New Economist

CBO: largest growth shortfall since the Great Depression

 The Congressional Budget Office's new director, Douglas W. Elmendorf, testified on the state of the US economy before the House Budget Committee today. It makes sober reading.

An accompanying blog post summarises his three key points:

1. The economy is currently weathering a recession that started more than a year ago, and absent a change in fiscal policy, CBO projects that the shortfall in the nation’s output relative to potential levels will be the largest– in duration and depth– since the Depression of the 1930s.
   
2. Most economists agree that both significant fiscal stimulus and additional financial and monetary policy approaches are needed.
3. H.R. 1, the American Recovery and Reinvestment Act of 2009, would, in CBO’s judgment, provide a substantial boost to economic activity over the next several years relative to what would occur without the legislation.

Somehow the low key style makes these conclusions seem all the more compelling.

Austan Goolsbee

The September/October 2008 edition of the MIT Technology Review has a feature by Mark Williams on Obama's senior economic advisor, Austan Goolsbee: Obama's Geek Economist No earth shattering insights, but another reminder of just how Chicago-ist an Obama presidency could be.

The credit crunch: what happened?

While Ken 'worst is yet to come' Rogoff is trying his level best to scare global financial markets about the credit crunch, research is now starting to filter through about just what happened last year. A new IMF working paper by Nathaniel Frank, Brenda González-Hermosillo and Heiko Hesse, Transmission of Liquidity Shocks: Evidence from the 2007 Subprime Crisis, does some of the spadework. As they explain, liquidity crisis soon segued into a solvency crisis (think Northern Rock, Bear Sterns):

It is found that the interaction between market and funding illiquidity increased sharply during the recent period of financial turbulence, and that bank solvency became important. ...What started out as a liquidity crisis, turned into a solvency issue.

It wasn't simply credit that dried up, it was trust - the whole basis of interbank money markets. Banks were unwilling to trust the disclosures or assurances of their counterparties. As a result central banks had to pump hundreds of billions into financial markets to address the liquidity spiral and to ensure the solvency of key financial institutions.

So why did these interactions and correlations spike when the sub-prime crisis hit?

The analysis presented here suggests that increasing financial integration and innovation can make market and funding liquidity pressures readily turn into issues of insolvency.

The easy answer would be to blame the quants and financial engineers. But the real culprit was greed, reinforced by the lousy risk management and lax prudential standards of most major banks (and their clients, many of whom bought products they did not understand). While the money kept rolling in the door, senior managers were quite happy to avert their eyes to the ever-mounting risks.

I was not surprised by the sub-prime crisis; it was an accident waiting to happen. But I didn't expect the credit crunch to have been protracted, particularly once central banks interviened with such gusto.

Rogoff is probably right to say that we are only about half-way through the crisis. But the key issue for me is not whether another major bank goes bust (some of them clearly deserve to). It is whether the risk of US recession is now receding (a U-shaped downturn), or whether we are instead facing a 'W'-shaped downturn, with another growth dip looming. So far my controversial call of no US recession this year has held up, and I still think I am odds on to be proved correct. But the outlook for 2009 has becoming bleaker; there are now too many uncertainties to rule out an eventual recession.

Skilled migration boosts innovation

A recent paper by McGill University's Jennifer Hunt to an NBER labour studies programme conference asks whether the increase in foreign-born college graduates has contributed to innovation in the United States. Her paper, How Much Does Immigration Boost Innovation? (PDF), finds that it does:

In this paper I have demonstrated the important boost to innovation per capita provided by skilled immigration to the United States in 1950-2000. A calculation of the effect of immigration in the 1990-2000 period puts the magnitudes of the effects in context.

The 1990-2000 increase from 2.2% to 3.5% in the share of the population composed of immigrant college graduates increased patenting by at least 81:3 = 10:4%, and perhaps by as much as 18%. The increase in the share of post-college immigrants from 0.9% to 1.6% increased patenting by at least 10.5% and perhaps by as much as 24%. The increase from 0.30% to 0.55% in the share of workers who are immigrant scientists and engineers increased patenting by at least 13% but probably by less than 23%.

While I find evidence for the crowding-out of natives in the short run, in the long run there is evidence for the reverse: that skilled natives are attracted to states or occupations with skilled immigrants. The results hint that skilled immigrants innovate more than their native counterparts, especially if they are scientists or engineers. If correct, the result could reflect higher education of immigrants within skill categories, or positive selection of immigrants in terms of ability to innovate. However, the effect of natives is not as well identified econometrically as the effect of immigrants.

