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: