New Economist

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.

Do economic sanctions deter?

Harvard doctoral graduate Ioana M. Petrescu has studied a much-discussed but little-studied subject: do economic sanctions actually work? Her recent paper, Rethinking Economic Sanction Success: Sanctions as Deterrents (PDF), finds that they do appear to deter future disputes:

Economic sanctions are one of the most common foreign policy tools. Despite their widespread use, there is little empirical evidence and much debate about how sanctions affect countries’ behavior. In this study, I investigate whether sanctions affect future military behavior.

I look at the effects of sanctioning a country involved in a militarized dispute on the probability that the sanctioned country or any other country involved in the dispute will be involved in a militarized dispute in the future. I also look at the effects of the sanction on the probability that countries similar to the ones in the sanctioned dispute will participate in another dispute in the future. I use the Correlates of War data on militarized interstate disputes and Hufbauer et al.’s data on economic sanctions.

I find that countries involved in a dispute and countries similar to the ones involved in the dispute are less likely to participate in another dispute in the future if one of the countries involved in the original dispute was sanctioned.

What drives the growth in FX activity?

Earlier this year the Bank for International Settlements published their Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity. The survey reported a massive jump in daily turnover:

Turnover in traditional foreign exchange instruments increased by an unprecedented 71% to $3.2 trillion.

What has been driving this upsurge? The latest BIS Quarterly Review includes a 10 page article which offers an explanation: What drives the growth in FX activity? Interpreting the 2007 triennial survey The three main factors identified by BIS authors Gabriele Galati and Alexandra Heath appear to be hedge funds, portfolio diversification of pension funds, and higher turnover of emerging market currencies:

Two specific findings stand out. First, the growth in transactions between banks and other financial institutions was particularly strong, consistent with the increasing importance of hedge funds, as well as portfolio diversification by institutional investors with a longer-term horizon, such as pension funds. Second, there has been a marked increase in turnover involving emerging market currencies.

The first two are not much of a surprise. The third can be seen as a by-product of the very healthy economic and trade performance of many emerging economies in recent years. In the past many emerging currencies had remarkably low fx turnover for the size of their economies; less so now.

'The continuing muddles of monetary theory'

One of the more lively papers delivered at this week's 75th Anniversary Lionel Robbins Conference in London was by the LSE's Charles Goodhart: The Continuing Muddles of Monetary Theory: A Steadfast Refusal to Face Facts (PDF). Goodhart believes monetary economics has "a long way yet to go", and few economists "have bothered much to relate theory to reality." Here's the abstract to his short paper:

Lionel Robbins was much concerned about the methodology of economic science.
When he discussed the desirable relationship between theory and ‘reality’, two of the
three examples that he presented where the theoretical analysis was not sufficiently
based on a knowledge of historical fact were taken from monetary economics.
Indeed, monetary theory has remained prone to such shortcomings ever since.

Amongst the worst are:-
(1) IS/LM: the monetary authorities set the monetary base, and the interest rate is
determined in the market;
(2) The monetary base multiplier of bank deposits, and the role of reserve ratios;
(3) The current three equation neo-classical consensus, which not only assumes
perfect creditworthiness for all agents, but also an essentially non-monetary
system, e.g. no need for banks;
(4) The standard theory of the evolution of money.

Monetary economics can only get better, but it has a long way yet to go.

The nature and significance of economic science: Lionel Robbins revisited

This year marks the 75th anniversary of Lord Lionel Robbins's An Essay on the Nature and Significance of Economic Science - the book where he famously redefined the scope of economics to be:

the science which studies human behavior as a relationship between scarce means which have alternative uses.

As Ken Binmore writes, Robbins "beat the drum for what eventually evolved into neoclassical economics." Robbins also emphasised the importance of separating economics and psychology, making him "an ogre for the new school of behavioral economists".

The LSE and the editors of Economica organised a 75th Anniversary Conference to mark the occassion. Held in London yesterday and today, there have been a wonderful array of contributions. There are 22 full papers and 8 abstracts available online from leading economists including Richard Lipsey, Ken Binmore, David Colander, Charles Goodhardt and Roger Backhouse.

For any readers with a good working knowledge of, and interest in, economic history, methodology, or the purposes of economics, I recommend you dive straight in.

Do central banks react to house prices?

Some do and some don't, according to a new working paper by Swedish Riksbank economists Daria Finocchiaro and Virginia Queijo von Heideken:

The substantial fluctuations in house prices recently experienced by many industrialized economies have stimulated a vivid debate on the possible implications for monetary policy. In this paper, we ask whether the U.S. Fed, the Bank of Japan and the Bank of England have reacted to house prices. We study the responses of these central banks by estimating a structural model for each country where credit constrained agents borrow against real estate. The main result is that house price movements did play a separate role in the U.K. and Japanese central bank reaction functions, while they did not in the U.S.