These findings suggest there are clear merits in adopting policies to both attract foreign students and to retain them once they have completed their studies (as the UK and Australia, among others, currently do).

Rethinking free trade?

Is support for free trade losing ground amongst economists? Business Week Washington bureau chief Jane Sasseen writes of an apparent shift in mood: Economists Rethink Free Trade:

..something momentous is happening inside the church of free trade: Doubts are creeping in. We're not talking wholesale, dramatic repudiation of the theory. Economists are, however, noting that their ideas can't explain the disturbing stagnation in income that much of the middle class is experiencing. They also fear a protectionist backlash unless more is done to help those who are losing out. "Previously, you just had extremists making extravagant claims against trade," says Gary C. Hufbauer, a senior fellow at the Peterson Institute for International Economics. "Now there are broader questions being raised that would not have been asked 10 or 15 years ago.

So the next President may be consulting on trade with experts who feel a lot less confident of the old certainties than they did just a few years ago. From Alan S. Blinder, a former vice-chairman of the Federal Reserve and member of the Council of Economic Advisers in the Clinton Administration, to Dartmouth's Matthew J. Slaughter, an international economist who served on President George W. Bush's CEA, many in the profession are reevaluating the impact of globalization. They have studied the growth of low-wage work abroad and seen how high-speed telecommunications make it possible to handle more jobs offshore. Now they fear these factors are more menacing than they first thought.

No one is suggesting that trade is bad for the U.S. overall. According to estimates by the Peterson Institute and others, trade and investment liberalization over the past decades have added $500 billion to $1 trillion to annual income in the U.S.

Yet concern is rising that the gains from free trade may increasingly be going to a small group at the top. For the vast majority of Americans, Dartmouth's Slaughter points out, income growth has all but disappeared in recent years. And it's not just the low-skilled who are getting slammed. Inflation-adjusted earnings have fallen in every educational category other than the 4% who hold doctorates or professional degrees. Such numbers, Slaughter argues, suggest the share of Americans who aren't included in the gains from trade may be very big. "[That's] a very important change from earlier generations, and it should give pause to people who say they know what's going on," he says.

US recession risk revisited

My previous posts, Is the US heading into a recession? seems to have a caused a flurry of comments. I remain of the view that the US economy will just scrape through 2008 without one. Admittedly, the run of data since that post has hardly been encouraging, with a plunge in the ISM (signalling a likely manufacturing recession) and some very weak non-farm payroll numbers.

Richard Berner & David Greenlaw from Morgan Stanley put the case for the prosecution in their recent piece: Is Recession Now in the Price?

Incoming data suggest that tighter credit has pushed the US economy to the brink, and we reiterate our call for a mild US recession in the first half of 2008. Weak employment data and slowing in export orders reported by purchasing managers undermine the case that a healthy consumer and strong global growth would forestall a downturn. Moreover, the ongoing housing recession is deepening, declines in capital goods bookings hint that business equipment spending will contract, and inventory liquidation seems likely. ...Most of the weakness is concentrated in the first half of the year; we project the economy will contract by about ¾% annualized in the first half of 2008, compared with 0.3% last month.

I agree the weakness will be in the first half, as I argued in my post 2008: No US recession. We might even see one negative quarter; but I'd be surprised if we see two consecutive declines. And that is the standard definition of a recession. My views are closer to those of Stefan Schneider at Deutsche Bank. In today's talking point he puts forward the DB baseline:

The US economy staggers for a few quarters, but does not actually collapse. The USD recovers in line with the US economy and the pricing process on the oil market returns to “more reasonable” ranges. In this environment the emerging markets grow somewhat less than last year but still quite strongly, at roughly 6½%.

Like Deutsche, I agree most of the risk are to the downside, and I could well be proved wrong. But don't underestimate the Fed. Today's dovish comments by Ben Bernanke show a preparedness to take whatever steps are deemed necessary:

...we stand ready to take substantive additional action as needed to support growth and to provide additional insurance against downside risks.

Meanwhile, the Economist today published its's latest R-word index. While it is certainly spiking upwards, we are not in 2001-territory just yet.

