real yields according to TIPS seems fairly low in historical perspective

From Econbrowser:

"High Anxiety (about Interest and Inflation Rates)

In March 2001, I was tasked to follow developments in Japanese macro policy (including monetary, exchange rate, and banking recapitalization issues). Readers will be tempted to ask what this has to do with current events. Well, at the time, Japan was facing rapidly rising net debt-to-GDP ratios (rising from 60.4 ppts of GDP to 84.6 ppts from 2000 to 2005), and was embarking upon a policy of quantitative easing in an attempt to stave off a deep recession. And yet opponents of quantitative easing worried about hyper-inflation, even as y/y inflation at the time remained mired in the negative range. I didn't understand the fears at the time; and I still don't. Now flash forward eight years, and move across the Pacific.

Recent commentary has focused on the sharp reversal in US long term interest rates [0] and the steepening of the yield curve [1] [2]. The anxiety seems to be centered on the collision between increasing supply and decreasing demand for US government debt (although see Brad Setser's recent article), combined with quantitative easing that spurs fears of debt monetization. US Federal debt held by the public to GDP ratios are projected to rise from 56.8 ppts to 73.2 ppts (end-FY09 to end-FY14) (Source: CBO, March 2009), while reserves have gone from $96.5 billion in August 2008 to $949.6 billion by April 2009 (seasonally adjusted figures, from FREDII). Of course, returning to my Japan case, reserves (actually, the "current account balance") rose from about 5 trillion yen to about 32 trillion by 2004 during the episode quantitative easing, before reverting to about 9 trillion in 2006 (Source: Humpage and Schenk, 2009). And yet, Japanese y/y inflation never really stayed in positive territory until 2008 (and it's back to negative range in 2009Q1).

Hence, I thought it useful at this juncture to review trends in long term nominal interest rates and long term real interest rates, in order to get some perspective.

Figure 1: Five year (blue) and ten year (red) constant maturity nominal yields, monthly averages of daily data. Triangles denote data for May 27. NBER defined recession dates shaded gray. Dashed line indicates sample start for Figure 2. Source: FREDII and NBER.

Figure 2: Five year (blue) and ten year (red) TIPS constant maturity yields, monthly averages of daily data. Inverted triangles denote data for May 27. NBER defined recession dates shaded gray. Dashed line indicates sample start for Figure 2. Source: FREDII and NBER.

Ten year constant maturity rates as of 27 May are back to levels of September 2008, as are the real rates (keeping in mind the distortions in the TIPS markets). The sharp rise in the nominal rates, even while real rates are only slightly above where they were in April, suggests to me that about half the nominal interest rate movements are due to revisions to inflation expectations (here's Jim's take on the inflation component to these yield shifts).

Taking the Treasury-TIPS spread literally as a measure of inflationary expectation (see caveats in the appendix here), 10 year expected inflation was 1.36% in April; as of May 27, the implied annual inflation was 1.88%, an increase of about 0.5 percentage points. The increase in the 10 year real rate was 0.26 percentage points. Of course, one would want to allow for a lot of uncertainty in these calculations, given the academic research detailing the problems with equating break-even with expected inflation (see D'Amico et al. 2008), even before the recent turmoil in the TIPS markets.

Of course, the United States in 2009 is different than Japan in 2001. One key difference is that Japan was, and remains, a net creditor. America is a big net debtor to the rest of the world, with extremely large holdings of US Treasurys by foreign private and state actors. And so, for me, I worry more about higher real interest rates (portfolio balance effects) than higher inflation. But even here, real yields according to TIPS seems fairly low in historical perspective (and roughly comparable to those prevailing during the period characterized as "the saving glut").

My bottom line: Think, and recollect, before panicking.

Technorati Tags: yield curve, quantitative easing, inflation expectations, recession, debt, and deficits.

Posted by Menzie Chinn"

so one has to be careful about using these prices as forecasts, even if one were to assume risk neutral agents

TO BE NOTED: From Econbrowser:

"House Prices Continue to Slide

House prices continued to tumble in March, according to the Case-Shiller index. Time to see what the futures say (keeping in mind the forecasting capacity of the Case Shiller futures are not well known).

Figure 2: Case-Shiller 10 city price index, (blue line), CME futures prices, 26 May 2009 (red triangle), and CME futures prices, 21 Sep 2008 (green diamond). NBER-defined recessions shaded gray, and start date dashed gray line Source: Standard and Poors' [xls], ino.com, St. Louis FRED II, NBER, and author's calculations.

So as of March, the 10 city is 40% lower than its May 2006 peak, in log terms (37%, in percent terms). The CME futures indicate that the 10 city index will be 52.7% lower by May 2010 (41% in percent terms). Compared to last September, the trough has moved up (the trough back then was slated to be in May 2011). However, one doesn't want to make too much of these long horizon indications, since the futures prices for these dates (November 2011 onward) have not changed since, for instance, the February 25 futures (shown in this post).

Of course, futures prices incorporate both expectations and risk preferences. In addition, these markets -- particularly at longer horizons -- are not likely to be particularly thick, so one has to be careful about using these prices as forecasts, even if one were to assume risk neutral agents. For an alternative, one can use the forecasts of the old OFHEO indices and convert to implied Case-Shiller (see this post for example).

More commentary at Calculated Risk.

Posted by Menzie Chinn"

while the sharp decline in trade flows might be over, I'm not so sure that we'll see trend increases soon

TO BE NOTED: From Econbrowser:

"Additional Reflections on the March Trade Release

My views on the short term prospects for GDP growth at home and abroad were little changed (relative to this post) by the information in the March trade release. Goods imports are collapsing, albeit at a slower but still substantial rate, and goods exports are declining, with high volatility.

First consider the growth rates of real goods imports ex.-oil and real goods exports.

Figure 1: Month-on-month annualized growth of real goods imports ex.-oil (bold red), and of real goods exports (bold blue); and year-on-year growth rates (respectively teal, purple); all in Ch.2000$, calculated as log differences. NBER defined recession dates shaded gray, assuming recession has not ended by May 2009. Source: BEA/Census, March trade release, NBER, and author's calculations.

Note that imports seem to be recovering. But it's important to look closely at the vertical axis; month-on-month annualized growth rate is minus 10.9%, and the year-on-year growth rate is minus 24.8%.

Goods exports month-on-month annualized growth rates have dropped back into negative territory -- at minus 22.3%. But even the year-on-year rate is -15.4%. So here, I'm in agreement with Brad Setser's observations [1], [2] -- trade has collapsed and there's little evidence that there's an incipient recovery.

Now, turning to the implications for future growth -- I believe that a recorded decline in imports implies (conditional on observing other data) an increase in contemporaneous GDP, but a decrease in future growth prospects (holding all else constant).

