NOW Are We In Recession?

Is the United States in recession? If one looked solely at the adverse shocks that have hit the economy over the last year, one would infer an unusually high probability of a recession. If one consulted some of the most import economic measures over the last year, one would say we clearly entered a recession last January. If one gauged the popular mood, one would hear, “Of course we are in recession!”

The one criterion that has been missing is the one criterion that people most commonly have in their minds as the definition of a recession: two consecutive quarters of negative growth. This morning, October 30, the Commerce Department released the preliminary estimate of GDP in the 3rd quarter. It showed a decline. The decline was small: just 0.3 per cent at an annual rate, and it is only quarter. But at this point there can be little doubt that we are really truly in recession.

The adverse shocks include the most severe housing bust in more than 70 years, an oil shock as big as those of the 1970s, the greatest financial crisis since the Great Depression, and the worst fiscal outlook ever. Any one of these developments would normally be enough to send an economy into recession. Leading economists from Martin Feldstein to Larry Summers have since the start of the year been warning that the downturn has arrived.

And sure enough, many of the most reliable statistical indicators have suggested all year that we are in recession.

The most important statistical criterion besides GDP is employment. Jobs peaked in December 2007 and have declined steadily ever since. The cumulative loss is 760 thousand (or 0.55%) as of September. My personal favorite among indicators is Total Hours Worked in the economy, because it combines both employment (number of people working) and average length of workweek (are they working 40 hours a week? Overtime? Part-time?). Total Hours Worked shows a similar pattern as employment, but with an even steeper decline since December: 1.4%. (The Bureau of Labor Statistics is the agency that releases these numbers, on the first Friday of the subsequent month.)

The index Leading Economic Indicators, which is designed to try to warn of turning points in advance, turned down more than a year ago. Not only that, but also the index of Coincident Economic Indicators, which is supposed to move contemporaneously with the real economy, appears clearly to indicate that a recession started toward the end of 2007.

Housing prices as of August are down 27%, relative to their peak in July 2006 (Case-Shiller composite of 20 cities). Consumer confidence, an important determinant of household spending, fell to an all-time low in September, according to the October 28 release from the Conference Board. The version collected by the University of Michigan is also looking quite bleak. Retail sales are down, especially autos. The trend in industrial production has been downward for a year, and accelerated in August and September. Corporate profits are down.

But it is still not yet officially a recession! Why not? The most important criterion for dating business cycles is real growth. The rate of change of real GDP, surprisingly, was above zero in the first quarter of 2008, and was even moderately strong in the second quarter: 2.8%. (The revised “final” estimate of GDP in the fourth quarter of 2007 did turn out to be below zero, but just barely.) It is quite a mystery why output pointed up during the first half of the year, while everything else pointed down. Clearly the demand for US goods received some boost in the 2nd quarter from tax rebates and exports, both of which are expected to diminish subsequently.

But perhaps there is some measurement problem with GDP. Gross National Income (GNI) has as much claim to measure growth as Gross National Product does. In theory the two are supposed to be virtually the same: the value of goods and services sold is conceptually the same as the value of income earned. Real GNI did in fact turn down in the 4th quarter of 2007 and the first quarter of 2008, though it rebounded in the third quarter as real output did. Real personal income – one of the indicators that the NBER Business Cycle Dating Committee looks at – has been declining almost throughout the year.

The weight of evidence is overwhelming: we are currently in recession.

Did it start at the end of 2007, when employment and the other indicators peaked? Or was the stimulus from the government and from exports enough to hold off the turning point, and did the recession thus only start towards the end of the summer, when the financial crisis intensified very sharply? I am afraid that we need to wait for some more data and some more (regularly scheduled) revisions before we will know.

The Unwinding of the Carry Trade Has Finally Hit Currencies

Why has the yen strengthened so much the week, even though the Japanese stock market has plummeted? The financial media have largely got this one right: the answer is unwinding of the carry trade, and the associated flight to quality, which means flight to yen and dollar (cash and treasury bills).

This was to be expected. It is an unseemly tooting of ones’ own horn, but –

Earlier this year I wrote in an article in the Milken Institute Review (vol. 10, no. 1, pages 38-45)

“The traditional pattern is most clear with the carry from the yen to the euro: it has been predictably profitable for the last five years, and this will predictably end soon, as the yen reverses its depreciation against the euro.”

(“Getting Carried Away: How the Carry Trade and Its Potential Unwinding Can Explain Movements in International Financial Markets.”)

