Econbrowser

What if we'd been on the gold standard?

Fri, 09 May 2008 05:59:23 -0800

If the U.S. had decided to go back on the gold standard in 2006, where would we be today? That's a question my friend Randy Parker recently asked me. Here's how we both would answer.

]]> Many things might have been different had the U.S. decided to promise to exchange dollars for gold at the 2006 price of $600 per ounce of gold. But let's start with some of the things that wouldn't have changed. I contend that we'd be no less worried today about geopolitical events in places like Nigeria, Iraq and Iran. The phenomenal growth of the Asian economies would presumably have continued. The bad mortgage loans made prior to that time would still be on the books and still be problematic, with attendant worries about the financial soundness of many institutions. All of this would have meant an increase in the demand for gold. Equilibrium would then require an increase in the relative price of gold compared to what it had been in 2006. That is, the number of umbrellas, or cars, or chairs that people would be willing to surrender in order to obtain an ounce of gold would have gone up relative to what it had been in 2006.

Now, if the number of dollars you have to surrender to obtain an ounce of gold is fixed by the government's commitment to a gold standard, and the number of umbrellas, or cars, or chairs you'd be willing to surrender for an ounce of gold has gone up, the only way that can be is if the dollar price of umbrellas, cars, and chairs have all fallen. Maintaining a gold standard while the relative price of gold increases requires deflation in the dollar prices of all other goods.

The only way the Fed could engender that deflation is with a monetary tightening. Suppose the Fed had been dutifully implementing that procedure in August 2007, when there was a sudden increase in doubts about the soundness of key financial players. A savvy speculator would then reason as follows.

The U.S. has promised that it will continue to convert dollars to gold at $600 per ounce. But that will require them to raise interest rates at a time of potential financial panic, and I don't believe they have the stomach for that. I'm going to ask for my dollars in gold right now, in the guess that they'll abandon this policy shortly. When they give up the standard, my gold will have appreciated, and I'll have a handsome profit.

And how could the U.S. respond to such a speculative attack? We'd have two choices. One would be to say to the speculators, you're right, this idea of driving interest rates up at a time of financial crisis was a dumb one. Dollars are no longer convertible to gold at the old fixed rate.

Or the other option would be to say, no, we really mean it this time, honest, we're serious about this whole gold standard thing. So, we drive interest rates higher and watch the deflation mount. Outstanding debt that is denominated in dollars becomes more and more costly for people to repay, and we'd see a really impressive level of bankruptcies and business failures. The cycle would continue until the politicians who promised to stay on the gold standard are driven out of office and the deflation spiral could finally be ended by the new leaders choosing option 1 after all.

Now, I know that the gold-standard bugs are howling at this point, "but that's not how a gold standard would actually work, because..." But what I just described was not a hypothetical scenario. Instead, in my opinion it's a pretty accurate description of what happened in the United States during the Great Depression of 1929-33.

In 1929, the U.S. was on a gold standard, with the exchange rate fixed at $20.67 per ounce of gold. Geopolitical insecurity and financial worries warranted an increase in the relative price of gold, which, with the dollar price of gold fixed, required a decline in the dollar price of most everything else. Speculators bet (correctly) that Britain would abandon the standard in 1931, but the U.S. fought against the speculation, with the Federal Reserve Bank of New York raising its discount rate from 1.5% to 3.5% in October 1931. This sharp increase in interest rates at a time of great financial turmoil succeeded in defending the parity with gold, but produced an economic disaster.

A 1991 research paper by Ben Bernanke and Harold James noted the very strong correlation between when a country abandoned the gold standard and when it began to recover from the Great Depression. The top panel above shows their calculations of the average annual growth of industrial production for the 14 countries that decided to abandon their currencies' gold parity in 1931-- they experienced positive growth in every year from 1932 on. Countries that stayed on gold, by contrast, experienced an average output decline of 15% in 1932. The U.S. abandoned gold in 1933, after which its dramatic recovery immediately began. The same happened after Italy dropped the gold standard in 1934, and for Belgium when it went off in 1935. On the other hand, the three countries that stuck with gold through 1936 (France, Netherlands, and Poland) saw a 6% drop in industrial production in 1935, while the rest of the world was experiencing solid growth.

As I pointed out in an article published in 1988, gold-standard advocates think in terms of an institution whose continued operation, once adopted, would never again be doubted. But the problem is, if you can go on a gold standard, then you can go off a gold standard. And uncertainty about if and when the latter will occur can make the system itself a very destabilizing force.

Technorati Tags: Great Depression, gold standard, macroeconomics

Lazear Sees No Recession for U.S. Economy

Wed, 07 May 2008 21:45:42 -0800

From WSJ, Henry Pulizzi and John D. McKinnon write:

]]>

"The data are pretty clear that we are not in a recession," Council of Economic Advisers Chairman Edward Lazear told a meeting of editors and reporters from the Wall Street Journal and Dow Jones Newswires.

...

"I would be very surprised if the NBER, looking back at this period, would date this as a recession," Mr. Lazear said. There are even indications that revised first-quarter estimates would be slightly stronger than 0.6%. "The optimists seem to have been closer to right on that than the pessimists," he said.

Mr. Lazear's remarks follow optimistic comments on the economy by other administration officials this week. Treasury Secretary Henry Paulson, who has spearheaded the White House's response to the credit crunch in financial markets, said Tuesday that "the worst is likely to be behind us."

I must confess that I am amazed that Lazear can be so confident, given that we know that GDP is revised multiple times (see this post). In addition, we know that there are four series that the NBER places primary emphasis on, aside from GDP. (As noted previously, the President seems to be similary confident, despite the trajectory of these four key series).

Nonetheless, remaining focused on the national accounts does not necessarily make the case unambiguously stronger in Lazear's favor. Consider growth rates of final sales to domestic purchasers and final sales of domestic product, compared to GDP.

Figure 1: Quarter on quarter growth rates of real GDP (blue), real final sales to domestic purchasers (red), and real final sales of domestic product (green), SAAR Ch.2000$. Growth rates calculated as log differences. NBER-defined recession shaded gray. Source: BEA NIPA release of 30 April 2008, and NBER.

What the real final sales series indicates is that taking out inventory accumulation yields a negative growth rate in Q1. It is of course possible that the observed inventory accumulation was in anticipation of resumed growth in Q2. The alternative interpretation is not so benign; it was that firms overestimated demand in Q1.