It turns out that updating the advance release figures for imports with the actual March import numbers changes the implied GDP for 2009Q1 (to -5.9% SAAR, as opposed to -6.1% [3]), but does not change the overall picture regarding imports in a perceptible manner (see for instance Figure 1 in this April 27th post).

Figure 2: Log GDP (blue, left scale), log goods import ex.-oil from NIPA (red, right scale), estimated from trade release (purple, right scale), all in Ch.2000$, SAAR. 2009q1 estimate is based on actual January-March data, rescaled to match in 2008Q4 NIPA data; 2009Q1 GDP number is edited to reflect -5.9% growth, rather than officially reported -6.1%. NBER recession dates shaded gray. Source: BEA, GDP advance release of 27 April 2009, March trade release, NBER, and author's calculations.

Lower imports implies lower future GDP to the extent that lower imports are associated with lower exports (vertical specialization), and lower consumption (since at least 22% of imports -- if one includes cars -- are for consumption, as of last year). On the other hand, the inventory channel works in the other direction -- if inventories have fallen along with imports, then rebuilding of inventories in the future will have to be done in part with greater production. I'm betting this latter channel is not as big as the first two, as I argued in this post.

In addition, I'll observe that some observers must be assuming some persistence in the trade balance, and assuming a smaller April trade deficit implies higher GDP in 2009Q2 [4], conditioning on everything else (consumption, investment, government spending) in that quarter.

So, while the sharp decline in trade flows might be over, I'm not so sure that we'll see trend increases soon (although Deutsce Bank believes trade flows in dollar terms might increase in the near future), especially given the downside surprise in retail sales reported today.

Posted by Menzie Chinn"

augment price theory with a more realistic depiction of human behavior if we are to avoid a repeat of the current situation

TO BE NOTED: From Econbrowser:

"Two Books

...and the Financial and Economic Crisis

I don't read very many books. At least not during the academic year. But I have read two books recently that are quite germane to thinking about the buildup to the financial crisis, and thinking about how to respond to the current economic downturn. The first is Akerlof and Shiller's Animal Spirits. The second one is actually not yet out -- it's Justin Fox's The Myth of the Rational Market (I got a prepublication copy; here's a hint of it). They are both important books, well worth reading.

As one can guess from the titles of these two books, neither text is a paean to the predictive power of the neoclassical view of the world. I'd expect that most readers trained in this tradition would then skip this blogpost. But before you do, and go back to reading your financial industry newsletter, you might consider where these seemingly neutral phrases such as "risk appetite" come from. Why did "risk" seemingly disappear in 2005-06, only to reappear in 2008? Why did asset prices (including house prices) climb so much? Think about the traditional asset pricing (Gordon Growth equation):

P_t = D_t/(k_e - g)

Where P is the stock price, D is the dividend today, k_e is the equity discount rate, and g is the deterministic growth rate of dividends; and k_e equals the risk free rate plus the equity risk premium.

Where does this equity risk premium come from? Well, it could come from the covariation of real equity returns with the ratio of the marginal utility of consumption. Or it could come from waves of excess optimism and pessimism. Or it could come from both – although one would need to take a stand on the relative weights of the two effects.

I'm sure there are readers out there at this moment saying "But what about the finding that stock prices follow a random walk; this is consistent with the efficient markets hypothesis." But as Fox writes:

Fama had proposed that the way to test the efficient markets hypothesis was to see if stock price movements obeyed the dictates of the capital asset pricing model, but this was only a relative test. It might reveal whether stock price movements made sense in relation to each other and the overall market, but it was no help in showing whether the overall market was correctly price or not. (p. 184)

Digression 1: To place this in technical terms, the maintained hypothesis is the statistical null hypothesis of no predictability. Failure to reject to no-predictability null is consistent with the random walk hypothesis, and hence the weak form efficient markets hypothesis (EMH). However, it is very difficult for most statistical test to differentiate between no predictability and little predictability. Jeffrey Frankel has called this econometric approach "the zen of perfect nothingness".

Digression 2: Larry Summers (J. Finance, 1985) showed how a financial market pervaded by strong and persistent deviations from the fundamentals ("fads") would take five thousand years to have 50% chance of distinguishing it from a truly efficient market, defined in the statistical sense Fama defined it.

To the extent that these waves of optimism and pessimism -- heck why not call them animal spirits -- are a real world force, then this argues that self-regulation of the financial industry is not likely to be sufficient. It's not a prima facie case in support of government regulation (especially if regulation can be captured, a la Simon Johnson's regulatory capture view). But I think we should at least try to regulation and/or other means of slowing down the excess movements (financial taxes could in principle work this way, as in the Tobin tax).

Akerlof and Shiller conclude Chapter 11 thus:

...financial markets require regulation. And sometimes, when these regulations fail, because of all the feedbacks between financial markets and the real economy, there is also room for thoughtful, careful policies of financial insurance. Rededication to protecting the financial consumer must be one of our highest economic priorities.

In an emergency, as a backup, when we do get into a recession, there is a monetary and fiscal policy. But we know that there are limits to such policy and to its effectiveness. It is now time to redesign financial regulations to take account of the animal spirits that often drive the markets, to make the markets work more effectively, and to minimize the extent to which we will need after the fact bailouts to get us out of the hole.

See also the oped in yesterday's WSJ.

By the way, the authors of both books agree that the point is not to dispense with price theory. That point is made on page 2 of Akerlof-Shiller, and in a quote of one of the fathers of behavioral economics, Richard Thaler, regarding the Shanghai apartment market: "Maybe it's just supply and demand" (p. 286). Rather, the point is that we need to augment price theory with a more realistic depiction of human behavior if we are to avoid a repeat of the current situation.

I leave with two figures from Robert Shiller's paper "Do stock prices move to much to be justified by subsequent changes in dividends," American Economic Review 71(3) (June 1981).

(Hint on interpretation: The dashed line should be more variable than the solid line, under the EMH and assumptions regarding stationarity. See Engel (2004) for updated discussion.)

Posted by Menzie Chinn at April 24, 2009 09:10 PM"

In addition to its severity, this global recession also qualifies as the most synchronized

TO BE NOTED: From Econbrowser:

"The Great Recession Goes Global

One of the most interesting "boxes" in the IMF's World Economic Outlook (in Chapter 1) is the one entitled, somewhat innocuously "Global Business Cycles", by Marco Terrones, Ayhan Kose and Prakash Loungani at the IMF. Yet, it's important to read until the ending paragraph:

To summarize, the 2009 forecasts of economic activity, if realized, would qualify this year as the most severe global recession during the postwar period. Most indicators are expected to register sharper declines than in previous episodes of global recession. In addition to its severity, this global recession also qualifies as the most synchronized, as virtually all the advanced economies and many emerging and developing economies are in recession.

The authors are to be commended for simultaneously analyzing the data for numerous countries (not easy, as anybody who's tried this knows!) and applying a systematic procedure for dating the troughs and peaks.

From my perspective, the graphs easily summarize the main points.

