Comments on economics, mystery fiction, drama, and art.

Wednesday, April 29, 2009

The Continuing Recession, GDP Edition

The preliminary numbers for real GDP for the first quarter of 2009 have been released, and they are worse than expected, but pretty much in line with the kinds of employment declines we've seen in January, February, and March. GDP declined at an annual rate of 6.1%; apparently the consensus expectation was a decline of 4.7%.

The truly striking decline was in Gross Private Domestic Investment (purchases of new capital equipment), which fell at an annual rate of 37.9% (compared to a fourth quarter 2008 decline of "only" 21.7%). Investment has declined more sharply in this recession than in any recessions ince at least 1974/75.

But even more strikingly, Investment has declined as a percent of GDP since the first quarter of 2006, from 17.3% of GDP to 11.7%. This is a lower Investment share than at any time since the 1991 recession (but the decline then was only from 13.6%). Even in the "biggest recession since World War II" (the 1980-82 recession), Investment's share of GDP declined only by 2.6 percentage points.

The current decline in Investment spending, because it means our capacity to produce is growing much more slowly and we are incorporating new technologies at a much slower rate, has significant implications both for the recovery and for our longer term growth.

Tuesday, April 28, 2009

Leverage? You want leverage?

You learn something every day. And I learned this from William Cohan's House of Cards (p. 61):

"...the ratio of ssets to equity capital in investment banks--one measure of leverage--often aproached 50:1 during the middle of a quarter. (Before the [leverage] ratio was published at the end of each quarter, investment banks would...sell enough of the assets to get the leverage down to a more "acceptable" 35:1 ratio.)

I thought the 30:1 ratios people were tossing around were scary. But 50:1?

And just why did you have to learn this lesson in 2008?

I'm reading William Cohan's House of Cards about the implosion on Wall Street in 2008, in the chapters dealing with the collapse of Bear Stearns. (So far, this is a magnificent fly-on-the-wall picture of an epic collapse). I have just been struck by the reaction of Jimmy Cayne, emeritus CEO and current board chairman of Bear Stearns, to the company's financing crisis (other financial firms have quit making overnight loans to it): "I knew we were highly dependent on overnight repo...This was good collateral, and all of a sudden, poof! You're vulnerable to it any time you're leveraged. You didn't have a chance. So , that same lesson we learned today, Long-Term Capital Management had back then [in 1998] and the tulip people had it back in the 1400s." (On p. 59)

(Let's ignore his mis-dating the tulip mania, which was in the early 1600's.) But this is a lesson that everyone in the financial sector should have learned long ago. And the LTCM debacle should still have been in people's minds. And the people running Bear Stearns had to learn it in 2008? Being highly leveraged in a fragile market (which financial markets had been for going on a year) was highly risky, and you had to learn that? You had to learn that because people finally decided lending to you was to great a risk? Your firm had to collapse in order for you to learn that? And how much was Jimmy Cayne being paid before he learned that lesson?

The mind boggles.

(And, by the way, Roger Lowenthal's When Genius Failed, about the LTCM fiasco is also well worth reading.)

(P.s. Jimmy Cayne was playing in one of the north American contract bridge championships, in Detroit, when the crisis hit, with a team of professional bridge players that he personally had hired for about $500,000 a year, according to Cohan. Not fiddling. but...) (P.s.s. And I love to play bridge.)

Thursday, April 16, 2009

Scenario for a meltdown

I recently posted a challenge on a listserv on teaching economics, which essentially asked people to use our current understanding of the macro economy to make sense of what has happened over the past year. I wanted to comment here about the issues.

Suppose it’s June 30, 2008. What do we know about the current state of the economy? (1) Employment has been falling (by small amounts) for about six months. (2) Housing values have been declining, slowly in some parts of the country, severely in other parts of the country, for nearly two years, so the residential housing part of the construction business is in serious collapse. (3) The rate of inflation (as measured by the CPI) has increased (slowly, and in fits and starts) from about 1.5% (using year-over-year percentage changes in the monthly CPI-U) since early 2004 to over 5% by the middle of 2008. (4) Real GDP has been growing at (generally) between 2% and 3% on an annual-rate basis, but growth has begun, in the second quarter of 2008, to slow.

