What Happens If Europe Crushes the Swap Market?

An interesting piece here by John Carney: What Happens if Europe Crushes the Swap Market?

An excerpt:

Many European politicians probably wouldn't mind killing the CDS market. From their point of view, the CDS market has been an unmitigated evil, allowing speculators to profit from the debt burdens of Europe's peoples. Even worse, because the bond market appears to react to widening credit spreads by pushing down the value of sovereign bonds, it appears to make government borrowing more expensive.

Some of Europe's leaders believe the CDS market is manipulated by hedge funds.

But the European leaders misunderstand the CDS market and its relationship to the bond market. The CDS market serves two important purposes: It's both a hedge for investors and an indicator of how risky the market thinks certain bonds are. Many investors are able to buy more of a country's bonds because they can reduce their risk by purchasing swaps that pay off in a default. And the price of the swaps is an indicator—albeit not always a reliable one—of the riskiness of the underlying bonds. In short, the CDS market provides liquidity and transparency to the bond market.

Take away that liquidity and transparency and governments will likely find that lenders are less likely to extend credit. With fewer opportunities to hedge, and prices based on less information, fewer investors will be willing to buy. That would mean selling bonds that have already been issued and staying out of new issues, which would ultimately push up the cost of government borrowing.

The great sectoral shock of 2006

There's a lot to disagree about when it comes to understanding the great recession and subsequent slow recovery. But at least one thing seems clear: the U.S. real estate sector has played, and continues to play, a significant role in the ongoing saga.

In this post I want to talk about an old theme: the idea that a shock in one sector of the economy can reverberate throughout the entire economy. This theme was highlighted by John Long and Charles Plosser in their classic paper Real Business Cycles (JPE 1983). But it was a view that really never gained much traction. The one-sector neoclassical growth model was, and continues to be, the preferred basic framework of modern macroeconomic analysis.

The fact that most economic sectors tend to expand and contract together has something to do with the willingness to approximate the economy as consisting of one sector. But in doing so, one is then led to search for explanations in terms of hypothetical "aggregate demand" and "aggregate supply" shocks. And so we hear today that the slow recovery is attributable to "deficient demand," and that this explanation is borne out by the survey responses of businessmen who report that their main problem is a lack of product demand. (I have spoken about the pitfalls of this interpretation here.)

In any case, what I want to talk about here is the work of my colleague Juan Sanchez (with Constanza Liborio) about the role of the construction sector in the great recession. Let's start off with a look at U.S. construction sector data over the period 2005-2010.

Construction sector GDP (value-added), gross output, and employment are all normalized to 100 in the year 2006. All variables decline by about 30% over the next four years. Note that the U.S. economy officially went into recession in December 2007. The decline in the construction sector occurred over a year before that.

The Direct Effect

Construction sector employment at it's peak in 2006:Q1 was 7,651,000 workers. By 2010:Q4, employment in this sector shrank to 5,505,000 workers; a decline of 28.1% (2,146,000 workers).

Total employment in 2006:Q1 was 135,401,000 workers. By 2010:Q4, total employment fell to 130,128,000 workers; a decline of 3.9% (5,273,000 workers). 

Consequently, 40.7% of the decline in total employment over this period of time is directly attributable to the employment losses experienced in the construction sector. 

This sounds like a big number--and it is. But there is reason to believe that it is, in fact, just a lower bound. That's because this direct effect is likely to have implications for product demand in other sectors that supply the construction industry. 

Indirect Effects

The following data shows the share of a sector's output used in the construction sector (for the year 2006). 

The way to read this graph is as follows. In 2006, roughly 3% of what was produced by the U.S. mining sector was used as an intermediate input in the U.S. construction sector; and so on. According to this data, Both manufacturing and retail depend heavily on product demand generated by construction.

Quiz: A business manager at the local Home Depot (retail sector) reports that her regular customers in the construction sector have scaled back their purchases. She would like to hire more workers but the problem, she explains, is a "lack of demand" for her store's product. It follows immediately and conclusively that the problem with the U.S. economy is "deficient demand" and that government stimulus is needed. Answer true/false/uncertain; and explain.

Input-Output Analysis

To get a rough sense of how the collapse of the construction sector may have spilled over into the rest of the economy via the intersectoral linkages described above, Juan uses the BEA input-output tables to construct a simple model.

To be conservative, he applies the actual decline of output in the construction sector from 2006-2007 (average of these two years) to 2009. Evidently, the effect will be larger if one considers the change from 2006 to 2010.