Excerpt from Figure in Box: "Global Business Cycles," IMF WEO April 2009.


Excerpt from Figure in Box: "Global Business Cycles," IMF WEO April 2009.


Excerpt from Figure in Box: "Global Business Cycles," IMF WEO April 2009.

Related to these indicators related in the Box is the IMF's view of the world output gap. As Econbrowser readers know, I think the output gap is another important indicator -- despite the imprecision associated with such estimates -- of economic distress. Here's the relevant graph:

Excerpt from Figure 1.9 from IMF World Economic Outlook, April 2009.

Posted by Menzie Chinn at April 22, 2009 09:31 AM"

recessions are longer and deeper when associated with financial crises

TO BE NOTED: From Econbrowser:

"How Bad Is This Recession? And Why? -- Illustrated Version

Chapter 3 of the IMF's World Economic Outlook has a great summary figure:

The chapter documents the stylized facts that (1) recessions are longer and deeper when associated with financial crises, and (2) recessions are longer and deeper when the downturns are synchronized with recessions abroad. And those two points are why this otherwise reasonable -- and representative (but not from the IMF) -- prognostication from 15 months ago proved so wrong:

We know this for sure: It could be a lot worse, recessions used to last almost two years during the 1854-1919 period, and 1.5 years in the 1919-1945 period. Since WWII, the average recession lasted 10 months, and the last two recessions (1990-1991 and 2001) lasted only 8 months. With the support of a booming world economy, we could expect a short and shallow 2008 recession, IF it happens. If futures trading is correct, there's a 29% of NOT having a recession, so don't give up hope.

Source: a blog posting from January 2008.

Posted by Menzie Chinn at April 17, 2009 05:57 PM"

this perspective contrasts with Charles Wyplosz's view, who argues that QE is basically a beggar thy neighbor policy

TO BE NOTED: From Econbrowser:

"The Demise of the Dollar? Should We Worry about Quantitative Easing and Deficit Spending?

Over the weekend, I was working on my long delayed manuscript on exchange rate modeling [0], and pondering how useful the conventional econometric techniques were for making predictions about the future value of the dollar.

Figure 1: Log value of trade weighted dollar, against a basket of major currencies (blue), and against a broad basket of currencies (red); and Deutsche Bank forecasts, calculated using implied changes of DB TWI (dark blue boxes). NBER defined recession shaded gray; only peak indicated for current recession. Source: Federal Reserve via FRED II, Deutsche Bank Exchange Rate Perspectives (27 March 2009), NBER, and author's calculations.

Why wonder? Well, in the final chapter of the text, I outlined the use of Taylor rule fundamentals to explain exchange rates (see this paper and these posts [1], [2], [3]). However, the fact that several central banks have hit the zero interest rate bound, and instituted quantitative easing (QE), makes the plausibility of such models limited in the near future.

Figure 2: Assets of the Federal Reserve, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to March 25, 2009. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright. Source: Hamilton, "The Fed's new balance sheet".

At the same time, we are witnessing a substantial increase in government debt, as documented in this post. Working off a portfolio balance model, as discussed in this post, one would expect a depreciation of the dollar or an increase in the exchange risk premium. However, all developed countries are expanding debt to GDP ratios.

Table 1.5 from OECD, Economic Outlook (March 2009) [pdf].

(Notice that gross debt differs from net debt, so these figures are not comparable to those in this post.)

Deutsche Bank, in its most recent Exchange Rate Perspectives (March 27, 2009) [not online], concludes:

Fiscal expansion combined with QE

What is the implication of fiscal expansion combined with QE? We have argued that history suggests the implications of higher fiscal deficits for the dollar will depend on whether or not the higher deficits are accompanied by higher relative US longer-term rates (Fiscal Deficits and the Dollar, ERP, September 2008). So if relatively more activist fiscal policy in the US raises relative US yields, history suggests this should be positive for the dollar. But there is widespread concern that if the higher deficits are accompanied by expectations of or actual QE, this will be negative for the dollar. This is essentially a "risk premium" argument that even with higher relative US yields, because of or under QE, this will be negative for the dollar. Looking at historical experience for episodes of risk premia against the dollar by examining the correlation between daily returns in EURUSD versus the longer-term rate differential indicates six episodes of negative correlations between the differential and the dollar. Four of these are episodes of risk premium in favor of the dollar, with declines in the dollar rate differential associated with a higher dollar. There have only been two episodes—in the late summer and early fall of 1998 and in the summer of 2003 -- when a move in rate differentials in favor of the dollar was associated with a weaker dollar. There have thus historically been very few episodes of such a risk premium. Presently this correlation between changes in the yield differential and the dollar is running around zero to very modestly negative. This is consistent with the view that most of the recent sharp depreciation in the dollar has been in line with the decline in US rate differentials and there is little or no evidence that higher expected fiscal deficits in the US combined with QE have created a risk premium against the dollar ...

Interestingly, this perspective contrasts with Charles Wyplosz's view, who argues that QE is basically a beggar thy neighbor policy. Perhaps it is, but when many countries are undertaking QE [4] [5] the effects cancel out.

What about China? As Brad Setser points out, China has slowed accumulation of Treasurys. How this will play out depends on how much the currency composition of assets changes as a consequence. And indeed whether the slowdown in accumulation persists.

Returning to the question that inspired this post, DB asserts that the long term yield differential will drive the dollar. That seems to be a hypothesis that one will be able to test as the data roll in. So I remain hopeful that the empirical methods of the past will prove yet again useful in the future, despite the changed nature of the world.

[Addition, 8:15pm Pacific It turns out that Barry Eichengreen has already observed this nullification effect -- but adds that it would be better to coordinate QE across countries. See this article from last month.]

By the way, if you're looking for estimates of increased debt-to-GDP stocks on interest rates, see Table 3.5 of the OECD, Economic Outlook (March 2009) [pdf]....you'll see a reference to this paper.

Technorati Tags: zero interest rate policy, quanitative easing, exchange rates, Taylor rule, and portfolio balance.

Posted by Menzie Chinn at April 13, 2009 07:40 PM"

0% of respondents perceived inflation as the biggest threat to their forecast

TO BE NOTED: From Econbrowser:

"Growth Expectations Stabilize

The WSJ survey of forecasts has just come out [link]. One key finding is that the mean forecast has barely budged since March. In other words, unlike previous months, the perceived outlook has ceased deteriorating.

That being said, the dispersion of forecasts is pretty high, even q4/q4, ranging (-3.5%, 3.4%).

Figure 1: Histogram of 4q/4q growth rate of real GDP (in percent) from March WSJ survey. Source: WSJ April survey and author's calculations.