Although the phrase “carry trade” became widely popular in the context of currency speculation, where scholars know it as the “forward discount bias,” its etymological root is in commodity speculation. The same phenomenon is observable in housing, equities, commercial bonds, and emerging markets: when money is easy and nobody is worried about risk (2002-2005), the search for yield sends the excess liquidity surging out of the low-interest currencies, and into all other assets. When the process reverses, investors pull out of the risky assets and retreat back to the safe haven of the low-interest-rate currencies. Over the last six months, the reversal of this broadly-defined carry trade hit equities and bonds first, and then commodities (having hit housing earlier, of course). This month it is finally hitting the high-interest-rate currencies.

Restructuring the International Financial System: A New Bretton Woods?

The first thing to say about the calls for a “new Bretton Woods” is that they overreach, in the sense that it is very unlikely that any changes in the structure of the international monetary or financial system will or should, at this point in history, come out of multilateral discussions that are big enough to merit comparison with the first Bretton Woods. Certainly we are not talking about fixing exchange rates, as the 1944 meeting did.

Detour for an anecdote. In mid-1998, when the crisis that originated in Southeast Asia had reached its one-year anniversary without abating, President Bill Clinton decided to give two important speeches. He wanted to call for a new Bretton Woods. His economic advisers (including both at Treasury and in the White House) advised him against this, on the grounds that one should not call for something as portentous as a new Bretton Woods when one was not likely to have proposals substantive enough to merit the name. Soon after the (successful) speeches, British PM Tony Blair called for a new Bretton Woods. Clinton asked his advisers, “How come Blair got to call for a new Bretton Woods when you wouldn’t let me do it?” Our answer was along the lines, “Blair’s Treasury Secretary, Gordon Brown, doe s not necessarily have his interests aligned with his boss, in the way that Bob Rubin does. So Brown had less incentive to stop Blair from saying something foolish.” The big irony of the story is that Brown today is himself leading the move for a “new Bretton Woods.”

Nevertheless, it is worth taking the opportunity to consider what changes – whether more ambitious or less — might be made at the multilateral level to improve the functioning of the system.

Changes in government policy at the national level have already been radical in many countries, compared to anything that would have been imagined a short time ago:

  • central banks’ extension of credit to institutions and under terms not contemplated in the past,
  • governments’ buying up bad assets and taking over troubled banks and financial institutions (or engineering their transformation),
  • agencies guaranteeing deposits (without limit) and money market funds, and so on.

Some of these steps can be done at the purely domestic level (US takeover of Fannie Mae and Freddie Mac); others require cooperation between a small number of countries (rescue of Fortis by Benelux countries); but others arguably require multilateral agreement, and thus are candidates for a modest “Bretton Woods.”

  • The International Monetary Fund has been given the task of outlining what a new Bretton Woods would look like – appropriate since the IMF is one of the original Bretton Woods institutions (along with the World Bank).
    • An Early Warning system is almost certain to be high on its list. But it already developed early warning indicators, after the East Asia crisis of 1997-98, and they haven’t been much help.
    • Now that the financial crisis is spreading to small economies like Iceland, transition economies in easternmost Europe, and poor countries like Pakistan, the IMF country rescue programs will get back in the saddle.
      • This time around, however, the Fund has more competition (including from the ECB, the Gulf countries, China, and Sovereign Wealth Funds), and partly for that reason will probably demand less conditionality from the borrowing countries.
        • Bill Rhodes has proposed that the Fund facilitate expansion of currency swap arrangements, to allow emerging markets to have the same access that has been made available to developing countries; and that it should try to resurrect a lending facility known as Contingent Credit Lines.
        • The Fund would have to turn to newly-wealthy countries like China to help finance such new facilities and programs.
        • Michael Bordo and Harold James have suggested that the Fund could manage reserve assets of the new surplus countries; but it is not clear why the latter should want it to.
      • There has been a loose one-year campaign to suggest guidelines for the operations of Sovereign Wealth Funds themselves. But benefits of the SWFs may be more widely appreciated now, in the context of the current crisis than previously.
      • The IMF, just as all the multilateral economic institutions, has moved far too slowly to give added representation to the newly important developing countries such as China, Brazil, Korea, India and Mexico – representation at least in proportion to their economic role, to say nothing of population.
        • A big part of the problem is that larger quotas and voting shares for these countries would have to come to a substantial extent out of Europe’s share.
        • In a fair world, Europe would also give up its stranglehold on the Managing Directorship (especially after the performance of the last two incumbents); and the same goes for the U.S and the World Bank presidency.
    • The IMF, just as all the multilateral economic institutions, has moved far too slowly to give added representation to the newly important developing countries such as China, Brazil, Korea, India and Mexico – representation at least in proportion to their economic role, to say nothing of population.
      • A big part of the problem is that larger quotas and voting shares for these countries would have to come to a substantial extent out of Europe’s share.
      • In a fair world, Europe would also give up its stranglehold on the Managing Directorship (especially after the performance of the last two incumbents); and the same goes for the U.S and the World Bank presidency.
    • The G-8 has been increasingly handicapped in recent years by virtue of its obsolete membership.
      • How can they discuss global current account imbalances or the need for exchange rate adjustments without China and Saudi Arabia at the table? It looked like the G-20 would supplant the G-7.
      • The G-7 still retains some relevance, in its role as self-appointed steering committee for world governance. After all, this financial crisis did not start in the developing countries, as it did those of 1982, 1997 and 2001.
      • But they will still have to start inviting China, Saudi Arabia, and any other country that they expect to help finance any of its plans.
    • The most probable substantive outcome from talk of the need for a bold new multilateral initiative is that there could be a “Basel III” to replace the “Basel II” agreement.