The real final sales to domestic purchasers series highlights a separate concern -- namely that GDP growth has been sustained by now-waning external demand. Recall, final sales to domestic purchasers is:

Y - EX + IM - I^Inv = C + I^Fix + G

Where Y is GDP, EX is exports, IM is imports, C is consumption, I^Inv is inventory investment, I^Fix is business fixed investment plus residential investment, and G is government spending on goods and services.

As the figure clearly illustrates, the contribution to GDP from net exports is now much less pronounced than it was in 2007Q3. This point can also be seen in Jim's post on the release. We'll know a bit more about Q1 net exports when March's trade figures are released this Friday.

So, in this sense, the decoupling hypothesis is no longer academic. Whether US GDP growth remains positive may hinge crucially on whether rest-of-world growth is durable.

Other commentary: ECRI in CNN, Feldstein in Bloomberg, Greenspan in Bloomberg, Ritholtz in Big Picture (II), Ritholtz in Big Picture (I).

Technorati Tags: recession, GDP, final sales, inventory investment, Ed Lazear.

Current Account Balances, Again

Tue, 06 May 2008 20:00:39 -0800

Two years ago, as part of a multi-year project, Charles Engel and I organized a conference on current account sustainability in major advanced economies. Lask week, we convened a follow-up conference aimed at updating our knowledge on this subject. Below is the latest read on the U.S. current account to GDP.

]]> Figure 1: Current account (blue), net exports (red) and net exports ex. oil (green) to GDP ratios. Source: BEA GDP advance release of 30 April 2008.

The agenda for this year's conference is here. Economists from the Federal Reserve System, the European Central Bank, the IMF, and universities (Harvard, Columbia, Virginia, European University Institute, USC, as well as Wisconsin) participated.

Steve Kamin started off the conference with a paper entitled "How Long Can the Unsustainable U.S. Deficit be Sustained?" (coauthored with Carol Bertaut and Charles Thomas). In the paper, they investigate the prospects for the U.S. current account deficit, examining in particular how long it will take for measures of external debt and debt service to reach levels that could prompt some pullback by global investors (if ever).

They address these issues using projections from a detailed partial-equilibrium model of the U.S. balance of payments. Under plausible assumptions of income at home and the rest of the world, the current account deficit will resume widening and the negative NIIP/GDP ratio will continue to expand. However, even by the year 2020, the negative NIIP/GDP ratio will be no higher than it is in several industrial economies today, and U.S. net investment income payments will remain very low.

They also examine the issue of sustainability from the perspective of portfolio holdings. They conclude that it would take many eyars for the U.S. debt to cumulate to a level that would test global investors' willingness to extend financing.

A somewhat different perspective on exactly how the U.S. accounts stand is provided by a paper presented by Frank Warnock. In "Current Account Sustainability and the Relative Reliability of the International Accounts," coauthored with Stephanie Curcuru and Charles Thomas, they conduct a forensic analysis of the gaps in the U.S. international accounts, in order to determine why there is a gap between the cumulated current account and the net international investment position. They conclude that a closer examination of the data suggests that there is little evidence of an exorbitant privilege within asset classes, save for FDI. Hence, current account sustainability assessments predicated on the existence of dark matter might rightly be questioned. While the paper is preliminary and not available online, some related insights can be found in Curcuru, Dvorak and Warnock.

Interestingly, even two years after our first conference, economists are still debating why the U.S. current account spread so widely. Marcel Fratzscher, in a paper coauthored with Roland Straub, argues in Asset Prices and Current Account Fluctuations in G7 Economies that equity price shocks were important.

The paper analyses the effect of equity price shocks on current account positions for 16 industrialized countries in 1974-2007. It presents a DSGE model to derive restrictions for the identification of asset price shocks, and uses a Bayesian VAR with sign restrictions to empirically test for the effect of equity price shocks. Such shocks are found to exert a sizeable effect, with a 10% equity price increase for instance in the United States relative to the rest of the world worsening the US trade balance by 0.9 percentage points after 16 quarters. Moreover, the response of the trade balance to equity price shocks varies substantially across countries, and this heterogeneity appears to be linked in particular to the financial market depth and equity home bias of countries.

In contrast, Robert Dekle, in a paper coauthored with Suparna Chakraborty, takes a different tack:

An influential explanation for the recent rise in the U.S. current account deficit is the boom in U.S. productivity. Using a two country general equilibrium model, this paper quantitatively shows that the gap in productivity growth between the U.S. and the "rest of the world" cannot explain the U.S. current account deficits, especially in the 1980s and the 2000s. This is because on a GDP-weighted basis, the "rest of the world" actually had higher productivity growth during these periods, and standard macroeconomic models would predict an outflow of funds from the U.S. to the rest of the world, and a consequent U.S. current account surplus. We show that changes in the degree of global financial integration can help explain this anomaly in U.S. current account behavior. We find, however, that our model overpredicts the growth in U.S. GDP in the 1990s and 2000s.

Giancarlo Corsetti presented preliminary work conducted with Andre Meier and Gernot Mueller, attempting to answer this question:

What are the macroeconomic effects of shocks to government spending? We analyze this question by specifically exploring non-linearities in the impact of fiscal shocks on output, private consumption, the trade balance, and real exchange rates in a sample of OECD countries. We consider non-linearities due to the size of the shock, the degree of openness and size of the country, and the initial budgetary conditions. After identifying fiscal shocks as residuals of estimated spending rules, we use them as explanatory variables in single variable regressions, including interaction terms. In our finding, in normal times the consumption multiplier is positive, yet quickly decreasing in the size of expansions; at times of fiscal strain it becomes unambiguously negative. Correspondingly, the trade balance deteriorates substantially in normal times, consistent with twin deficits; it shrinks, and turns into a small surplus at times of fiscal strain.

Turning to current account balances more generally, Jaewoo Lee presented a paper coauthored with Hamid Faruqee entitled "Global Dispersion of Current Account: Is the Universe Expanding?". From the introduction:

This paper reexamines the global distribution of current accounts viewed from a longer term perspective. Using a panel of over one hundred countries that comprise over 95 percent of world output, the analysis establishes a set of "stylized facts" regarding the individual and collective behavior of current accounts over the past four decades. In particular, we examine the dispersion properties of external imbalances and interpret these empirical regularities in the context of increasing openness in trade and financial flows -- often referred to as "globalization."