One is tempted to ask who is forecasting 3.4%. That would be James F. Smith, of Western Carolina State University and Parsec Financial Management. Dr. Smith has been extremely consistent in his forecasts for q4/q4 growth, having forecasted 3.4% in the December 2008, as well as in the January, February and March 2009 surveys (I didn't go further back than December...). Note that once his forecast is removed, the distribution of the survey responses is approximately Normal (i.e., a Jarque Bera test can't reject the null of a Normal, at the 43% msl). In addition, the mean growth rate drops to -1.48%.

I noted in the first paragraph that the mean forecast had ceased deteriorating. One can see this if one plots the March and April mean forecasts. The forecasted trajectory of GDP is essentially unchanged. One has to go back to the February forecast to see the detioration, as is shown in Figure 2.

Figure 2: Log real GDP (blue), April WSJ survey mean forecast (red), real GDP advance (teal), February WSJ mean forecast (pink), CBO potential GDP (black), all in log of Ch.2000$. Source: BEA GDP final and advance releases, WSJ, CBO, NBER and author’s calculations.

In this sense, the statements by several individuals that the outlook has stopped deteriorating are consistent with forecasters' views. [0] [1] However, this is not the same as saying economic conditions have stabilized. In fact, the mean GDP forecast still indicates continued decline into 2009Q2. And of course, means by definition do not show the variance in forecasts.

Because of the aforementioned sensitivity to outliers (I'll call it the James Smith problem), I've plotted in Figure 3 (log) real GDP, the mean WSJ forecast from the April survey, and trimmed high and low forecasts (that is, looking at the 6th highest and 6th lowest q4/q4 forecasts; thus I've dropped the top 5 and bottom 5, out of 54 forecasts).

Figure 3: Log real GDP (blue), April WSJ survey mean forecast (red), trimmed high and trimmed low forecasts (gray), CBO potential GDP (black), all in log of Ch.2000$. Source: BEA GDP final release, WSJ, CBO, NBER and author’s calculations.

The mean forecast implies that the output gap will be -8% (in log terms) in 2009q4. If the optimists are right, then the output gap will only be -6%.

The survey was conducted between April 3-6. Thus, they came before the trade release for February. Since the trade balance was above consensus, conditional nowcasts of GDP have probably risen [2].

On the other hand, the OECD forecast cited in this post implies continued decline throughout 2009. I'm not certain why the OECD is so gloomy (or alternatively, why the US-based forecasters are so optimistic). Using the OECD forecast and the CBO potential, the output gap will be 10.9% (log terms) by 2010q4. Perhaps this is in part due to a more pessimistic assessment of potential GDP (eyeballing the "Output Gap" table in Appendix 1.2 of the March OECD Economic Outlook, it seems that the OECD's estimate of potential is about 1.2% ppts less CBO's).

A final observation: given the substantial negative output gap under reasonable assumptions, it's hard for me to be particularly worried about inflation in the current year, as evidenced in some fevered accounts (e.g., [3]). Given that 0% of respondents perceived inflation as the biggest threat to their forecast, I think I'm in good company. (Digression: in 2000-01, when I was following the Japanese economy on the CEA staff, I also heard worries about hyperinflation in the wake of rising debt-to-GDP ratios; so far we haven't seen that outcome materialize).

Technorati Tags: recession, GDP, inflation,output gap, potential GDP, hyper-inflation, and forecast.

Posted by Menzie Chinn at April 10, 2009 09:00 PM"

his account is one that everbody should read

From Econbrowser:

"Phillip Swagel on the Financial Crisis

I'm behind the curve on recommending Phillip Swagel's BPEA paper on the Administration's response to the financial crisis. But today he talked to the students in my macro course, and his presentation just reinforced my view that his account is one that everbody should read.

Here's a picture showing the evolution of the one-month Libor-OIS spread.

Figure 2: from P. Swagel, "The Financial Crisis: An Inside View," paper presented at Brookings Panel on Economic Activity, March 2009.

Other commentary on the paper: [0], [1], [2], [3].

Posted by Menzie Chinn at April 8, 2009 06:30 PM"

large liabilities are important to the extent that bank deleveraging implies a long drawn out curtailment of credit to emerging markets

TO BE NOTED: From Econbrowser:

"Stress

As the G-20 leaders meet in London, one graph should remind the representatives of these disparate countries of their shared interest in restoring the health of the financial systems of the developed countries.

Figure from Box 2 IMF.

What this graph shows is financial stress in the advanced economies leads to financial stress in the emerging markets.

The indices depicted were developed for individual countries and will be detailed in a chapter in the forthcoming* IMF World Economic Outlook (by Ravi Balakrishnan, Stephan Danninger, Selim Elekdag and Irina Tytell), to be released later in April. The advanced country financial stress indices (FSI) are a composite of banking sector, interbank spreads, term spreads (described in the October 2008 WEO, Chapter 4). Specifically:

• Banking sector: rolling 12-month covariance of the year-over-year percent change of a country’s banking sector equity index and its overall stock market index, divided by the rolling 12-month variance of the year-over-year percent change of the overall stock market index.
• TED spread: three-month LIBOR or commercial paper rate minus the government short term rate.
• Inverted term spread: government short term rate minus government long-term rate.

The emerging market FSI is constructed as a weighted average of the exchange market pressure index, sovereign spreads, the banking sector beta, stock returns, and time-varying stock return volatility.

The authors note that the pass through of financial stress from advanced countries to emerging markets is almost one-for-one. That being said:

there is significant cross-country variation. An empirical analysis of stress comovement shows that stronger financial (i.e., banking, portfolio, and FDI) linkages are associated with a higher stress pass-through from advanced to emerging economies. During the most recent crisis, bank lending linkages have been the main driver of stress transmission.

This characterization is obtained via a two-step procedure, as in Forbes and Chinn (2004). In the first step, the coefficient relating emerging market stress to advanced is obtained. These coefficients are then treated as data, in a regression on determinants such as FDI and banking linkages.

Another way of seeing the importance of, for instance, bank linkages is by inspecting the emerging market liabilities to advanced country banks:

Figure from Box 2 IMF.

In my view, large liabilities are important to the extent that bank deleveraging implies a long drawn out curtailment of credit to emerging markets. The IMF analysis observes:

Evidence from past episodes of systemic banking stress in advanced economies (Latin American debt crisis of the early 1980s and the Japanese banking crisis of the 1990s) implies that the decline in capital flows may be sizeable and drawn out. Given their large exposure, emerging European economies might be heavily affected, although EU membership offers some protection.

The complete analysis will come out in the next WEO.

* Full Disclosure: I was a consultant on this forthcoming chapter.

Posted by Menzie Chinn at March 31, 2009 09:24 PM"

I suspect we'd have a lot more latitude for stimulus

TO BE NOTED: From Econbrowser:

"The Debt to GDP Trajectory in Perspective

There's been substantial discussion of how the debt-to-GDP ratio evolves under the Obama plan. In part, the House attempts to pare back certain provisions of the Obama budget are a reaction to the projected rise in the debt-to-GDP ratio [0].