        It would make capital requirements on banks countercyclical, rather than what has turned out to be procyclical, i.e., destabilizing, under Basel II. (Ironically economists at the BIS in Basel probably deserve credit for being the observers, in addition to Charles Goodhart, who most accurately warned of the procyclicality before the crisis.)

      • A Basel III could also replace the option of self-regulation of banks (under which they could choose their own Value At Risk models) with external regulation.
      • International guidelines for guaranteeing deposits (possibly reinstating a ceiling, such as $100,000, after the crisis has passed) should perhaps be coordinated, to avoid flight of the sort that Ireland’s European partners experienced.
    • Other possibilities:
      • A more ambitious reform would be to try to agree on guidelines to extend prudential regulation from international banks to non-bank financial institutions, since the latter were such a serious part of the problem in 2008 that many either failed or were bailed out, against all expectations.
      • More radically, regulation of this sort not just agreed multilaterally but carried out multilaterally, rather than at the national level, by the BIS (which now includes major emerging market countries) or a new agency.
      • The IMF, Financial Stability Forum, and other institutions will vie to lead the effort.
      • Other radical proposals:
        • A securities transactions tax, harmonized internationally, to raise revenue in a way that satisfies the public’s understandable feeling that the financial sector, which created this financial crisis, should not benefit from the solution.
        • Regulation of certain derivatives, such as Credit Default Swaps.
        • But there is a danger that derivatives regulation could do more harm than good, e.g., a ban on futures markets or short-selling.
      • At the other end of the spectrum, one should consider the possibility that doing nothing might in the end be better than undertaking fundamental reforms in the international financial system.

The Best-Predicted Event in Economics in 35 Years: Paul Krugman’s Nobel Prize

I wish to add my heart-felt approval to many others, regarding the awarding of the Nobel Prize in Economics to Paul Krugman. For those readers of the New York Times who can only think of him as a columnist, let me assure you that long before he ever wrote a newspaper opinion piece, Krugman had become the leading international economist of my generation. I leave it to others to explain the work on trade theory that earned the ultimate accolade. I will only say that (together with Elhanan Helpman) Krugman took traditional trade theory – which ever since David Ricardo had assumed perfect competition, constant returns to scale, and unchanging technology – and made it more realistic by assuming imperfect competition, increasing returns to scale, and endogenous technology.

Paul was my classmate in graduate school at MIT in the mid-1970s. In 1974 I departed my idyllic undergraduate institution for life in the big city (academically speaking). My college mentor had given me some final words of advice: not to waste much time worrying about how a position near the top of my undergraduate class would translate to the MIT Economics Department, where all the students had been at the top of their class. He said, “My impression is that within a few months of starting the graduate program, the students sort out for themselves who is the top student, the second student, and so on, and then they don’t worry about it from then on.” As it turned out, it only took two weeks for us to figure out that Paul was the star of the class. This was clear, not so much from grades on problem sets, but from the intense discussion among classmates that is the core of a good graduate program.

When it came time to write a class skit at the annual MIT Christmas party, we did a parody of the Wizard of Oz. There was no question who should play the Wizard, who was a parody of Paul Samuelson: our own Paul. Here are some of his lines, from 34 years ago:

“Though I made a lot of money
No one thought my jokes were funny
‘Til I won the Nobel Prize…”

“So you see you can be winners
even though you are just beginners
When you win your Nobel Prize.”

Congratulations, Paul. We always knew you would do it!