The result of this simple simulation exercise suggests that the collapse of the construction sector accounts for 46.4% of the decline in U.S. GDP and 51.9% of the decline in total employment (roughly 3.4 million jobs).

The following bar graph summarizes his results.

Juan uses the same model to ask how much of the expansion during 2002-2006 was attributable to construction. His analysis suggests that construction played a much smaller role in the expansion, accounting for only 7.4% of the increase in GDP over this period.

Conclusion

The rosy expectations that drove residential investment prior to the recession turned out to be overly optimistic. The "overbuild" in residential capital needs time to work off, through depreciation and population growth. The adjustments taking place in this sector will take time. To the extent that other sectors are tied to the fortunes of the construction sector, economic activity throughout the economy is likely to remain relatively depressed. What can or should be done about this remains an open question.

PS. If you would like to contact Juan to learn what he did in greater detail, send him a message here: sanchez@stls.frb.org

The St. Louis Fed Financial Stress Index

My colleague Kevin Kliesen (and his coauthor, Doug Smith) have recently introduced a new financial market stress index; see Measuring Financial Market Stress. Here's a link to the Appendix, which describes its construction and the data series used: appendix. A brief description:

The St. Louis Fed’s Financial Stress Index is constructed using principal components analysis. Briefly, principal components analysis is a statistical method of extracting factors responsible for the comovement of a group of variables. We assume that financial stress is the primary factor influencing this comovement, and by extracting this factor (the first principal component) we are able to create an index with a useful economic interpretation. We construct the STLFSI using 18 weekly data series beginning December 31, 1993.  Prior to the principal components analysis, each of the data series are de-meaned and then divided by their respective sample standard deviations.

The index is available on FRED here. Let me reproduce some of this data here. Here is what the FSI looks like since December 2009.

Stress is on the rise, but looks like we're still a long way from 2008...

The big question, however, is whether the temperature will keep rising. 

Inflation expectations: a downward march

This graph is courtesy of my colleague, Kevin Kliesen.

If you squint your eyes near the end of the sample, you'll see that Operation Twist appeared, on impact, to move short and long inflation expectations in opposite directions. The effect did not last long, however. The march downward continues--for now, at least.

Update: October 7, 2011

At the request of one of my readers, I had my RA (Constanza Liborio) plot a measure of inflation forecast errors over the last five years.

The inflation rate data is based on headline CPI. We use quarterly inflation at annual rates, and then subtract off the rate of inflation expected in a quarter, 2 and 5 years prior. The results are plotted here:

A blogger's ten commandments

I came by this the other day via a friend: A Liberal Decalogue, by the great philosopher Bertrand Russell. Thought you might enjoy it too.

1. Do not feel absolutely certain of anything.

2. Do not think it worth while to proceed by concealing evidence, for the evidence is sure to come to light.

3. Never try to discourage thinking for you are sure to succeed.

4. When you meet with opposition, even if it should be from your husband or your children, endeavour to overcome it by argument and not by authority, for a victory dependent upon authority is unreal and illusory.

5. Have no respect for the authority of others, for there are always contrary authorities to be found.

6. Do not use power to suppress opinions you think pernicious, for if you do the opinions will suppress you. 

7. Do not fear to be eccentric in opinion, for every opinion now accepted was once eccentric.

8. Find more pleasure in intelligent dissent than in passive agreement, for, if you value intelligence as you should, the former implies a deeper agreement than the latter.

9. Be scrupulously truthful, even if the truth is inconvenient, for it is more inconvenient when you try to conceal it.

10. Do not feel envious of the happiness of those who live a fool's paradise, for only a fool will think that is happiness.

Source: A Liberal Decalogue, Bertrand Russell (1951)

European banks and US dollars

I sometimes get asked why European banks are in apparent need of US dollars, and why the Fed is lending money to the European Central Bank (ECB).

Ah, the wacky world of international finance. I can't pretend to understand it fully--or even very well--but here are some thoughts nevertheless. (I'm learning a lot about this stuff from my colleague, Richard Anderson, but still lot's to learn!)

We have all heard about the apparent troubles European banks are having. They have (we believe) invested in the sovereign debt of fiscally strapped nations like Portugal and Greece; see here. Fine, you say. This might explain why they need short-term Euro financing, which the ECB can in principle supply. What the heck do they need USD for?