The basic point is illustrated by this graph.

Figure 1 from Faruqee and Lee (2008).

They find the following:

The universe of current accounts has been expanding over the past half century. Based on a variety of measures and methodologies, the global constellation of external current account positions has markedly widened over time. While dispersion can vary significantly from year to year -- ostensibly in response to large international shocks, there is a steady, underlying rate of expansion of around 2 to 3 percent per year.
In other words, in a context where global gross financial flows have grown rapidly, net flows have also increased (on a sustained basis) to individual countries. And sign reversals in the current account are occasional, but not frequent. Reflecting this persistence in current account imbalances, countries that have run larger external imbalances in the past also tend to run subsequent, larger imbalances (of the same sign), suggesting a extenuation of international lending or borrowing patterns. However, the underlying, long-run trend toward greater global dispersion suggests that inertia in current accounts from year to year may be overstated by simple estimates of persistence.
Rising dispersion is also found to be closely associated with increasing financial integration of the world economy, among other things. At the same time, individual current account series and changes in net foreign assets (as ratios to GDP) are found to be stationary (albeit persistent), indicating that while dispersion is rising, basic intertemporal resource constraints are not likely violated for individual countries.
Global imbalances though have run well ahead of underlying dispersion trends. The recent acceleration of external positions in major countries (including the United States) is clearly not fully accounted for by the trend behavior exhibited by the universal expansion.

Shang-Jin Wei presented a paper entitled "Current Account Adjustment: Some New Theory and Evidence", coauthored with Jiandong Ju:

This paper aims to provide a theory of current account adjustment that generalizes the textbook version of the intertemporal approach to current account and places domestic labor market institutions at the center stage. In general, in response to a shock, an economy adjusts through a combination of a change in the composition of goods trade (i.e., intra-temporal trade channel) and a change in the current account (i.e., intertemporal trade channel). The more rigid the labor market, the slower the speed of adjustment of the current account towards its long-run equilibrium. Three pieces of evidence are provided that are consistent with the theory.

Turning to the issue of trend increase in services exports, Catherine Mann presented U.S. International Trade in Other Private Services: Do Arm's Length and Intra-Company Trade Differ?, coauthored with Deniz Civril:

US international trade in so-called 'other private services' (OPS) has more than tripled in the last decade to account for 13 percent of total exports and 5 percent of total imports. About 30 percent of this trade is between a US multinational parent and its affiliates abroad (intra-firm trade), about 60 percent is 'arms-length' trade. Using annual panel data across countries and time, this paper examines the likelihood that US trading partners in goods also exchange Other Private Services, whether this probability affects the factors that drive OPS trade, and finally investigates whether the factors that drive OPS trade differ according to multinational ownership and the level of income in the source and destination country. We conclude that selection bias – to trade with the US in goods and services or just goods – does not impact the foreign factors that affect trade in services. The positive factors are economic size, richness, internet connectivity, tertiary FDI assets, and bilateral trade agreements and negative factors of distance, taxes, corruption. The foreign factors that differentially enhance intra-firm trade in OPS as compared to arms-length trade include: a higher share of services in GDP, greater internet connectivity, and more tertiary FDI assets. Factors such as relative wage growth abroad, corruption, distance, and language do not differentially affect intra-firm vs. arms-length trade in OPS. Dividing the sample into relatively richer vs. relatively less rich foreign trading partners suggests that internet connectivity is much more importantly associated with intra-firm trade in OPS for the less rich trading partners.

Finally, Charles Engel presented a paper coauthored with John Rogers, entitled "Expected Consumption Growth from Cross-Country Surveys: Implications for Assessing International Capital Markets". They find that ten year real expected interest rates (as measured by survey data) are not equalized across major economies. And further, consumption growth seems to follow income growth more, and to be less correlated with expected real interest rates, than implied by theory. As they observe, "the empirical findings present a challenge to the building block of many macroeconomic models, in which expected consumption growth is driven by the ex ante real interest rate."

The conference is part of the three year project on "Current Account Sustainability of Major Industrialized Countries", funded by the Center for World Affairs and the Global Economy (WAGE). As part of our activities, we also held another conference on May 1st, entitled "Global Imbalances and the U.S. Dollar: Doing Business in the World Economy". At that conference, Mike Knetter (Dean of the UW Business School), Jeffrey Frankel (Harvard Kennedy School of Government), Michael Melvin (Barclay's Global Investors), and Catherine Mann (Brandeis and Peterson Institute) debated the global outlook.

Technorati Tags: current account, dollar, sustainability, net foreign assets, productivity.

Gasoline prices: consumers and politicians respond

Mon, 05 May 2008 20:41:58 -0800

The trend is clear: demand is down and complaints are up.

]]> U.S. sales of cars manufactured in North America actually rose 1.3% in April 2008 compared with the same month the previous year.

Data source: Wardsauto.com

But sales of domestic light trucks, which includes the once-almighty SUV category, fell 20.6% in April, even more dramatic than the 18.3% drop between March 2007 and March 2008. Combined sales of domestic and imported cars now outnumber light trucks by a significant margin, the first time that's happened since I've been collecting these numbers in 2003.

Data source: Wardsauto.com

U.S. gasoline consumption since January has averaged 1% lower than the first four months of 2007, another quite unusual development:

U.S. finished motor gasoline produce supplied, 4-week averages, in thousands of barrels per day. Most recent year in red, previous year in blue. Data source: EIA

Counts of the number of miles traveled by vehicles on U.S. roads are also turning down.

U.S. vehicle miles traveled in billions of miles, 12-month moving average. Source: Federal Highway Administration

None of which has been accomplished without significant complaining, to which two of our three presidential candidates have willingly hearkened, proposing a cut in the 18.4-cent-per-gallon federal gasoline tax. Although I could easily imagine circumstances in which an 18 cent cut in gasoline prices would not much affect the quantity demanded, my inference from the evidence above is that at the moment, price relief might well bring a measurable boost to demand. Proponents of a gasoline tax cut have an important task explaining where the necessary additional gasoline supply will come from. I think the most natural expectation is that it would come from increased imports which could be diverted to the U.S. if we offered a higher price, though that of course would mean that much of the intended benefits of the gas tax holiday would in fact go to foreign suppliers.

Such considerations leave me endorsing a statement recently signed by many of my colleagues that reducing the gasoline tax would be an inappropriate and ineffective response to the current situation.