Inspection of Figure 1 does provide some support for the view that we need to pare back spending, or raise taxes (seldom mentioned).

Figure 1: Ratio of Federal debt held by public to GDP (blue), CBO baseline (green), Obama budget as scored by CBO (black), and CBO baseline minus stimulus package (red), by fiscal years. In the baseline minus stimulus, I have merely subtracted the cumulated stimulus bill deficits; hence, no accounting for associated interest is included. Dashed line indicates last observation on actual data. Sources: CBO, CBO historical statistics, and CBO letter to Grassley (March 2, 2009), and author's calculations.

I'll make three observations at this point.

• A big chunk of the increase in the debt-to-GDP ratio occurs because of the recession-driven collapse in revenues and the policy actions undertaken by the previous administration and Congress. Graphically, this is shown by the sharp jump in the series in FY 2009 (which started in October 2008).
• The debt-to-GDP projections do not take into account the stimulative effects of the stimulus plan, and in the budget. This is appropriate (as I have argued in the past, in my discussion of dynamic scoring [1]) because the magnitude of the stimulative effect is a subject of debate. Still, for those who are neither RBCers, nor Classical economists, we would expect the actual path of the debt-to-GDP ratio to be lower than projected (ceteris paribus) as GDP is higher than baseline in the first few years of the outlook [2] [3].
• The baseline debt-to-GDP ratio is in some sense unrealistic because it assumes discretionary spending grows with the CPI. Assuming that discretionary spending grows with nominal GDP -- a more realistic assumption [4] -- would make the gap between the baseline and the Obama budget debt/gdp ratio as scored by CBO smaller.

Still, even taking into account these factors, one should worry about crowding out, and the possibility that dollar denominated assets will become less desirable as the supply of Federal debt increases.

At this juncture, it might be useful to take a longer, historical, perspective on this issue. Below I plot data going back to FY 1938

Figure 2: Ratio of Federal debt held by public to GDP (blue), Ratio of end-FY Federal debt held by public to Calender Year GDP (real), CBO baseline (green), Obama budget as scored by CBO (black), and CBO baseline minus stimulus package (red), by fiscal years. In the baseline minus stimulus, I have merely subtracted the cumulated stimulus bill deficits; hence, no accounting for associated interest is included. Dashed line indicates last observation on actual data. Sources: CBO, CBO historical statistics, and CBO letter to Grassley (March 2, 2009), FRED II, and author's calculations.

So, in the past, the Federal debt-to-GDP ratio has been higher than it is projected to be. Admittedly, the times are different. Financial autarky (approximately) prevailed in the 1940's and early 1950's, so the degree of substitubility between dollar and pound (and franc) denominated assets was low. That is not so now. However, it's also important to realize that debt-to-GDP ratios are rising in many other economies that are associated with currencies that might be thought to be close substitutes (think UK). And in the euro area, doubts about the government debt of certain economies is likely to make euro denominated assets also poor substitutes. (Remember that many of the debt-to-GDP ratios in Europe are higher than that in the US -- see slightly different [gross] ratios here). In any case, the analysis of the dilemma we are currently facing I laid out in this post from last July.

A last observation. Just think if the 2001 and 2003 tax cuts had never occurred. What would the debt-to-GDP ratio look like? I suspect we'd have a lot more latitude for stimulus. Not a new observation -- see here (and the accompanying commentary, which in retrospect is quite amusing) -- but one useful to recall.

Posted by Menzie Chinn at March 26, 2009 05:42 AM"

why GOP calls for using tax cuts to stimulate demand are likely not going to be the most effective policy tool

From Econospeak:

"Ricardian Equivalence Does Not Imply That Obama’s Fiscal Stimulus Will Be Ineffective

Kevin Quinn noted that the Wikipedia discussion of Ricardian Equivalence had the following error:

Ricardian equivalence states that a deficit-financed increase in government spending will not lead to an increase in aggregate demand. If consumers are 'Ricardian' they will save more now to compensate for the higher taxes they expect to face in the future, as the government has to pay back its debts. The increased government spending is exactly offset by decreased consumption on the part of the public, so aggregate demand does not change.

As noted here, John Cochrane made the same error. I would hope the Myron S. Scholes Professor of Finance at the University of Chicago Booth School of Business does not rely upon Wikipedia for his economic research. Alas, in an otherwise excellent post on fiscal policy, Menzie Chinn sort of falls into this trap as well:

Case 5 (government debts will have to be paid off in its entirety the future): When budget constraints hold with certainty intertemporally, and there is no way to default even partially on government debt (say via unexpected inflation), then increases in government debt due to tax cuts (for instance) induce no change in current consumption because households fully internalize the present value of the future tax liability

Menzie is right about transitional changes in tax policy not being able to change consumption in this Barro-Ricardo model, which is why GOP calls for using tax cuts to stimulate demand are likely not going to be the most effective policy tool. But what about transitional changes in government purchases? It is interesting that Wikipedia noted Ricardo’s 1820 Essay on the Funding System:

Ricardo studied whether it makes a difference to finance a war with the £20 million in current taxes or to issue government bonds with infinite maturity and annual interest payment of £1 million in all following years financed by future taxes. At the assumed interest rate of 5%, Ricardo concluded that "In point of economy there is no real difference in either of the modes, for 20 millions in one payment, 1 million per annum for ever ... are precisely of the same value".

Let’s modernize this example. Suppose we decide to have an additional $100 billion in public investment in 2009. In Ricardo’s example, permanent taxes will increase by $5 billion per year which would have a very modest offsetting reduction in consumption. So if government purchases rise by $100 billion and consumption falls by $5 billion, then isn’t the direct impact on aggregate demand closer to $95 billion for the year rather than zero?

Update: Republicans will oppose more government spending as they prefer tax cuts:

Hours before a meeting with President Barack Obama, House Republican leaders sought to rally opposition Tuesday to a White House-backed economic stimulus measure with an $825 billion price tag. Several officials said that Reps. John Boehner of Ohio, the GOP leader, and Eric Cantor of Virginia, his second-in-command, delivered the appeal at a closed-door meeting of the Republican rank and file. Both men said the legislation contains too much wasteful spending that will not help the economy recover from its worst nosedive since the Great Depression, the officials added ... Senate Republican Leader Mitch McConnell, R-Ky., said in a televised interview that Obama was having problems with Democrats, whom he said favor spending over tax cuts as a remedy for the economic crisis.

If Ricardian Equivalence holds, the GOP is opposing fiscal stimulus that will impact aggregate demand preferring tax cuts that will not increase aggregate demand. Go figure!

Posted by ProGrowthLiberal at 10:56 AM "

Now me:

January 28, 2009 1:09 PM

Don said...