Well, evidently, European banks do not invest just in Europe. They also lend to companies operating in the US. Where do they get the USD to do this? A big source of  funding apparently comes from U.S. money market mutual funds (MMMFs), which lend funds to branches of these foreign banks residing on US soil. (All of this somehow is governed by the US 1978 International Banking Act -- if you understand how, please write back!)

Now, when things start to look scary in the financial market, credit begins to tighten. And it looks like the American MMMF industry is running scared from Europe. Here is an interesting tidbit, published by the Investment Company Institute (ICI), an enterprise described to me as the "public face of the U.S. MMMF industry" The piece is called Deja vu--US Money Market Funds and the Eurozone Debt Crisis (by Chris Plantier and Sean Collins). Here is an excerpt:

Direct exposure to both public and private issuers in the European “periphery” countries is virtually zero. Since June, U.S. money market funds have almost eliminated holdings of Italian and Spanish government and private debt, including bank securities. 

U.S. money market funds have reduced the maturity of their holdings in banks in Europe’s “core” (France, Germany, the United Kingdom, and other countries). According to JP Morgan Securities, 60 percent of U.S. prime money market funds’ holdings in French banks as of the end of August will mature in 30 days or less, compared to 28 percent of their holdings at the end of June. Shorter maturities provide flexibility and reduce the impact of any potential downgrades. 

According to Crane Data, at the end of July, 69 percent of money market funds’ holdings in German banks and 67 percent of holdings in British banks were set to mature in 30 days or less.

So, MMMFs are shortening the maturity structure of their lending to European banks (and raising rates). This makes European banks more susceptible to a "rollover freeze"--an event where short-term financing collapses altogether. This is the "Lehman event" that policymakers worry about for Europe.

The policy response to date has been for the Fed to re-activate its swap line with the ECB. If you go to some websites and blogs, they might describe this operation as the Fed "creating money and pumping it into Europe." One could equally well describe it as the ECB "printing up Euros and pumping them into the US." That is, at its most basic level, the two central banks are simply exchanging "green money" for "blue money." This is the nature of a swap (for those who are prone to confusing the word "swap" with "gift").

I should like to point out a fact that is seldom emphasized. The dollars that the Fed lends to the ECB through the swap line are fully collateralized (and hedged against currency risk). The ECB gives the Fed Euros in exchange for USD; the operation is then reversed a short time later (and the Fed generally earns a small return for its service). The ECB then takes these dollars and lends them those European banks "in need" of short-term USD financing--including those European banks operating on US soil, making loans to US businesses. (Essentially, the ECB is subsidizing European banks--and it is the ECB that bears the risk, not the Fed.)

Is this policy response by the Fed and the ECB justified? That's a tough one. As usual, one can make arguments pro and con.

On the pro side, one might note that US MMMFs have become somewhat skittish since the 2008 financial crisis. (You might remember an MMMF "breaking the buck" on Lehman's IOUs; see here.) They are now
very sensitive to adverse publicity about the firms they lend to (that is, invest in).  And now, it is evidently the case that banks with foreign names, even if located on US soil, might "sound" risky.

From a purely economic standpoint, this credit contraction seems a little hard to understand (but then again, who are we to argue with how creditors want to bet their money?) It is my understanding, for example, that the short-term loans issued by U.S-based branches of European banks to American companies are fully collateralized (by American capital). If this is true, and if American industry is showing no signs imminent distress, then why should a potential haircut on PIIGS debt (borne by European banks) have the American MMMF industry sufficiently worried to pull their financing (of American industry) on such a dramatic scale? Are these fears overblown? And might such overblown fears increase the likelihood of a Lehman-style event for European banks?

On the con side, we have the usual arguments for why policymakers should just let the market get down to business and resolve any outstanding credit issues. Claims of imminent contagion are made largely to justify transfers of wealth (bailouts). Moreover, there is a possibility that policy interventions, like the Fed-ECB swap line, simply delay the inevitable debt restructuring that is presently necessary. 

An interview with Bob Lucas

An interesting interview with Robert E. Lucas, Jr. by Holman Jenkins (WSJ) here: Chicago Economics on Trial.

Let's face it, the "Chicago School" of economics—the one with all the Nobel Prizes, the one associated with Milton Friedman, the one known for its trust of markets and skepticism about government—has taken a drubbing in certain quarters since the subprime crisis.

Sure, the critique depends on misinterpreting what the word "efficient" means, as in the "efficient markets hypothesis." Never mind. The Chicago school ought to be roaring back today on another of its great contributions, "rational expectations," which does so much to illuminate why government policy is failing to stimulate the economy back to life.