To which advice Hillary Clinton has bravely responded:

I'm not going to put my lot in with economists.

And to which Bryan Caplan even more bravely declares I'll shill for Hillary:

1. The American people want to "do something," and Hillary's tax cut will at least do little harm....

2. If (due to highly inelastic short-run supply) 100% of the tax cut goes to producers, that's not a bad thing. It helps to balance out the long-run disincentive effects of populist measures....

3. The short-run elasticity of supply is probably near-zero for the world market, but Hillary's tax cut affects only the U.S. So as I argued previously, American consumers will at least get a moderate piece of the tax cut.

It's nice to see that we have some economists with a sufficient number of hands to be able to lend one to Clinton and McCain.

Technorati Tags: macroeconomics, autos, auto+sales, gasoline demand, economics, gas tax, gas prices, oil

Updated Chinn-Ito Financial Openness Index Online

Sun, 04 May 2008 21:22:00 -0800

The newest version of the Chinn-Ito financial openness index (earlier discussed here), extending up to 2006, has just been posted. Here's the series for Argentina and for Venezuela.

]]> Figure 1: Chinn-Ito financial openness index for Argentina (blue) and Venezuela (red). Higher values indicate greater openness. Source: Chinn-Ito index (2008) (Excel).

The index is available here as an Excel file. Documentation is here [pdf]. More extensive discussion of the uses of the index is contained in this paper [pdf]. (Note that these items are also available on Hiro Ito's website as well.)

Note: This is a de jure, not de facto, measure of financial openness.

Technorati Tags: capital controls, financial openness, globalization, financial liberalization.

A Memo I'd Love to See: Whales and Economics

Sat, 03 May 2008 18:20:55 -0800

From the Washington Post:

White House officials for more than a year have blocked a rule aimed at protecting endangered North Atlantic right whales by challenging the findings of government scientists, according to documents obtained by the Union of Concerned Scientists.

]]>

The documents, which were mailed to the environmental group by an unidentified National Oceanic and Atmospheric Administration official, illuminate a struggle that has raged between the White House and NOAA for more than a year. In February 2007, NOAA issued a final rule aimed at slowing ships traversing some East Coast waters to 10 knots or less during parts of the year to protect the right whales, but the White House has blocked the rule from taking effect.

North Atlantic right whales, whose surviving population numbers fewer than 400, are one of the most endangered species on Earth, and scientists have warned that the loss of just one more pregnant female could doom the species. Some shipping companies have opposed the NOAA proposal, saying slowing their vessels will cost the industry money.

...

In one document, the Council of Economic Advisers questioned "the reliability of analysis in the published literature on which NOAA is basing its position." The council conducted its own analysis and concluded that "the relationship between [vessel] speed and [whale] injury . . . may not be as strong of a relationship as is suggested in published papers."

The juxtaposition of economics and whales is quite intriguing. In my own experience, the two haven't come up in the same conversation since Art Laffer argued eloquently for the need to save the whales (now over twenty years ago).

Of course, I would also be intrigued to see the other memos, e.g.:

A separate document reveals that Cheney's staff argued "that we have no evidence (i.e., hard data) that lowering the speeds of 'large ships' will actually make a difference." NOAA again fired back, writing that there was "no basis to overturn our previous conclusion that imposing a speed limit on large vessels would be beneficial to whales."

This document [pdf] is I believe the originally cited NOAA study.

Late addition, 8pm Pacific: Some of the various documents discussed in the article are here.

Macroeconomics and ARCH

Sat, 03 May 2008 05:37:30 -0800

That's the topic of my most recent research paper. Reader warning: this is a bit more technical than the standard Econbrowser post, so if you're not a user of regression analysis, this may not be up your alley.

]]> One of the contributions for which my colleague Rob Engle received the Nobel Memorial Prize in Economics was development of ARCH, a class of models for predicting the volatility of a variable. One's first priority might be to predict the level of the variable, such as asking what the price of oil will be next month. With ARCH models, we instead try to predict the absolute or squared value of the change-- are oil prices likely to change more this month than usual?

ARCH models have become popular in finance, where measuring the volatility is extremely important for purposes of characterizing the riskiness of portfolios. They have been less used by macroeconomists, who are usually interested in predicting how the levels of variables might change under different circumstances.

In my latest research paper, I argue that even if one's primary interest is in measuring consequences for the levels, it can be very important to use ARCH to model any changes in the volatility, for two reasons. First, correcting for outliers can give you much more accurate estimates of the parameters you're interested in. Second, if you make no corrections, there is a possibility of a kind of spurious regression. The expression spurious regression is known to economists as a common finding when you regress two variables that have nothing in common except a tendency to drift from their starting values; (Jesus Gonzalo has some amusing examples). The result is high t statistics that would lead you to reject the null hypothesis of no relation, even though the null hypothesis is surely true.

I found there's a possibility of something similar arising if you rely on the usual OLS test of a hypothesis about a lagged dependent variable in a regression that is characterized by ARCH. If the sample size is large enough, you are certain to reject the null hypothesis that the coefficient is zero, even if the null hypothesis is true. For example, the diagram below shows the asymptotic probability you will reject a true null hypothesis of zero serial correlation as a function of the parameters α and δ of a GARCH(1,1) process for the residuals. This would be a flat plane at height 0.05 if the t test were doing what you expected, rejecting only 5% of the time when the null hypothesis is true. In fact, for α and δ in the range often found for macroeconomic series, you'd end up wrongly rejecting 100% of the time with the standard t statistic.

My paper also illustrates these issues with a couple of examples taken from the macroeconomics literature. The one I'll discuss here involves estimation of the Taylor Rule, which is a description of how the Federal Reserve changes its target for the fed funds rate in response to variables such as inflation and GDP. The conventional understanding by most macroeconomists is that since 1979, the Fed has responded more aggressively to deviations of inflation or GDP from their desired levels, and that this change in policy has helped to stabilize the economy.

The first row in the table below reproduces that finding and its apparent statistical significance using OLS estimates of the coefficients and their standard errors. However, there is strong evidence of ARCH dynamics in the residuals of this regression. When one takes those into account in the estimation, the change in the responsiveness to inflation is 1/3 the OLS estimate, while the changed responsiveness to output is less than 1/10 of the magnitude one would have inferred by OLS.