Now suppose we add to this one piece of information. Over the next nine months, the money supply, measured as M1, will grow at a 15.4% annual rate. What would we expect to happen?

I suspect we’d get a clear majority answer from most economists, including those who pay more attention to macro—inflation will continue to accelerate. I suspect there would also be a significant minority that said, “Why did the Federal Reserve allow that kind of growth in M1? Something bad must have happened to the economy,” and some effort to come up with what that might have been.

So let’s add a second piece of information. In addition to the accelerated (15.4% annual rate) growth in the money supply, we also know that the rate of inflation fell abruptly and sharply, until by March 2009, the annualized rate of inflation had declined to -0.5%--the general level of prices was actually falling. Now what would we get?

Well, one thing that my post did get as a response was, “Obviously, the velocity of money has declined. Well, purely by definition that almost had to be true:

Mv = PQ

is the quantity equation. If growth in M (money) accelerates and if the rate of inflation decelerates, and if there’s no change in the growth in output, then v (velocity) has to fall. But that’s boring. The question is, what’s happening in the economy that is causing velocity to fall?

And the question really is, what could happen that would cause velocity to fall, if you have to answer this question before-the-fact, rather than after we have gone through the decline in velocity.

Again, I suspect there would be a majority answer, which would go something like this: Suppose something happened that raised the riskiness of most financial instruments. (We’ll worry about what this could be later.) Note that this increase in risk has to affect the US economy directly. How will people react? They will move their financial assets to cash or to risk-free cash-equivalents (short-term Treasury bills). People will acquire cash, not to spend, but to hold as an asset. (We can express this by saying that the demand for money as a store of value not as a medium of exchange—or, if you’d like it in Keynesian terms, that the demand for money for precautionary reasons--has increased.) One effect of this will be to drive down the interest rate in risk-free cash equivalents. A second effect will be to reduce the velocity of money.

Now the Federal Reserve, observing this, and knowing that the likely outcome is reduced spending (the aggregate demand curve shifts to the left (or, in older Keynesian terms, the IS curve shifts to the left) and a decline in output. The Fed responds in typical fashion, adding to bank reserves in order to encourage spending. But if the demand for cash (or cash-equivalents) is extremely interest elastic, people and institutions will hoard cash—we are in a liquidity trap.

The tricky part is specifying what might cause the increase in the perceived riskiness of many (most?) financial assets. I suspect there might be many candidates, and I suspect some people would have pointed to mortgage-backed securities as one candidate.

My point here is that we can tell a consistent story, using fairly standard (indeed, entirely Keynesian) macro theory. It’s easier after-the-fact, but I think it’s also clearly possible to construct a reasonably accurate scenario before-the-fact as well.

Wednesday, April 15, 2009

An inflation conundrum

Suppose someone had told you, on June 30, 2008, that M1 would grow, over the next 6 months, at an annual rate of 15.4%. And suppose s/he also told you that the rate of inflation (calculated on the basis of the current month CPI cpmpared with the 12-months-earlier CPI) would fall from more than 5% to -0.5% (that's minus 0.5%). Would you have believed that to be possible?

Well, believe it. That is exactly what has happened.

Monday, April 13, 2009

When the world is in crisis

Simon Johnson has a very interesting article in the May (2009) issue of The Atlantic. But I find bits of it not only disconcerting, but dangerously wrong. Like this: "Almost always, countries in crisis need to learn to live within their means after a period of excess—exports must be increased, and imports cut..."

Think about this. It might be useful advice for a single country (or not; ignoring comparative advantage has its costs). But when the entire world economy is in crisis, this is dangerously bad advice, bad because it cannot be done. (If we all reduce our imports, then we must all also reduce our exports.) Bad because it will make the world crisis worse. (As we did in the Great Depression.)

What might (and I repeat, only might) be true for a single country, can, and often is, extraordinarily misguided for us all.

Friday, April 03, 2009


The Employment-Population Ratio fell to 59.9% (seasonally adjusted) in March. That is its lowest level since 1985.

That is all.