns.

The timing was different in this recession -- the largest employment drops seemed to come immediately after the financial panic -- but a recent paper by Ravi Jagannathan, Mudit Kapoor and Ernst Schaumburg of Northwestern argues that the coincidence is just as misleading. They argue that the changing global economy -- with more employment of residents in developing countries like China -- created a glut of savings in those countries, and was destined to reduce employment in developed countries regardless of whether there had been a financial panic.

This paper was discussed earlier on this weblog, and Professor Jagannathan provided some clearly exposited counterarguments to my criticisms in his comments. Indeed, I think there's a lot more subtlety to that paper, and the posited causal chain, than is related above, even if I disagree with the main thesis (see [1]).

But even if you believe the Jagannathan, Kapoor, Schaumberg thesis in full, this does not invalidate the idea that banks provide useful intermediation services, and that failing banks, insolvent banks, or banks that are retrenching in terms of their lending will exert a contractionary influence on the economy. (After all, if one reads Bernanke's 1983 paper (AER 73(3)), you'll see him focus on the declining ratio of loans to the sum of checking and savings deposits, shown in his Table 1) It's just that you think that what caused the banks to overleverage is the "saving glut". (Another way to put it is you think the financial system is the proximate cause, and Beijing the ultimate cause, a la "Blame it on Beijing"). This interpretation is suggested to me by this passage in the conclusion to Jagannathan et al.:

...History might have taken an entirely different path with better risk management controls in place in the US but then again, financial innovation might just have found a different way of getting highly leveraged deals done off-shore or through creative accounting. The root cause of the excess liquidity in the global financial system must be addressed, otherwise we are just squeezing the proverbial balloon only to see it bulge out somewhere else. However, this does not negate the need for the development of improved risk management in the broadest sense in order to ensure financial stability and prosperity going forward.

One truly odd aspect of Professor Mulligan's discussion is the treatment of the banking system as the financial system. I've been hearing a lot about the "shadow financial system" for quite a while -- and I have some inkling there was trouble brewing there somewhat before the plunge in employment and output in September 2008. Below, I graph one aspect of the broader financial system.

So in my view, the financial system problems preceded the initial decline in employment and output. That doesn't preclude the possibility of the subsequent declines in employment and output causing further financial system problems. That I believe is what is called an adverse feedback loop.

More graphs from the real world in this post and the IMF's GFSR.

Postscript: Brad Delong also appears to find this post befuddling.

One way to come up with a prediction is to look at a regression of the historical values of π_t+8 that we currently know (that is, for t = 1948:Q1 through 2007:Q2) on the historical values of u_t. The results from this regression (with Newey-West standard errors in parentheses) and scatterplot of the raw data are given below.

Each circle corresponds to a particular quarter t between 1948:Q1 and 2007:Q2. Horizontal axis: value of unemployment rate in last month of quarter t. Vertical axis: average PCE inflation rate for two years that came subsequent to quarter t. Upward sloping line is the estimated regression relation.

This is of course a version of the famous Phillips Curve, according to which higher rates of unemployment are supposed to be associated with lower rates of inflation. But there's just one problem-- whereas the Phillips Curve is supposed to slope down, the relation we just estimated slopes up. If a given quarter's unemployment rate was above average, it's likely that the subsequent inflation rate was above average as well.

The traditional interpretation of this seemingly anomalous result is that there's another important component of the Phillips relation that was left out of the above regression, which is expectations of inflation. Particularly for the observations from the 1970s and 1980s, people at the time were expecting inflation to remain high. The traditional argument is that if we could add inflationary expectations as a shift variable to the regression, we would see the anticipated negative relation between unemployment and inflation.

One simple way to try to do this is to add lagged values of inflation to the above relation, that is, include π_t, π_t-1, and earlier values that would have been known as of quarter t, and see what the contribution of unemployment is to that modified regression. Results of that regression when we add the previous 3 years of inflation observations are given below. Note I haven't reported the individual estimated coefficients on π_t, π_t-1, and π_t-11 because that exceeds our quota for how many numbers can be reported in an Econbrowser entry.

If you allow for the possibility of changing inflation expectations in this way, the result is that the coefficient on unemployment switches from positive to negative, and the negative coefficient is quite statistically significant. In other words, if we're going to forecast inflation over the next two years on the basis of what inflation has been over the last three years along with the current unemployment rate, the unemployment rate would enter that forecast with a negative sign-- higher unemployment causes us to predict lower inflation.

The forecasts of the above regression (in blue) are compared with the actual values (in black) in the top panel below. We don't know what the actual values after 2007:Q2 are going to turn out to be yet. But the forecast of the model for the average inflation rate between 2009:Q4 and 2011:Q4 is -0.5%.

Top panel: Black line is the value of subsequent average 2-year inflation rate (π_t+8) corresponding to each indicated date t Blue line is the predicted value from the dynamic regression for each indicated date t. Bottom panel: unemployment rate as of last month of indicated quarter t.