Post-1979 change in estimated coefficients (and standard errors) relating change in fed funds rate to change in inflation rate and deviation of output from potential as estimated by OLS and GARCH
	inflation	(std err)	output	(std err)
OLS	0.26	(0.09)	0.64	(0.14)
GARCH	0.09	(0.04)	0.05	(0.07)

The diagram below displays the features of the data that are responsible for this result. The top panel is the monthly change in the fed funds rate, in which the ARCH features are quite apparent, with increased volatility particularly over the 1979-82 period. The bottom panel is the scatter diagram relating the change in the fed funds rate (vertical axis) to the output gap (horizontal axis) over the 1979-2007 subperiod. The apparent positive slope is strongly influenced by those observations for which the variability of interest rates is highest. Because GARCH downweights these observations for purposes of estimating the slope, the post-1979 response of the Federal Reserve to the output gap is significantly smaller than that estimated by OLS.

The recommendation that the paper offers for macroeconomic researchers is quite simple. It is extremely straightforward to test for the presence of ARCH effects-- just look at the R² of a regression of the squared residuals on their own lagged values. Macroeconomists might want to glance at this diagnostic statistic even if their primary interest is not the volatility but some other feature of the data.

Technorati Tags: macroeconomics, ARCH, GARCH, spurious regression, Taylor Rule

Fast and Easy Fannie

Fri, 02 May 2008 06:20:23 -0800

The Wall Street Journal had a very disturbing story on Wednesday about the "Fast and Easy" loan program of Countrywide Financial Corporation, many of whose mortgages were bought up by Fannie Mae.

]]> WSJ reports:

Some of the problems are surfacing in a mortgage program called "Fast and Easy," in which borrowers were asked to provide little or no documentation of their finances, according to [people with knowledge of a Federal probe] and to former Countrywide employees.... Fast and Easy borrowers aren't required to produce pay stubs or tax forms to substantiate their claimed earnings. In many cases, Countrywide didn't even require loan officers to verify employment, according to an October 2006 presentation by Countrywide's consumer-lending division. That left the program vulnerable to abuse by Countrywide loan officers and outside mortgage brokers seeking loans for customers who might have been turned away if their finances had been more closely scrutinized, according to three current and former Countrywide senior executives and to several mortgage brokers who arranged loans through the program.

But here's the part that really scared me:

Both Countrywide and Fannie Mae, the government-sponsored company that bought many of the loans, classify the loans as "prime," meaning low-risk.... A Fannie spokesman agreed that the verification of employment wasn't required on all loans, but added that Countrywide was expected to verify employment details on a "sampling" of loans. The Countrywide spokesman said his company fulfilled that obligation.

It's news to me that Fannie was buying no-doc loans and calling them prime. I presume that if the WSJ article is correct as to the magnitude of fraud, Fannie would have a case in trying to recover any losses by suing Countrywide. But if Countrywide goes bankrupt, that plus a few dollars will get you a cup of coffee. Or perhaps we hope our Fannie is covered by credit default swaps that are supposed to pay if these loans default. Unfortunately, it doesn't require much imagination to conjecture a scenario in which the counterparty to those CDS also lacks the resources to make good on their promises. So who's holding the bag here?

Fannie Mae total book of business from their 2007 Annual Report.

From page 102 of Fannie's 2007 Annual Report, as of the end of 2007, the enterprise had leveraged $44 B in stockholders' equity with $796 B in short- and long-term debt to acquire $761 B in mortgages either held outright or intended for resale or trading. I read that as an equity cushion against a 5.8% loss on the mortgages held directly (44/761 = 0.058). But in addition (page 1), Fannie has guaranteed $2.1 trillion in separate mortgage-backed securities it has sold to outside investors, for a ratio of core capital to total book of business of 1.6%.

From the beginning, my conception of a really big financial meltdown would be one that pulls one of the GSEs into insolvency. Please tell me why it can't happen.

Technorati Tags: macroeconomics, economics, Federal Reserve, Fannie Mae, GSE, credit crunch

Revisions, Again

Wed, 30 Apr 2008 22:00:24 -0800

The 0.6 ppt growth rate (SAAR) reported in the 2008Q1 advance release seemed to validate the President's assertion that we're not in a recession, discussed in this post.

]]> Jim has discussed the release in depth, so there is not much to add. Although,the fact that inventory accumulation -- at 0.81 ppts -- more than accounts for total growth at 0.6 ppts is a little disquieting.

What I'd like to reiterate is that this is the advance release. As I observed back in August 2006, one doesn't usually know whether one's in a recession or not because the data are subject to so much revision. From "Could it be that we're already in a recession? Lessons from the last episode":

It's useful to recall that, not only are almost all macroeconomic series announced with a lag, NIPA announcements are also are revised twice after the first announcement ("advance", "preliminary", "final"). There is also a comprehensive annual revisions that go back several years that occur in July. the NIPA announcements provide information on the size of the revisions (mean change, standard deviation). The latest NIPA release of July 28th reports that the standard deviation of revisions from advance to final is 0.4 percentage points on an annualized basis; and 1.0 from advance to latest.

Compounding the difficulties associated with tracking the cycles in the economy, these revisions appear to be larger around turning points. Recalling the the period before the last recession (dated by NBER Business Cycle Dating Committee as ~~January~~ March 2001 to November 2001), I thought it would be useful to compare the data of the time against what we now think are the measures of macroeconomic performance.

Figures 1-3 denote the annualized growth rate (in log terms) of real GDP, real consumption, and real business fixed investment; the blue (red) line is the May 2001 (May 2006) vintage of data as provided by the Philadelphia Fed's realtime database.

Figure 1: Annualized quarter-on-quarter growth rate of real GDP (in log terms). Source: Philadelphia Fed's realtime database, St. Louis Fed, and author's calculations.

Figure 2: Annualized quarter-on-quarter growth rate of real consumption (in log terms). Source: Philadelphia Fed's realtime database, St. Louis Fed, and author's calculations.

Figure 3: Annualized quarter-on-quarter growth rate of real business fixed investment (in log terms). Source: Philadelphia Fed's realtime database, St. Louis Fed, and author's calculations.
As can be seen from these figures, growth rates were revised downward as more data were incorporated into estimates of macroeconomic aggregates. ....