"households fully internalize the present value of the future tax liability"

I'm puzzled by this statement. Does it purport at all to be about human behavior? Any incentive will work more or less well depending upon a whole number of factors that go into actual human beings making decisions at any given time. Even the historical context makes a difference. I don't think that there's much doubt that massive government spending could influence people's behavior. The question is how much it would take and what might the negative consequences be? These economic equations all look like correlative reasoning or counterfactuals, which are then taken to be like equations that detail the actions of non-teleological objects. Why can't we say say that we're going to spend some and cut some taxes hoping that something might work?

Don the libertarian Democrat

January 28, 2009 2:55 PM

either agents made implausible assessments of future risk/return tradeoffs, or were engaged in "looting" the system by exploiting implicit guarantees

The Spigot Theory is attacked by Menzie Chinn on Econbrowser:

"A New Meme: Blame It on Beijing (and Seoul, and Riyadh...)

Perhaps I'm overstating it, but I think this is the abridged version of the Bush Administration's perspective on how we got into the financial mess we find ourselves in. You might ask why I focus on the ideas of the outgoing government. Well, it's because I'm confident that this will be a thesis pushed by some commentators eager to absolve previous policymakers of blame( I AGREE. IT'S AN ATTEMPT TO SHIFT BLAME. ) [1]. And indeed (as Mish points out), this view has apparently adherents in high places.

But let me let the the Economic Report of the President [large pdf] (Chapter 2) speak for itself:

• The roots of the current global financial crisis began in the late 1990s. A rapid increase in saving by developing countries (sometimes called the "global saving glut") resulted in a large influx of capital to the United States and other industrialized countries, driving down the return on safe assets. The relatively low yield on safe assets likely encouraged( THAT'S ALL IT WAS ) investors to look for higher yields from riskier assets, whose yields also went down. What turned out to be an underpricing of risk across a number of markets (housing, commercial real estate, and leveraged buyouts, among others) in the United States and abroad, and an uncertainty about how this risk was distributed throughout the global financial system, set the stage for subsequent financial distress.
• The influx of inexpensive capital helped finance a housing boom. House prices appreciated rapidly earlier in this decade, and building increased to well-above historic levels. Eventually, house prices began to decline with this glut in housing supply.
• Considerable innovations in housing finance—the growth of subprime mortgages and the expansion of the market for assets backed by mortgages—helped fuel the housing boom. Those innovations were often beneficial, helping to make home ownership more affordable and accessible, but excesses set the stage for later losses.
• The declining value of mortgage-related assets has had a disproportionate effect on the financial sector because a large fraction of mortgage-related assets are held by banks, investment banks, and other highly levered financial institutions. The combination of leverage (the use of borrowed funds) and, in particular, a reliance on short-term funding made these institutions (both in the United States and abroad) vulnerable to large mortgage losses.
• Vulnerable institutions failed, and others nearly failed. The remaining institutions pulled back from extending credit to each other( A CALLING RUN ), and interbank lending rates increased to unprecedented levels. The effects of the crisis were most visible in the financial sector, but the impact and consequences of the crisis are being felt by households, businesses, and governments throughout the world.
• ...

There is greater detail in the section titled: "Origins of the Crisis", subheading "The Global Saving Glut":

...

As this influx of capital became available to fund investments, interest rates fell broadly. The return on safe assets was notably low: the 10-year Treasury rate ranged from only 3.1 percent to 5.3 percent from 2003 to 2007, whereas the average rate over the preceding 40 years was 7.5 percent. While to some extent the low rates reflected relatively benign inflation risk, the rate on risky assets was even lower relative to its historical average: the rate on a 10-year BAA investment-grade (medium-quality) bond ranged from only 5.6 percent to 7.5 percent from 2003 to 2007, whereas the average over the preceding 40 years was 9.3 percent. The net effect was a dramatic narrowing of credit spreads. A credit spread measures the difference between the yield on a risky asset, such as a corporate bond, and the yield on a riskless asset, such as a Treasury bond, with a similar maturity. Risky assets pay a premium for a number of reasons, including liquidity risk (the risk that it will be difficult to sell at an expected price in a timely manner) and default risk (the risk that a borrower will be unable to make timely principal and interest payments).

Thinking in terms of systems of supply and demand is a very useful disciplining device. And here I think resorting to this framework, even allowing for distortions in the markets, can be useful, for it reminds one that the outcome (current account balances or the mirror image, financial account balances, and interest rates) are the equilibrium outcome of supply and demand for saving. (A related, but distinct, perspective is Brad Setser's creditors/debtors story.)

I'll admit that it's plausible to think of an exogenous shift in excess saving (decrease in investment demand in East Asia, increase in corporate and household saving in China, etc.) as resulting in increased US borrowing from abroad. This is indeed a variant of the Bernanke "saving glut" thesis. The Bernanke focus is on the "depth and sophistication" of the US capital markets.

Well, I think this last point leads us to my critique. Was it really sophisticated capital markets in the US, or a mania in which either agents( YES ) made implausible assessments of future risk/return tradeoffs, or were engaged in "looting"( YES ) the system by exploiting implicit guarantees( YES ) and building up contingent liabilities for the taxpayers( YES ), that sucked in capital from the rest of the world.( YOU'VE GOT IT )

Three years ago, I'd surely have a difficult time convincing people that US capital markets weren't completely self-regulating and self-correcting. Maybe it's time to revisit the "saving glut" hypothesis, and say that perhaps capital "sucked" into America, rather than "pushed" into America.

Even if one were to say that the excess saving from East Asia -- and the oil exporters as we enter 2005-08 -- drove( HELPED ) the bubble (and I'm willing to admit that there is something to the argument that global imbalances exacerbated domestic imbalances, especially related to the housing sector), I have two big caveats.

The argument that the saving glut led to low interest rates is not unambiguously accepted. [2], [3], [4], [5] [6] [7]. Consider Wright's work [pdf] on how the conundrum can be explained without resort to a central role for international factors (although he allows for some; see also this post). Also consider the correlation between low interest rates and the US current account. Below is a graph from a post two years ago.

Figure 1: The Net Export to GDP ratio and the ten year constant maturity yield (end of quarter) yield minus the ten year ahead (median) expected CPI inflation rate. Source: FRED II and Philadelphia Fed.

But, thinking again about exogeneity, why were funds flowing to the US. Some of it was low national saving. And why was that saving low? Because we were piling tax cuts upon tax cuts (admittedly I'm sounding like a broken record here: [8] [9]). But then add to this question why did the oil exporters start building up current account surpluses of enormous magnitudes? Because demand for oil rose in China, and the US (some observers conveniently ignore the US and focus on China, but it was adding substantial amounts of incremental demand up to 2005 or so). But some of that Chinese demand for oil was "derived demand", driven by US consumption of Chinese made goods.

So, while I won't say that the idea of saving flows coming from East Asia had some role in the financial crisis we're now undergoing [is completely without content grammar corrected 11:15 Pacific 1/22]], I'd say one has to think about how those flows came about, as much as how big they are. We don't usually think of the rest-of-the-world driving macroeconomic events in the US (here's my take: [10]), and I still don't think it's time to start.