Robert E. Lucas Jr., 74, didn't invent the idea or coin the term, but he did more than anyone to explore its ramifications for our model of the economy. Rational expectations is the idea that people look ahead and use their smarts to try to anticipate conditions in the future.

Duh, you say? When Mr. Lucas finally won the Nobel Prize in 1995, it was the economics profession that said duh. By then, nobody figured more prominently on the short list for the profession's ultimate honor. As Harvard economist Greg Mankiw later put it in the New York Times, "In academic circles, the most influential macroeconomist of the last quarter of the 20th century was Robert Lucas, of the University of Chicago."

Mr. Lucas is visiting NYU for a few days in early September to teach a mini-course, so I dash over to pick his brain. He obligingly tilts his computer screen toward me. Two things are on his mind and they're connected. One is the failure of the European and Japanese economies, after their brisk growth in the early postwar years, to catch up with the U.S. in per capita gross domestic product. The GDP gap, which once seemed destined to close, mysteriously stopped narrowing after about 1970.

The other issue on his mind is our own stumbling recovery from the 2008 recession.

For the best explanation of what happened in Europe and Japan, he points to research by fellow Nobelist Ed Prescott. In Europe, governments typically commandeer 50% of GDP. The burden to pay for all this largess falls on workers in the form of high marginal tax rates, and in particular on married women who might otherwise think of going to work as second earners in their households. "The welfare state is so expensive, it just breaks the link between work effort and what you get out of it, your living standard," says Mr. Lucas. "And it's really hurting them."

Enlarge Image

Terry Shoffner

Turning to the U.S., he says, "A healthy economy that falls into recession has higher than average growth for a while and gets back to the old trend line. We haven't done that. I have plenty of suspicions but little evidence. I think people are concerned about high tax rates, about trying to stick business corporations with the failure of ObamaCare, which is going to emerge, the fact that it's not going to add up. But none of this has happened yet. You can't look at evidence. The taxes haven't really been raised yet."

By now, the Krugmanites are having aneurysms. Our stunted recovery, they insist, is due to government's failure to borrow and spend enough to soak up idle capacity as households and businesses "deleverage." In a Keynesian world, when government gooses demand with a burst of deficit spending, the stick figures are supposed to get busy. Businesses are supposed to hire more and invest more. Consumers are supposed to consume more.

But what if the stick figures don't respond as the model prescribes? What if businesses react to what they see as a temporary and artificial burst in demand by working their existing workers and equipment harder—or by raising prices? What if businesses and consumers respond to a public-sector borrowing binge by becoming fearful about the financial stability of government itself? What if they run out and join the tea party—the tea party being a real-world manifestation of consumers and employers not behaving in the presence of stimulus the way the Keynesian model says they should?

Mr. Lucas and colleagues in the early 1960s were not trying to undermine the conventional prescriptions when they began to think about how the public might respond—possibly in inconvenient ways—to signals about government intentions. As he recalls it, they were just trying to make the models work. "You have somebody making a decision between the present and the future. You get a college degree and it's going to pay off in higher earnings later. You make an investment and it's going to pay off later. Ok, you can't do that without this guy taking a position on what kind of future he's going to be living in."

'If you're going to write down a mathematical model, you have to address that issue. Where are you supposed to get these expectations? If you just make them up, then you can get any result you want."

The solution, which seems obvious, is to assume that people use the information at hand to judge how tomorrow might be similar or different from today. But let's be precise, not falling into the gap between "word processor people" and "spreadsheet people," as Mr. Lucas puts it. Nothing is assumed: Data are interrogated to see how changes in tax rates and other variables actually influence decisions to work, save and invest.

Mr. Lucas is quick to credit the late John Muth, who would later become a colleague for a while at Carnegie Mellon, with inventing "rational expectations." He also cites Milton Friedman, with whom Mr. Lucas took a first-year graduate course.

"He was just an incredibly inspiring teacher. He really was a life-changing experience." Friedman, he recalls, was a skeptic of the Phillips curve—the Keynesian idea that when businesses see prices rising, they assume demand for their products is rising and hire more workers—even if the real reason for higher prices is inflation.

"Milton brought this [Phillips curve] up in class and said it's gotta be wrong. But he wasn't clear on why he thought it was wrong." In his paper for Friedman's class, Mr. Lucas remembers reaching for a very rudimentary notion of expectations to try to explain why the curve could not operate as predicted.