Does that mean that deflation is the best forecast given the current high level of unemployment and the recent moderate behavior of inflation? It's certainly not a crazy forecast, given the historical correlations. But the critical question would seem to be whether the contribution of inflationary expectations in the current situation is adequately captured by the recent observed behavior of π_t.

If for further evidence on inflationary expectations you looked at the gap in yields between nominal Treasuries and TIPS, you'd say inflation expectations remain quite low-- currently the 10-year spread corresponds to anu average annual inflation rate under 2% for the next decade.

On the other hand, if your preferred indicator is dollar commodity prices and the sinking exchange rate, the claim that inflationary expectations will remain low is less compelling.

But regardless of where you stand on that question, I believe the Federal Reserve is correct in thinking that high levels of unemployment are a factor that will put downward pressure on inflation over the next two years. The question is how big a pull the dollar and commodities could prove to be in the other direction.

Today, we're fortunate to have Willem Thorbecke, Senior Research Fellow at Asian Development Bank Institute and a Consulting Fellow at Japan's Research Institute of Economy, Trade and Industry, as a guest contributor.

Asia's role in the propagation of the global recession has been a subject of study, but relatively little attention has been devoted to the interaction of exchange rates and production chains. The structure of East Asian production networks and the severity of the recession places a premium on policy coordination in the region.

For instance, Kraemer and Dedrick document that the lion's share of the international production of notebook PCs is produced in the Yangtze River Delta by Taiwanese Original Design Manufacturers (ODMs). These manufacturers form part of a network that includes branded firms such as HP, Apple, and Toshiba, suppliers of key parts and components, producers of basic industrial materials, and makers of operating systems and CPU. Local Chinese firms supply connectors, batteries, switches, and displays and are also active in molding, casting, forging, plating, and module-assembling. Both digital and human networks enable PC producers to react efficiently in real time to changes in consumer preferences and technology. Firms assembling the notebook PCs have also kept inventories lean by processing 98 percent of the orders within three days. Productivity growth within this value chain has been amazing.

The Achilles heel of Asian production networks, though, is its dependence on developed economies for final demand. As private demand in the U.S., Europe, and Japan fell during the crisis, exports produced within regional production networks collapsed. This in turn caused output and employment throughout Asia to plummet.

Signs are emerging that East Asian production networks are reviving. Figure 1 shows imports for processing into China and processed exports from China to the rest of the world. Imports for processing are goods that are brought into China for processing and re-export. Processed exports are final goods that are produced using imports for processing. The figure shows that imports for processing and processed exports both collapsed earlier this year. Since then, however, imports for processing have recovered 85 percent of their losses and processed exports 75 percent. Thus trade within East Asian production networks is recovering. This is the good news coming out of Asia.

The not so good news is that exchange rate arrangements within the region may not allow this revival to be sustained. While many Asian countries have adopted greater exchange rate flexibility, China has returned to a de facto dollar peg. This implies that exchange rates between Asian countries have become very volatile (see, e.g., Figure 2). In general the effect of exchange rate volatility on trade is ambiguous. Within East Asian production networks, however, both theoretical and empirical evidence indicates that exchange rate volatility deters trade (see Thorbecke (2008) and Hiyakawa and Kimura (2009)). This effect arises because the service link cost for production blocks separated by national borders is an increasing function of risk and uncertainty, and exchange rate volatility increases risk and uncertainty. In a recent survey of Japanese MNCs, Professor Takatoshi Ito and his co-authors found that exchange rate stability between Asian currencies is essential for the uninterrupted flow of parts and components within regional production networks.

In addition, since Asian economies do not only cooperate within production networks but also compete in third markets, China's exchange rate peg puts pressure on other countries in the region to prevent their exchange rates from appreciating. Thorbecke and Smith (2009) reported that exchange rate appreciations across Asian supply chain countries are necessary to reduce global imbalances. If the renminbi is kept fixed, it becomes much harder for the huge surpluses generated within East Asian production networks to lead to a generalized appreciation of Asian currencies.

A solution to this impasse would be for China to abandon its de facto dollar peg and adopt a regime characterized by a multiple-currency, basket-based reference rate with a reasonably wide band. In this case, there would be more stability between the renminbi and other Asian currencies. In addition, exchange rates in the region would be able to appreciate together in response to regional trade surpluses.

This move would be difficult for China. Labor-intensive exports and thus employment in these industries are sensitive to exchange rate appreciations. On the other hand, exchange rate appreciations would reduce the need for Chinese and other Asian central banks to continue accumulating U.S. Treasury securities. Private and social rates of return are much higher for investments in education, healthcare, and clean water than for investments in U.S. government securities. An appreciation of the RMB would also allow Chinese consumers to purchase more of the final manufactured goods that were previously exported to developed markets (Thorbecke, 2009). A stronger renminbi would thus allow Chinese workers to enjoy more of the fruits of their labor while reducing their dependence on final demand in the West.