The Economist's informal R-word index is also sounding alarms. Our gauge counts how many stories in the Washington Post and the New York Times use the word “recession” in a quarter. This simple formula pinpointed the start of recession in 1981 and 1990 and 2001. In the past few years the R-word index has been extremely low. It began to rise in the second half of 2007 and, measured at a quarterly rate, has soared in early 2008 (see chart). Although the number of stories is still lower than before previous recessions, the recent jump—if sustained for a quarter—is similar to that which preceded the 2001 downturn

Other pointers include the Economic Cycle Research Institute weekly index. According to an Investor's Business Daily report, we're not there yet:

"A lot of things are teetering on the edge of tipping toward a recession," said Lakshman Achuthan, managing director of the Economic Cycle Research Institute.

...The ECRI's leading U.S. index ticked higher in the latest week. But the annualized growth rate fell to -6.2%, the weakest since Nov. 16, 2001, at the end of the last recession. The index's components include housing activity, job growth, interest rates, investor confidence, money supply growth, corporate profits and productivity.

"If these downward trends in the leading indicators continue for much longer, we will end up with a recession," Achuthan said. F

Finally, what about the prediction markets? Intrade have a US recession 08 contract, where you can bet on the likelihood that there are "two successive quarters of negative real GDP growth" this year. The contracts were hovering around the 50% mark until last week. Since then they have shot up to the 60-65% mark (click on chart). Given my assessment, I should probably short the contract.

2008: No US recession

I guess it's time I made some of my own predictions for the new year. The really big question this year (aside from the Presidential election) is what fate the US economy in the wake of the credit crunch, oil at $100 a barrel and collapsing house prices? Will the economy sink in 2008?

While there are too many unknowns about financial market or housing trajectories over coming months to completely rule out a recession, I doubt we will see it. My tip is a first half of very tepid economic growth, followed by a hesitant recovery in the second half as confidence kicks in again. Trade gains from a still cheap dollar and continued buoyancy in emerging markets will both help to prop up the economy through 2008.

To be sure, the downside risks are considerable and a Minsky-type financial crisis remains a possibility. What prevents me from forecasting more gloom is that central banks have demonstrated their preparedness to do whatever it takes to maintain stable financial market stability. For that we can probably thank Ben Bernake, who understands very well the lessons of the Great Depression.

Even the professional doomsayers at Morgan Stanley are hedging their bets, predicting a "mild" recession - an oxymoron if ever I read one. Meanwhile Krishna Guha from the Financial Times explained it succinctly on Monday:

The US will skate along the brink of recession in early 2008, but should avoid tipping over the brink, in part owing to continued strong exports to the rest of the world. Nonetheless, the economy will not bounce back quickly and will instead endure a protracted period of weak growth, during which time it will be vulnerable to any further economic shocks.

House prices will continue to fall nationwide, with big declines in California and Florida. However, the negative wealth effect on consumers will be partly offset by adequate earnings growth in a resilient jobs market. Unemployment will edge up, but not by much. The Federal Reserve may end up cutting interest rates by more than it thought it would, but its ability to do so will be constrained by inflation risk, especially if oil and food prices remain high or move higher.

Quite so. Larry Elliott provides a useful round-up of economist opinion in today's Guardian piece, Is this the big one? See also the lively commentary on my earlier post: Is the US heading into a recession?

Today's FT features a longer article by Krishna Guha, Danger ahead: The prospect of recession again confronts America, with a nice set of charts. Click on the thumbnails to see them full size.

Is the US heading into a recession?

"The American economy is slipping into its second post-bubble recession in seven years."

So writes Stephen Roach, Morgan Stanley's official doomster and chairman of Morgan Stanley Asia, in today's New York Times. I don't agree - and neither do some of the other contributors in today's issue:

Six experts assess the current state and forecast the future direction of the American economy.

You Can Almost Hear It Pop, by Stephen S. Roach

The Facts Say No, by Marcelle Chauvet and Kevin Hassett

Bet the House on It, by Laura Tyson

Not if Exports Save Us, by Jason Furman

Nobody Knows, by James Grant

Wait Till Next Year, by Martin Feldstein

University of California Riverside's Marcelle Chauvet and American Enterprise Institute's Kevin Hassett are not too pereturbed. They are the co-authors, with James Hamilton, of the forthcoming Calling the Business Cycle. Their model suggests there is no reason to panic just yet:

According to the model, the probability that the American economy was in a recession in October, the last month for which we have data, was only 16.5 percent. This is high enough to make us nervous about the future, but it is low enough that we can be fairly sure that if a recession is going to be visible in the data, it did not begin until November at the earliest.

Productivity vs employment growth: a zero-sum game?