Growing up in the Seattle area, Mr. Lucas recalls a road trip he took as a youngster that terminated in Chicago, a city with two baseball teams! Chicago, in his mind, became "the big city," a gateway to a wider world. That, and a scholarship, is how he would end up spending most of his career at the University of Chicago.

We are sitting in an inauspicious guest office at NYU. A late summer sprinkle dampens the city. Mr. Lucas describes his parents as intelligent, reading people, neither of whom finished college—he suspects the Great Depression had something to do with it. "They got into left-wing politics in the '30s, not really to do anything about it, but to talk about. That was our background—me and my siblings—relative to our neighbors and relatives, who were all Republicans." In a community not noted for its diversity, his parents were especially committed to civil rights, his mother giving talks on the subject.

I ask about a report that he voted for Barack Obama in 2008, supposedly only the second time he had voted for a Democrat for president. "Yeah, I did. My parents are dead for a long time, but my sister says, 'You have to vote for Obama, for what it would have meant for Mom and Dad.' I felt that too. It's a huge thing. This [history of racism] has been the worst blot on this country. All of a sudden this charming, intelligent guy just blows it away. It was great."

Related Video

Steve Moore and Mary O'Grady discuss the week's economic news.

A complementary consideration was John McCain's inability to say anything cogent about the financial crisis then engulfing the nation. "He didn't have a clue about the economy. I just assumed the guy [Obama] could do it. I thought he was going to be more Clinton-like in his economics and politics. I was caught by surprise by how far left the guy is and how much he's hung onto it and, I would say, at considerable cost to his own standing."

Refreshing, even bracing, is Mr. Lucas's skepticism about the "deleveraging" story as the sum of all our economic woes. "If people start building a lot of high-rises in Chicago or any place and nobody is buying the units, obviously you're going to shut down the construction industry for a while. If you've overbuilt something, that's not the problem, that's the solution in a way. It's too bad but it's not a make-or-break issue, the housing bubble."

Instead, the shock came because complex mortgage-related securities minted by Wall Street and "certified as safe" by rating agencies had become "part of the effective liquidity supply of the system," he says. "All of a sudden, a whole bunch of this stuff turns out to be crap. It is the financial aspect that was instrumental in the meltdown of '08. I don't think housing alone, if it weren't for these tranches and the role they played in the liquidity system," would have been a debilitating blow to the economy.

Mr. Lucas believes Ben Bernanke acted properly to prop up the system. He doesn't even find fault with Mr. Obama's first stimulus plan. "If you think Bernanke did a great job tossing out a trillion dollars, why is it a bad idea for the executive to toss out a trillion dollars? It's not an inappropriate thing in a recession to push money out there and trying to keep spending from falling too much, and we did that."

But that was then. In the U.S. at least, the liquidity problems that manifested themselves in 2008 have long since been addressed. To repeat the exercise now with temporary tax and spending gimmicks is to produce the opposite of the desired effect in consumers and business owners, who by now are back to taking a longer view. Says

Mr. Lucas: "The president keeps focusing on transitory things. He grudgingly says, 'OK, we'll keep the Bush tax cuts on for a couple years.' That's just the wrong thing to say. What I care about is what's the tax rate going to be when my project begins to bear fruit?"

Mr. Lucas pulls up a bit when I ask him what specific advice he'd give President Obama (this is before Mr. Obama's two back-to-back speeches, one promising temporary tax cuts and the other permanent tax hikes, which mysteriously fail to levitate the economy). Unlike many of his colleagues, Mr. Lucas has not spent stints in Washington advising politicians, or on Wall Street cashing in on his Nobel laureate reputation. "No, that doesn't interest me at all," he says. "Now I've taken a salary cut. I don't go to faculty meetings. I don't teach undergraduates. I just write papers. It's great. I feel lucky about this."

Still, an answer comes. Mr. Lucas launches into a brisk dissertation on the work of colleagues—Martin Feldstein, Michael Boskin, others—whom he credits with disabusing him and fellow economists of a youthful assumption that taxes have little effect on the overall amount of capital in society. A lesson for Mr. Obama might be: If you want to stimulate growth in investment, productivity and income, cut taxes on capital.

Alas, don't look for this idea to feature in the next Obama speech on the economy, due any minute now.

Mr. Jenkins writes the Journal's Business World column.


Update: Oh, and I just came across this today by Paul Krugman "Lucas in Context." Steve Williamson has the appropriate reply here.