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.

Hollywood and the cost of revealed talent

Why are there more mediocre films being made by Hollywood now than during the 'golden years' of the studio system in the 1930s and 1940s? Drawing on a new paper by Berkeley's Marko Tervio, Chris Dillow at Stumbling and Mumbling offers a plausible explanation in his post Superstars and talent:

Top bosses and film stars get multi-million pound salaries because talent is scarce. Everyone knows this. Which is a shame, because it's bull, as this fantastic paper by explains.

Start from the premise that talent is initially unknown, and can only be revealed by working with expensive equipment. So, for example, we can only find out if a manager is any good if he's in charge of a big venture, or if an actor has box office appeal if he's in a mega-costly film. It is, therefore, very expensive to learn who's got talent and who hasn't.

What's more, people with talent cannot offer to share this cost with employers, either because of lack of cash or risk aversion: people don't pay for the chance to become bosses or film stars.

In these conditions, what's scarce isn't talent, but revealed talent. There might be loads of people with the ability to be film stars or bosses, but only a handful get the chance to show what they can do. Marg Helgenberger gets big money not (just) because she's a better, more popular or more beautiful actress than others, but because she's a proven quantity.

This has three consequences:

1. The industry employs lots of mediocrities on good money - people just above the threshold of acceptable competence. Employers prefer these to untried but potentially better workers because the risk of a single failure - the box office flop of a $100m film, or the failure of a large company - far exceeds the possible benefit of finding lots of people a little better than the barely competent.
2. Output is inefficiently low, and prices high. This follows from the industry being staffed by the barely competent rather than the brilliant.
3. People who have proved that they are genuinely brilliant earn huge salaries as economic rent.
Tervio illustrates this with Hollywood films. Compare films today with those made by the studio system of the 1930s and 40s.

Today, there's vast inequality among film actors, as there's only a handful of proven box-office stars, and the quality of films is indifferent.

By contrast, the studio system allowed potential stars to share the costs of revealing their talent with producers, by entering long-term contracts which gave low pay even to stars; the lower cost of making films then also helped. This allowed for many more great films to be made, as more great actors could enter the industry, but with less inequality among the stars.

In this sense, superstar salaries arise not because talent has become scarcer, but because it's become harder to reveal talent.

In other industries, however, the opposite trend exists. Clive reminds us that in the 1980s a mere economics writer got a flash Beemer from the Indy. This would be unheard-of today. This is because back in the 80s, it was hard to reveal a "talent" for writing on economics. Today, any idiot can do this (see here, passim), so revealed talent has become more abundant.

Marko's paper, Superstars and Mediocrities: Market Failure in the Discovery of Talent (PDF), is well worth reading.

Obese American women's rising wage penalty

The latest foray into the economics of obesity debate comes from David Lempert of the Bureau of Labor Statistics. His new economic working paper, Women's Increasing Wage Penalties from Being Overweight and Obese, finds that overweight working women in the United States face a rising wage penalty:

This paper first utilizes annual surveys between the 1981 and 2000 waves of the National Longitudinal Survey of Youth to estimate the effect of being overweight on hourly wages. Previous studies have shown that white women are the only race-gender group for which weight has a statistically significant effect on wages. This paper finds a statistically significant continual increase in the wage penalty for overweight and obese white women followed throughout two decades.

A supporting analysis from a cross-sectional dataset, comprised of the 1987 National Medical Expenditure Survey and the 2000 and 2004 waves of the Medical Expenditure Panel Survey, also shows an increasing wage penalty. The bias against weight has increased, despite drastic increases in the rate of obesity in the United States. Alternatively, the increasing rarity of thinness has led to its rising premium.

Lempert concludes:

The increasing wage penalty corresponds to current psychological research that demonstrates increased weight stigmatization in the United States. Further, as larger women age, their wages incur the effects of years of cumulative discrimination. With other factors controlled, their starting wages are lower. Throughout their working careers, these women receive less frequent raises and promotions. Therefore, we see increasing penalties in both NLSY data and the synthetic cohort constructed from NMES/MEPS data.

This paper has shown that an obese 43 year-old woman received a larger wage penalty in 2004 than she received at 20 in 1981. This paper also provides some evidence that an obese 20 year-old woman receives a larger wage penalty today than she would have in 1981 at age 20. Future literature should further explore this aspect of the story, as well as the mechanisms by which the wage disparities occur. It can be concluded that increased body weight has drastic economic consequences that have grown over time.

This is a surprising finding. One would have thought it was now the norm to be overweight in the US, and employers have become habituated to it. This paper provides strong evidence to the contrary. Comments welcome.

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.”