I recall in May of 2001, looking at the GDP numbers and taking solace from the preliminary 2001Q1 growth rate (which, if you look carefully at Figure 1, was positive). Subsequent data revisions cast a substantially different light on the situation (i.e, that growth rate for 2001Q1 was later negative). The lesson I took from that experience was that a bit of circumspection is a good thing.

Technorati Tags: recession, GDP, consumption, business fixed investment, industrial production.

GDP still growing (barely)

Wed, 30 Apr 2008 07:49:51 -0800

The Bureau of Economic Analysis reported today that U.S. real GDP grew at a 0.6% annual rate in the first quarter of 2008, the same tepid growth rate we saw in the fourth quarter of last year.

]]>

The plotted value for each date is based solely on information as it would have been publicly available and reported as of one quarter after the indicated date. Shaded regions represent dates of NBER recessions, which were not used in any way in constructing the index, and which were sometimes not reported until two years after the date.

Recent sluggish growth rates bring our recession indicator index for the fourth quarter of 2007 up to 26.9%. That's its highest value since the 2001 recession, but still well short of the 65% reading that we require in order to make a declaration that the U.S. economy had entered a recession as of 2007:Q4.

This index is calculated from a simple pattern recognition algorithm that interprets moves into and out of recession as a key determinant of GDP growth rates. It is slightly more sophisticated than the traditional rule of thumb that designates two quarters of falling real GDP as a recession, though either approach would lead you to the conclusion that a recession had not yet started as of the fourth quarter of last year. Note that our index is always looking backward one quarter; we've used the just-released advance 2008:Q1 estimates to inform our assessment about 2007:Q4. The historical performance of the index suggests that given the likelihood of data revisions and the usefulness of subsequent information, it is prudent to wait a quarter before making a declaration about what the data signify. More background on how the index is constructed can be found here.

I believe there is an important benefit to having a purely objective, data-based algorithm for making these declarations. The numbers are reminding us that if, for example, the tax rebates were to keep GDP growth positive in the second quarter, we would end up characterizing the most recent experience as a period of slow growth rather than a typical economic contraction.

In terms of the specific details behind the 2008:Q1 numbers, housing remains the big story. If there had been no growth in any other category, the fall in housing would have been enough by itself to produce a 1.2% decline in real GDP. As it was, three other components-- consumption, inventories, and exports-- made modest positive contributions that were sufficient to offset the drag from housing and leave us with positive overall economic growth. We'd normally expect a much bigger contribution from consumption spending than the observed +0.7%, because personal consumption expenditures alone account for about 70% of the level of GDP. It appears that lost housing wealth and consumer confidence are important factors behind the sluggish GDP growth. Inventory accumulation also contributed +0.8% to 2008:Q1 real GDP growth, meaning that real final sales actually declined in the first quarter-- not a good sign of economic health at all. Nonresidential fixed investment contributed -0.3%; a small factor in the total, but a development that worries Calculated Risk. The one cheerful note was the +0.2% contribution of net exports, one benefit perhaps of the sagging dollar.

Not a great quarter at all, but nevertheless better than many of us had been fearing.

Technorati Tags: GDP, recession probability, recession indicator index, macroeconomics, economics

The Monetary Model of Exchange Rates, Money Demand Shocks and Order Flow

Mon, 28 Apr 2008 22:25:52 -0800

Yes, exchange rate prediction once again. Last Thursday, Michael Moore (of Queen's University Belfast) and I presented a new paper at the IMF's conference on International Macro-Finance (co-sponsored with the ESRC funded World Economy and Finance Program). Here's the paper [pdf].

]]> In this paper, we introduce a novel data set, namely foreign exchange order flow spanning a eight year period. This far exceeds other order flow data sets, and allows us to investigate in a more comprehensive and innovative fashion the added explanatory power of order flow over conventional monetary model fundamentals -- namely the money supply, income levels (as proxied by GDP), short term interest rates and inflation rates.

In order to anticipate the results, we find that incorporating order flow into the typical monetary model specification leads to plausible parameter values for the long run relationship. Furthermore, in out-of-sample forecasting exercises (formally, ex post simulations) the hybrid specification incorporating order flow outperforms the monetary model at horizons up to six months for the USD/EUR and the USD/JPY. In addition, the hybrid model outperforms a random walk most of the times.

First, a recap as to the challenge that faces us. In this post from several months back, I laid out the difficulties that conventional macro models of exchange rates face. While it is relatively easy to find "good-fitting" equations, the estimated equations rarely perform well in out of sample forecasting exercises. In such procedures, a regression is estimated over a given sample period, and then this relationship is used to forecast out several periods, using the actually realized values of the right hand side variables. The resulting forecast error is then recorded. The estimation sample is then moved up one period, and the procedure repeated, until all the observations in the period reserved for out-of-sample forecasting are exhausted. Note that this is not a true forecasting exercise which would be useful for trying to exploit profit opportunities. Rather it is a form of robustness check, to determine whether the overfitting of the data has led to inappropriate statistical inferences. Generally, estimated models perform badly, relative to a random walk, in such exercises. For a recent survey, see Cheung, Chinn and Garcia-Pascual (2003).

In that post, I noted one explanation forwarded by Frydman and Goldberg [1], was that imperfect knowledge expectations was a better characterization than rational expectations.

In our paper,we take a different tack. We motivate our analysis by arguing that the conventional monetary model encounters empirical difficulties because it assumes stability of the money demand equation (or for the monetarists in the audience, random velocity shocks). While it is simple in principle to allow for such shocks to preferences that would manifest in velocity changes, empirical counterparts to such shocks are hard to identify. We take order flow as representing shocks to those preferences.

This results in a specification implying a long run relationship between the exchange rate, the conventional monetary fundamentals, and cumulated order flow. In econometric terms, there should be a cointegrating relationship. We use the Johansen maximum likelihood approach to determine whether a cointegrating relationship exists. On the basis of the finite sample critical values (Cheung and Lai, 1993), we determine that there exists ample evidence for at least one such cointegrating relationship (multiple ones are not ruled out).

We estimate a set of error correction models.

dx_t = f(dm_t-1, dy_t-1, di_t-1, dpi_t-1, of_t, ect_t-1)

Where ect is the "error correction term", that is the deviation from the long run cointegrating relationship, as identified using dynamic OLS; m is the inter-country (log) money differential, y is the income differential, i is the interest rate differential, pi is the inflation differential, of is order flow, and d is the first difference operator. We find that (1) contemporaneous order flow almost always enters in as a statistically significant variable, and (2) cumulated order flow enters into the long run relationship significantly. Order flow enters in these cases with the correct sign.