All economists know productivity matters. But they also know it isn't easy to measure, nor to explain the often large and persistent productivity gaps between nations. A new paper by Harvard's Ian Dew-Becker and Northwestern University's Robert J. Gordon makes a provocative contribution to the productivity debate. Presented at a meeting of the NBER Program on Technological Progress and Productivity Measurement in Boston last week, the authors argue there is a "strong negative tradeoff between productivity and employment growth". The abstract from their paper, The Role of Labour‐Market Changes In the Slowdown of European Productivity Growth (PDF), continues:

We document this tradeoff in the raw data, in regressions that control for the two‐way causation between productivity and employment growth, and we show that there is a robust negative correlation between productivity and employment growth across countries and time. We simplify the task of explaining intra‐EU differences in the performance by reducing the dimensionality of the issue from the 15 EU countries to four EU country groups, chosen by geography.

We provide a comprehensive analysis of the role of policy and institutional variables in causing changes in productivity and employment per capita growth across these country groups. Using both a calibrated theoretical model and several reduced‐form regressions, we document the strong effects of European policies that raised labour costs, such as the tax wedge, employment and product market regulation, unemployment compensation, and union density, in causing employment to fall and productivity to rise before 1995, and for this process to be reversed after 1995.

The policy implications of their research are stark:

The strong evidence that we find for a productivity‐employment growth tradeoff changes the questions that European policymakers should be asking. They should no longer ask how they should boost productivity growth or raise employment growth. Most policies will push productivity and employment in opposite directions, and we have shown that these offsetting effects make the effects of policies on growth in output per capita ambiguous. Our new policy framework suggests that policy changes be assessed as much on their effects on government budgets as on productivity or employment, since the productivityemployment tradeoff causes some policy changes to have a negligible effect on growth in output per capita.

I'm not sure I'd necessarily agree with the authors 'zero sum' conclusions. There are for example some economies which perform better on both productivity and employment growth than others; so it's not always such a direct trade-off. One implication - that higher employment rates or higher productivity in large part reflect different national preferences - has certainly been argued before. But if their general 'zero-sum' argument proves to be more the rule than the exception, it has profound implications for policy makers throughout the OECD - especially in Europe.

OECD Economic Outlook: "not that bad in view of the recent shocks"

The OECD released its latest Economic Outlook today. Though some fear that falling house prices and the global credit crunch might drive the US into a recession, that view is not shared in Paris. Their US forecast expects weakness in the US housing sector to drag down growth in the near term but it "is unlikely to trigger a recession". GDP growth is forecast to 2.0% in 2008. Private consumption will be weak - but public and non-residential investment should remain quite perky, and the cheap US dollar will see net exports add to growth next year just as it they have this year. Here's their summmary of the US outlook:

Healthy gains in private consumption have helped to keep GDP growth above trend thus far this year. However, the correction in residential construction is likely to accelerate over the near term, and housing wealth could decline which, together with weaker labour market conditions, could lead to lower consumption growth over time. GDP should therefore slow to a pace below potential in 2008 and then recover in 2009, although there are considerable downside risks.

This assessment is broadly in line with recent Federal Reserve and private sector forecasts. An outside risk of recession, to be sure - but not considered that likely. (For another recent official US economic overview, see yesterday's Congressional testimony by CBO Director Peter R. Orszag).

But what about the overall economic outlook? You can watch a webcast of the news conference by OECD's acting Chief Economist Jorgen Elmeskov here. Or just read his 18 page handout (PDF), which contained this precis:

Several shocks have hit OECD economies recently: financial turmoil, cooling housing markets, and higher prices of energy and other commodities. Fortunately, they have occurred at a time when growth was being supported by high employment that boosts income and consumption; by high profits and strong balance sheets that underpin investment and resilience in the face of financial losses and tighter credit; and by still buoyant world trade driven by robust growth in emerging economies. Hence, although near-term growth has been revised down virtually everywhere in the OECD area, the baseline scenario depicted in this Economic Outlook is actually not that bad in view of the recent shocks.

Of course, as the accompanying chartset makes very clear, there are still plenty of reasons to be concerned. Energy and commodity prices have surged, headline inflation has picked up, credit conditions are tight, house prices are decelerating, consumer confidence is softening, and job creation is slowing. Against that, fiscal positions have improved and world trade is buoyant.

It's not the end of the world, but it's not exactly time to crack open the champers either. Or as Elmeskov put it at the news conference: “It’s not a recession but obviously it’s not going to feel all that great either.”