A good policy mix for Asia would thus involve relatively stable intra-regional exchange rates that could appreciate together in response to regional trade surpluses combined with more spending on human capital. Stable exchange rates would help to strengthen regional production networks. Joint appreciations would prevent unpleasant outcomes such as beggar-thy-neighbor policies and excessive reserve accumulation while also reducing global imbalances and encouraging production for domestic markets. Spending on human capital would facilitate technology transfer by allowing firms in developing Asia to become more involved in the engineering and design aspects of production. If Asian countries could climb the value chain in this way and focus on knowledge-intensive activities rather than assembly operations, not only would living standards in developing Asia rise but the region could become an engine of growth for the rest of the world.

This post written by Willem Thorbecke

4-week average of seasonally adjusted weekly initial claims for unemployment insurance, from Department of Labor via Webstract. Vertical lines drawn at dates when the economic recovery began as judged by the National Bureau of Economic Research.

I first called attention on April 9 to the regularity that a peak in new claims for unemployment insurance usually means that a recovery from the recession will begin within two months. On May 7, I calculated that there was an 85% probability that the peak in new claims was behind us. Although August brought some setbacks to new claims, the last few weeks have confirmed the pattern of a significant drop in unemployment claims typical of economic recovery. Unfortunately, the level remains high enough that net job growth is likely still quite negative.

Black line: seasonally adjusted weekly new claims for unemployment insurance from January 1 through October 15, 2009. Blue line: 4-week average.

On Friday we received two quite favorable indicators from the Federal Reserve. The first is that the nation's capacity utilization rate has been steadily climbing since June. Calculated Risk regards that as another reliable indicator that the recession is over.

Source: FRED

Even more encouraging was the Fed's report that its index of industrial production rose by 0.7% in the month of September and at a 5.2% annual rate during the third quarter. Paul Krugman thinks that could mean a third-quarter GDP annual growth rate above 4%.

Source: FRED

That kind of growth is inconsistent with a jobless recovery. After the 2001 recession, we didn't see a GDP growth rate of that size until 2003:Q3. There are two separate feedback mechanisms operating. The first is that rapidly rising output will eventually bring hiring up with it. The second is that the high unemployment rates will bring more foreclosures and cause spending and output to sputter.

Which is it going to be? Nonfarm payroll employment is the key indicator to watch from here.

First, let's take a look at what a survey of approximately 50 banks and financial firms indicates, for the value of the dollar (Fed broad index) and the euro/dollar exchange rate.

The data are from FX4casts, which is the successor to Currency Forecasters Digest; Jeff Frankel and I used these survey data in our studies of expectations in foreign exchange markets [1] [2] [3]. Some additional results are reported in [4] and [5].

Both series are plotted in logs, and exchange rates defined such that up implies a stronger dollar. In both cases the 95 percent interval is shown. What is clear is the (geometric) mean forecast for the dollar implies relative stability. It's true that the lower bound implies some depreciation over the next year -- but no more than 5.6 percent decline (in log terms). That's hardly calamitous. But it would be helpful in terms of facilitating rebalancing (as I pointed out a few weeks ago [6] [7], dollar decline makes a lot of sense, perhaps even more than the 5.6 percent implied by the lower bound).

If one is more concerned about the dollar's value against major currencies (perhaps because of an interest in cross-border valuation effects on financial assets), one would want to see how the dollar evolves against the euro. Here, it appears the mean forecst implies strength over the medium term. Even the scenario for the weakest dollar implies no more than a 7.5 percent decline, at the 3 month horizon.

More from US Treasury's semi annual report and from Fred Bergsten in Foreign Affairs. Appendix I to the Treasury report discusses the dollar's reserve currency status, a topic discussed in a historical perspective by myself and Jeff Frankel here and here.

Double-dip Recession?

Anxiety remains (rightly so) that the economy will suffer a relapse, with the date perhaps in 2010 or 2011. The latest WSJ survey indicates little evidence of such fears.

The mean forecast suggests a story largely consistent with last month's forecasts. The biggest revisions (upward) came between the August and September surveys. Even then, it won't be until close to end-2010 that GDP reattains its previous peak. Forecast dispersion remains large, though, and the trimmed high (Dean Maki, Barclays) indicates reattainment around mid-2010.

The trimmed low (David Malpass) is, interestingly, kind of a "W", although not the typical discussed one; Malpass forecasts 0% SAAR growth in 2009Q4. Bart van Ark (Conference Board) has a drop in growth to 0.5% SAAR in 2010Q1.

Of course, these are conditional forecasts -- that is they incorporate assumptions regarding a certain combination of fiscal and monetary policies. I would guess most of them are assuming "reasonable" policy mixes. But some of the recent discussions of "W" relate to mistakes in policy making, such as a too-early monetary tightening (Roubini, Krugman) or inadequate stimulus (Krugman) or the time profile of the stimulus (Feldstein).