What about out of sample forecasting (recalling that these are tests for robustness)? We find that the hybrid model, incorporating order flow, outperforms a monetary model in almost all instances, according to a RMSE criterion. In addition, the hybrid model always outperforms the Evans and Lyons specification (incorporating interest rates and order flow) for the USD/EUR.

Figure 1: Log USD/EUR exchange rate (blue) and forecasts from random walk (red) Monetary (green), Hybrid (black). Source: Chinn and Moore (2008).

Figure 1: Log USD/JPY exchange rate (blue) and forecasts from random walk (red) Monetary (green), Hybrid (black). Source: Chinn and Moore (2008).

From this we take the finding that the monetary model should not be dispensed with. Money fundamentals do matter; what is necessary is for some proxy measure to enable one to accommodate empirically velocity shocks. Once that is accomplished, the monetary model appears much more empirically valid than it otherwise seems.

Technorati Tags: exchange rate, monetary model, order flow intervention, velocity, interest rates.

Let's Think Long and Hard about Extending Those Bush Tax Cuts

Sun, 27 Apr 2008 20:45:59 -0800

There was a time one could plausibly argue that importing lots of goods and services, and borrowing a lot from abroad (financing the budget deficits that we've incurred since 2001) was a great idea. But at the time, about two and a half years ago, I made the following warning in a Council of Foreign Relations report [pdf]:

The United States faces a wide variety of possible outcomes, with the most dire having a significant likelihood. One real possibility entails the satiation of global investors’ appetite for U.S. Treasury securities, combined with an endless vista of government budget deficits. After several years of large losses on dollar assets due to depreciation, they then demand a substantial premium for holding dollar-denominated assets; either the dollar must weaken so as to make Treasury securities cheap, or yields must rise relative to those on other assets.

]]> Here's what the dollar has done over the past ten years.

Figure 1: Log Real Value of the US Dollar, normalized to 0 at peak in 2002M02. NBER-defined recessions shaded gray. Source: Federal Reserve Board, NBER, and author's calculations.

Now, after contemplating that time series, consider this item from Bloomberg:

Dollar Slide Drives U.S. Budget as Japanese Desert Treasuries
By Wes Goodman
April 28 (Bloomberg) -- Add another ailment to the U.S. misery index of soaring gasoline and wheat costs and falling home values: a federal deficit that is burgeoning as foreign investors led by the Japanese recoil from the slumping dollar.
The Japanese, who own $586.6 billion, or 12 percent of U.S. government debt, had their worst quarter in Treasuries this decade, losing 7 percent in the first three months of the year as the dollar fell to the lowest since 1995 versus the yen, Merrill Lynch & Co. indexes show. Dai-ichi Mutual Life Insurance Co., Meiji Yasuda Life Insurance Co. and Sumitomo Life Insurance Co., three of the nation's four-biggest insurers, would rather accept the world's lowest bond yields in Japan than buy U.S. debt.
``It's too early to say the dollar will stop falling,'' said Masataka Horii, head of the investment team in Tokyo for the $53.1 billion Kokusai Global Sovereign Open, Asia's biggest bond fund. ``The U.S. economy will be slow for a while.''
Japan owns more Treasuries than any other nation. After raising their holdings by $9.2 billion to $620.6 billion between March and July 2007, Japanese investors trimmed that stake by $34 billion through February, the Treasury said April 15.
America relies on foreign investors, who own more than half the U.S. government debt outstanding, to finance a deficit that New York-based Goldman Sachs Group Inc. predicts will expand to a record $500 billion for the year ending Sept. 30, after a $163 billion gap last year. Without their support, long-term interest rates would be 0.9 percentage point higher, a 2006 Federal Reserve study found.
Diminishing Returns
The yield on the benchmark 3 1/2 percent Treasury due February 2018 rose 16 basis points last week to 3.87 percent, according to bond broker BGCantor Market Data. The yield is up from 3.28 percent on March 17, the lowest since June 2003. The note's price declined 1 9/32, or $12.81 per $1,000 face amount, to $97.
Ten-year Treasury yields fell to within 2.03 percentage points of similar-maturity Japanese government bonds on March 17, the narrowest margin in more than a decade. Japan's 1.65 percent 10-year yield is the lowest of 31 bond markets tracked by Bloomberg and compares with 4.18 percent for German bunds.
A survey of Japanese funds investing overseas found 58 percent favor euro-denominated bonds, up from 20 percent a year ago, Barclays Capital Japan Ltd., a unit of the world's fifth- biggest currency trader, said in an April 24 report. Kokusai cut its U.S. fixed income holdings to a record-low 20 percent in March, from 32 percent two years ago.
``European debt is more attractive than Treasuries,'' said Nobuto Yamazaki, executive fund manager at Diam Asset Management in Tokyo, which runs an $8.55 billion bond fund that is Japan's third-biggest. The euro, which gained 14.5 percent in the past year against the dollar, ``will continue to be strong,'' he said.

Of course, this is not the only hazard to the dollar's value. Interest rate differentials, accelerating inflation in the US vis a vis other countries, the possibility of dollar depegging are also important [1], [2], [3]. Which one will prove the most important is hard to say, which is why Justin Fox quotes me as "confused" about the likely path of the dollar. Downward, sure; but how far, and how long, are the questions that remain. But my guess is dumping a lot more US Government debt on the market over the next few years by making the Bush structural budget deficit permanent is not the way to stem the dollar's slide.

Technorati Tags: tax cuts, dollar, deficits, exchange rates, interest rates, Treasurys, portfolio balance.

Peter Hooper on the economic outlook

Sat, 26 Apr 2008 20:02:10 -0800

The speaker at our UCSD Economics Roundtable this week was Peter Hooper, chief economist for Deutsche Bank Securities. Here is a brief summary of his thoughts about the U.S. economic outlook.

]]> Hooper thinks the U.S. has likely already entered a recession and is expecting U.S. real GDP growth to come in slightly negative for the first two quarters of 2008. His forecast calls for a sharp but brief kick out in the third quarter, thanks to the tax rebate stimulus. He calculates that $100 billion in rebates might translate into $33 billion more spending on final goods and services in the third quarter, or $132 billion at an annual rate, though Robin Moroney and Joseph Carson seem less confident. After any consumption burst, Hooper's expecting the continuing drag from housing to bring us back to sluggish but positive growth numbers.