Figure 2: Trade balance to GDP ratio (blue) and trade balance ex. oil imports to GDP ratio (red). NBER defined recessions shaded gray. Sources: BEA/Census trade release for November, Macroeconomic Advisers [xls] (release of 15 January 2009), NBER, and author's calculations.

By the way, I am disagreeing slightly with Brad Setser's take on this subject, although I think it is more a point of emphasis than substance. My reading of his post is that excess saving from East Asia and oil exporters enabled( I AGREE ) (my phrase, not his) the US housing boom, and the search for yield. I think that's somewhat different from the ERP thesis."

This is basically my view.

"This leads me to wonder how we should view the Bush Administration's stewardship of the economy."

Menzie Chinn on econbrowser scores the Bush Economic Disaster. As you know, I believe that the causes of this crisis are:
1) Effects on Investors of the Implicit and Explicit Government Guarantees to intervene in a financial crisis. This allowed much of the excessive risk. I also include here the lack of clarity as to what the government will or won't do.
2) Fraud, Negligence, Fiduciary Mismanagement, and Collusion. I include here lack of enforcement by the government.
3) The perceived incompetence of the Bush Administration. In my view, when this crisis hit, expectations were that the Bush Administration would make things far worse.
Now, let me add:
4) The budget deficit and debt run up in the last eight years. Truly speaking, this should be 3, but, in this crisis, I think that 4 added with other Bush disasters to push the total Bush Disaster Effect higher.

Here's the post:

"Stuff Happens": the Bush Administration's Economic Stewardship

As we near the end of the year, and the end of eight years of Bush economic policy, I think it's useful( BUT NOT PLEASANT ) to look back. The White House has recently tangled with the NYT regarding what got us into the current economic crisis [0] (see also [1]). This comes on the heels of the Paulson argument that he would not have done anything different( SO ASININE ), had he known the full extent of the looming crisis. This leads me to wonder( I DON'T ) how we should view the Bush Administration's stewardship of the economy.

Figure 1: IMF, Global Financial Stability Report (Oct. 2008), Box 1.3.

Candidate Explanations

In particular, when one examines the mixture of policies and events that have led us to the brink of possibly the deepest and most persistent downturn since the Great Depression, one can see several suspects listed.

• Fannie and Freddie( A BIT )
  
• Community Reinvestment Act( A BIT )
  
• CDO's and CDS's( NO. THE MISUSE OF THESE WAS FRAUD, ETC. )
  
• Global saving glut( NO )
  
• Monetary policy( A BIT )
  
• Deregulation( A BIT )
  
• Criminal activity and regulatory disarmament( 2nd MAJOR CAUSE )
  
• Tax cuts and fiscal profligacy( 4 MAJOR CAUSE )
  
• Tax policy( A BIT )
  

Red Herrings

I've already dealt with the first two "betes noire" -- favorite villains in the fevered commentary of certain noneconomists -- in this post, so we can dispense with these as key drivers (Jim attributes some blame, here, although I don't think he attributes central blame here either). I don't think CDO's and CDS's in and of themselves caused the crisis( I AGREE ), although they certainly obscured the primary problem of overleveraging (CDO's) and lack of transparency (CDS's). And the saving glut -- well, the saving glut was a worldwide phenomenon, but I think it safe to say the countries that did and didn't borrow from the Chinese have suffered in the current crisis( I AGREE ) (here is my critique from 2005; CFR report [pdf]).

Synergy

So what I want to think about is the toxic mixture of the last five items, which interacted in a synergistic manner to place us in the situation we are now in.

First, monetary policy. While there seems to be a widespread consensus that it was too lax in 2002-04, this is a viewpoint made with the benefit of hindsight. As Orphanides and Wieland (2007) [pdf] have pointed out, according to the Greenbook forecasts, monetary policy was not -- according to a Taylor rule framework -- overly lax.( I AGREE )

Second, deregulation. On this front, I think it's important to not indict all deregulation (eliminating the Glass-Steagall barriers makes sense to me, while the Phil Gramm-sponsored Commodity Futures Modernization Act exemption of regulation of CDS's does not( A FAIR POINT). I outline some empirical research on what factors were important in this crisis in this post.

Third, regulatory disarmament/nonenforcement and "criminal activity". I would have discounted this item in the absence of clear evidence, but now that we know about how the OTS "helped out" IndyMac [2] [3], I think we can be reasonably confident that we'll hear a lot more about how deregulatory zeal [4] [5] metastatized over into criminal activities on the part of regulators and the regulated.( 2nd MAJOR CAUSE )

Fourth, fiscal profligacy via tax cuts. I think it's important to focus on profligacy (because it pushed the economy more into a boom exactly at a time when not needed) and on tax cuts (because it made people feel like they had more discretionary income than reasonable), thereby pushing the asset boom. ( 4th MAJOR CAUSE )

Fifth, tax policy. In particular, I have been thinking about the tax deductibility on second homes, a provision dating back to 1997 [6] [7] [8]. (I've been thinking about this in part because mortgage deductibility on a second home never made sense to me, let alone on a first home). Capital Games and Gains has pointed out this provision, citing a NYT article. But even this last article doesn't locate primary blame here; rather it's cited as a contributing factor. I suspect that on its own, this provision wouldn't had a big impact, but in combination, it might have. My caveat here is that I haven't found much empirical work backing a big role for this factor.( MINOR )

Typically, in my academic work, I would think of these factors adding up in a linear fashion, so that each of the impulses would sum to the total effect. But (departing from a model, and with no econometric work to back up the hypothesis interactive effects), I think it's worthwhile to think about lax monetary policy, deregulatory zeal and criminal activity/regulatory disarmament, and tax cuts and tax policy changes, all combining to lead to the "bubble" (in a nontechnical sense) we've witnessed, the deflation of which has been associated with the ongoing financial crisis.

Consider one example of a pernicious synergy: the 2001 and 2003 tax cuts were aimed at higher income households, while the second home mortgage deductibility benefited mostly higher income households [7]; with regulatory oversight absent, and low interest rates, well the stage was set.

Prescient, or Not

I won't claim to have foreseen the full enormity of the crisis we're now undergoing. As I indicated when I posted my first blogpost some three years ago, I thought the sheer irresponsibility of the fiscal policy being pursued( TRUE ), against a backdrop of overconfidence in largely nontraded derivatives, would lead to grief in the form of a "sudden stop" of net capital flows to the US. In this respect, I was wrong -- what we've achieved instead is a sort of "global sudden stop" where the process of deleveraging proceeded in a discrete (and "disorderly") fashion( TRUE. DUE TO THE FEAR AND AVERSION TO RISK AND THE ACCOMPANYING FLIGHT TO SAFETY ). So, unlike some, I was only partially -- not completely -- blindsided. (And, I'm sure Akerlof and Romer were completely aware of what was coming...)