Source: Hooper (2008)

Hooper's view, and I agree, is that the key uncertainty in such forecasts is how big the decline in house prices will prove to be. He guesses that for every 10% additional drop in home prices:

household wealth falls by $2 trillion
consumer spending is reduced by 1% via wealth effects
financial sector losses on foreclosures increase by $50 to 100 billion
tightening of credit conditions associated with deleveraging could reduce GDP by an additional 1/4-1/2%

Hooper presented this impressive graph of the impact of the deleveraging so far on the once booming practice of mortgage securitization:

Source: Hooper (2008)

How big will the house decline prove to be? Hooper rightly cautioned that it is difficult to answer that question with great confidence, but offered his reasons for thinking that we might see the overhang of unsold houses begin to drop significantly over the next few quarters, which would limit further price declines.

Let's hope he's right. If you're interested in more details, you can view his presentation here.

Technorati Tags: macroeconomics, economics, Federal Reserve, credit crunch, recession, house prices

The case for 2-1/4

Thu, 24 Apr 2008 18:59:50 -0800

The Federal Open Market Committee's next meeting is scheduled for April 29/30, which the May fed funds futures contract currently anticipates will result in another 25-basis-point reduction in the target fed funds rate down to 2.0%. Here's why I hope the Fed doesn't do that.

]]>

Interest rate for 30-year fixed jumbo mortgages. Source: Bankrate.com

No matter how dire your outlook for the real economy may be, the first question that must be asked is, How much benefit could another 1/4-point cut provide? For home purchases, for example, the expected change in house prices and income over the next 12 months is likely to be a more important factor than the interest rate in the current environment. And even if the interest rate were the most important variable, it's not clear how much a 1/4-point reduction in the fed funds rate would actually matter for the cost of borrowing. For example, over the last six months, the Fed has cut the target by 250 basis points, while the cost of a 30-year jumbo mortgage rose 60 basis points. That's if you can still get the jumbo loan, which you may well not.

By contrast, there is a compelling case that by rapidly bringing the yield on short-term Treasury bills well below the prevailing inflation rate, the Fed has played a role in the significant depreciation of the dollar and increase in the dollar price of virtually every storable commodity that we've seen since the beginning of January. A USA Today/Gallup survey this week found that 80% of Americans are worried about rising gasoline prices and 73% about rising food prices, with about half of respondents claiming that these price increases had created hardships for them. Would lurching further down that road really stimulate consumer spending?

Markets are assuming that Bernanke will go to 2.0, and that expectation is built into the current price of storable commodities and the dollar. If the Fed instead surprises the market with a little restraint next week, I predict that we'd see immediate adjustments in those prices.

In part those effects would result from changing the fundamentals, surprising speculators with a higher real interest rate and firmer inflation-fighting commitment from the Fed than the market is currently assuming. But it's possible in my mind that there also is a psychological component to the current commodity speculation as well, in which case the Fed has a rare opportunity right now to get some extra benefits on the inflation front by breaking that psychology. However, if the Fed waits and lets the present perceptions become more entrenched, that same psychology could turn out to be a factor that later proves to work against the Fed and make anything it tries to do more difficult.

The Fed's credibility as an institution that will not tolerate a resurgence of inflation is absolutely critical for its ability to achieve its dual mandate. If the Fed loses that credibility, monetary expansion brings inflation but little output improvement, and monetary contraction brings a recession but little relief on inflation. When consumers report in the latest Michigan/Reuters survey that they expect 4.8% inflation over the next year, the Fed has a real problem in that department. If the Fed waits to pause until the June 24/25 meeting, it may find itself swimming against that credibility current for many years to come. I believe that the Fed has a unique opportunity to signal its true commitment at next week's meeting that may not come again any time soon.

Furthermore, if I am reading this correctly, we will not have to wait around to ponder what the outcome means. If the Fed surprises the market with a pause, we should have unambiguous confirmation or refutation of the hypothesis that the Fed has been contributing to the commodity price run-up within 48 hours of the FOMC's announcement. That knowledge in itself would also be extremely valuable-- valuable to the Fed in calculating how to chart its course from here, and valuable in terms of making clear to the public why sometimes higher interest rates are the better choice for public policy.

Technorati Tags: macroeconomics, economics, Federal Reserve, interest rates, credit crunch, Bernanke, inflation

What Does the President Know, and When Did He Know It: "We're not in a recession..."

Wed, 23 Apr 2008 21:25:15 -0800

From Reuters:

"We're not in a recession, we're in a slowdown," Bush said at a news conference at the end of a two-day summit with Canadian Prime Minister Stephen Harper and Mexican President Felipe Calderon.

]]> This statement was made with a seemingly amazing amount of certitude. So much so that I am impelled to ask, what does the President know, and when did he get to know it? For sure, he has access to data that we do not have. And he has an army of economists to advise and inform him. So I think he must know something I don't.

His statement does give me the opportunity to update these graphs of series that the NBER places primary focus on in determining recessions.[1]

Figure 1: Log personal income less transfers in 2000Ch.$ (blue) and log nonfarm payroll employment. Real personal income calculated by subtracting off transfers from personal income, and deflating by the personal consumption expenditure deflator. NBER-defined recessions shaded gray. Source: BEA, St. Louis Fed FRED II, accessed 23 April 2008, and NBER.

Figure 2: Log industrial production (blue) and log manufacturing and trade sales, in Ch.2000$. NBER-defined recessions shaded gray.Source: Federal Reserve Board via St. Louis Fed FRED II, BEA, accessed 23 April 2008 and NBER. .

Figure 3: Log real GDP, in billions of Ch.2000$. NBER-defined recessions shaded gray.Source: Macroeconomic Advisers, accessed 23 April 2008, and NBER.

For its part, the NBER defines a recession thus:

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. ...

A "slowdown", while not explicitly defined by the President, conjures in my mind decreasing, but positive, growth rates in the indicators of economic activity. I'll let the reader decide which characterization is most apt (of course, keeping in mind the role of data revisions -- which in any case tend to be downward around (downward) turning points [2], [3]).

Other related discussion: WSJ RealTime Economics, WSJ MarketBeat.

Technorati Tags: recession, personal income, payroll employment, industrial production, manufacturing and trade sales.