I believe history will look critically on the Bush Administration's economic stewardship, in particular how the policies propelled an unsustainable bubble, and tied our hands in the use of fiscal policy tools. In sum, I think Kevin (Dow 36,000) Hassett's view "Bush's Legacy May End Up Better Than You Think" will not prove true."

You are thinking very clearly. I believe that her Synergy is equivalent to my Bush Disaster Effect. Only she fails to see how the Wars, Katrina, etc., can effect economic behavior. For me, Economics only exists in the context and presuppositions of its time.

"the other half attributable to the decline in consumer confidence."

This is an interesting post from Econbrowser by Menzie Chinn:

"One of the debates regarding the current financial crisis is whether in fact there is a crisis, or whether in fact the financial system is operating normally. I've been skeptical myself of the "times are normal view", but here is some evidence that the credit crunch is real. The findings also reinforces my view that un-nuanced reliance on highly aggregated volume statistics (e.g., Chari et al. 2008) is likely to result in misleading inferences (See the rejoinder from the Boston Fed's economists).( MY OPINION WAS THAT THEY WERE NOT THAT CONTRADICTORY. IT WAS MORE A MATTER OF TIMING ) From the conclusion to Tong and Wei (2008):

In this paper, we propose a methodological framework to study the underlying mechanisms by which a financial-sector crisis may affect the real sector, and apply it to the case of the subprime mortgage crisis. In particular, we are interested in documenting and quantifying the importance of ( A ) tightening liquidity constraints and the( B ) deterioration of consumer confidence on non-financial firms. We ask the question: could an ex ante classification of the firms based on their degrees of liquidity constraint and sensitivity to demand contraction prior to the subprime crisis help to predict their ex post stock price performance during the crisis period? We find the answer to be a resounding yes. Both channels are at work; liquidity constraints appear to be more significant quantitatively in explaining cross firm differences in the magnitude of stock price declines. A conservative estimate is that a tightening liquidity constraint is likely to explain at least half of the actual drop in stock prices for firms that were liquidity constrained to start with.

In order to reach these conclusions, we propose a novel methodology that distinguishes a shock to the supply of finance from an expected contraction of economic demand. We measure a firm’s sensitivity to demand contraction by its stock price reaction to the September 11, 2001 terrorist attack (change in log stock price from September 10, 2001 to September 30, 2001). We measure a firm’s liquidity constraint by the Whited-Wu (2006) index, valued at the end of 2006. We conduct extensive robustness checks to ensure that these indicators are valid and informative. For example, we verify that the 9/11 index is not contaminated by the impact of a liquidity constraint itself. While liquidity constraint and demand sensitivity, as measured by these two indicators, have statistically significant power in predicting stock price movement during the subprime crisis period, placebo tests suggest that they do not predict stock price movement in a period shortly before the subprime crisis broke out. An alternative measure of a firm’s dependence on external finance proposed by Rajan and Zingales (1998) and valued based on information during 1990 – 2006 also has predictive power about stock price movement during the subprime crisis period.

Correctly diagnosing the transmission channels for a financial crisis to affect the real economy has implications for designing appropriate policy responses to the crisis. For the subprime mortgage crisis, our analysis suggests that policies that aim primarily at restoring consumer confidence and increasing demand, such as a tax rebate to households, will probably be insufficient to help the real economy( BUT THEY WOULD BE USEFUL ); policies that could relax liquidity constraints faced by non-financial firms are likely to be indispensable ( SUCH AS? ). Our methodology should also be useful in other contexts where effects of a financial shock to the real economy need to be measured. We leave these applications for future work.

To illustrate their methodology and key findings, consider the following:

If subprime problems disproportionately harm those non-financial firms that are more liquidity constrained and/or more sensitive to a consumer demand contraction, could financial investors earn excess returns by betting against these stocks (relative to other stocks)( YES )? This is essentially another way to gauge the quantitative importance of these two factors. We now turn to a “portfolio approach,” and track the effects of the two factors over time. Specifically, we follow three steps. First, we classify each non-financial stock (other than airlines, defense and insurance firms) along two dimensions: whether its degree of liquidity constraint at the end of 2006 (per the value of the Whited-Wu index) is above or below the median in the sample, and whether its sensitivity to a consumer demand contraction is above or below the median. Second, we form four portfolios on July 31, 2007 and fix their compositions in the subsequent periods: the HH portfolio ( 1 ) is a set of equally weighted stocks that are highly liquidity constrained and highly sensitive to consumer demand contraction; the HL portfolio( 2 ) is a set of stocks that are highly liquidity constrained, but relatively not sensitive to a change in consumer confidence; the LH portfolio( 3 ) consist of stocks that are relatively not liquidity constrained but highly sensitive to consumer confidence; and finally, the LL portfolio ( 4 ) consists of stocks that are neither liquidity constrained nor sensitive to consumer confidence. Third, we track the cumulative returns of these four portfolios over time and plot the results in Figure 6.

Here is Figure6:

Figure 6: from Tong and Wei (2008).

They conclude that about half of the decline in stock prices is due to the credit crunch, with the other half attributable to the decline in consumer confidence( I'M MORE INTERESTED IN THE HALF FROM CONSUMER CONFIDENCE ).

By the way, if you think the "no financial crisis" view is a rare anomaly, see: [1], [2]."

"Then a stimulus of about 4 ppts of GDP -- roughly $580 billion -- will bring output up to about potential. "

Menzie Chinn on Econbrowser with some thoughts about the stimulus:

"Then a stimulus of about 4 ppts of GDP -- roughly $580 billion -- will bring output up to about potential. The bigger the tax cut element skewed toward higher income deciles, the larger the required stimulus. (However, I'm optimistic that with the new economic team of Summers, Orszag, Romer and Geithner that's been selected, the package will indeed hew to the idea of maximizing the stimulative impact, which is consistent with targeting the lowest and middle income groups for tax cuts/rebates [5], [6].)

And if stimulus across countries can be synchronized, then so much the better (especially since it would be hard to spend at $580 billion in one year).

By the way, the reason why I don't say "coordinated fiscal policy" is because, in the lexicon of academic economists, this would mean commitment to some sort of rules so that Nash outcomes can be avoided. See Frankel and Rockett (1986). In this discussion, I have in mind a more modest, one-shot, event, since I'm not sure a coordination is feasible over the longer term.

On a side note, I've just been watching Nancy Pfotenhauer on Larry King characterizing the new Obama economic team as "not change" because they are centrists. I think she misses the point entirely (not surprising). The "change" is not a matter of the economic ideology of the new team members -- rather the "change" is bringing in people who value expertise and evidence-based policymaking over ideology and dogma. That is, the end of PoMo Macro policymaking."

Her figure is probably close to what will be spent, over two years. At least, as of today.