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2013-05-22T15:20:00.000-05:00

Commerzbank sees high risk of housing crash in Sweden and Finland.

Structural fiscal deficits in Australia:

"Ringing the alarm on fiscal policy barely one week after the federal budget, two independent reports from the Parliamentary Budget Office and the federal Treasury reveal a sharp decline in the structure of the budget that will last for most of the decade. The reports show that last week's budget relied on unsustainably high commodity prices to achieve Labor's promised return to surplus in 2015-16, raising the risk of deficits for several years after that."

Migration to Germany (from the "periphery" of Europe)

2013-05-17T13:47:00.002-05:00

From Spiegel International.

The case for and against Catalonia's independence

2012-11-24T12:11:00.001-06:00

Against independence, The Economist:

Under Spain’s constitution of 1978, Catalonia enjoys more self-government than almost any other corner of Europe. It runs its own schools, hospitals, police, prisons and cultural institutions. It lacks only tax-raising powers and the Ruritanian trappings of statehood, which nationalist politicians appear to be hungry for. As for the self-deception, this is sometimes farcical: Catalan public television offers a weather forecast that includes provinces that have been part of France since 1659, but no meteorological information for Zaragoza or Madrid. And most Catalans still seem happy to be both Catalans and Spaniards. Support for independence has risen mainly because Catalans think it would offer relief from recession.

It would not. An independent Catalonia would have more fiscal revenues, but it would also have a higher debt burden than Spain. The argument that Catalans should not subsidise feckless Andalusians is a dangerous one: apply that more widely and the euro zone would fall apart. Indeed, far from welcoming Catalonia as an independent member, the euro zone’s leaders hardly yearn for an extra nation-state.

All that said, the Catalan problem cannot be wished away. Roughly three-quarters of the next Catalan parliament is likely to vote for the right to decide. The constitution says only the Spanish parliament can approve a referendum—and it will not do so. The constitution has in general served both Spain and Catalonia well—but there is a case for updating it.

The Catalans’ complaints come down to two things (see article). First they feel that Mariano Rajoy’s conservative government in Madrid refuses to recognise that Spain is a plurinational and pluri-linguistic country. Second, they think that, set beside the other 16 regions, they pay too much.

The neatest answer to these grievances would be for Spain formally to embrace federalism, with a federal senate and clear rules about who collects which taxes. Federalism would mean each region was equal, with the same rights and obligations. But it has been a dirty word in Spain since a failed federal government in 1873-74. A messier, but more feasible, alternative would be to accept that some regions—Catalonia, the Basque country and perhaps Galicia—should have more autonomy than the rest and be recognised as cultural nations within Spain. Doing this would require a national pact to revise the constitution. After the Catalan vote, Mr Rajoy would be wise to set that process in motion.

For it, Jordi Galí in The Guardian:

In the case of an independent Catalonia, we are dealing with the unique opportunity to design the institutions and regulations of a new state from scratch. A wide array of economic policy instruments that are currently under the exclusive control of the Spanish government and parliament would suddenly be at the Catalonians' disposal. It would allow us to define our own policies and a new regulatory framework for the labour, fiscal and financial sectors, as well as public administration – with no more additional restrictions than those coming from European regulations. It would thus be a good idea to enrich the current debate with proposals that answered the following question: independence, to do what?

To summarise: I believe it is important to recognise that the independence of Catalonia, in and of itself, could make us richer (because we would end the fiscal deficit), but not necessarily more productive. This second aspect would require us to make good use, the day after the celebrations are over, of the unique opportunity and the enormous possibilities offered by the building of a new state. Whether we are prepared for this challenge or not will depend exclusively on us Catalonians, and we will no longer be able to lay the blame on others. In the end, maybe that would be the best gift that independence could bring us.

I must admit (full disclosure, I am Catalan myself) that The Economist makes the better case here. By and large, my impression is that the renewed vigor of Catalan secessionism is a byproduct of the deep recession that Spain is in. Fiscal grievances have been simmering for centuries. The Catalan nationalist leaders have merely seized on the moment to push for an agenda of more self-governance.

I also believe that the secessionist position of Artur Mas (the leader of Catalonia's majority party) is merely strategic. He and most of his party, I think, would be as happy as a clam if Spain moved on to fiscal federalism, even if Catalonia was never granted the right to a independence referendum. Ironically, the only party in the election that has taken federalism as its banner, the Socialist Party (PSC), is the one that is slated to lose the most votes in tomorrow's elections relative to 2010, according to the latest polls.

Either move from the status quo --independence, or mere fiscal federalism--, however, requires a modification of the Spanish constitution, which is a big no-no for the ruling party in the Spanish parliament. I am, therefore, quite skeptical that any of those changes will take place before the end of the current political term, which is in 2015. If the current government in Madrid manages to hold on to power until then, it probably will be because the economic situation improves. By then, Catalonia's secessionist fever may have cooled off.

The real reason behind oil price rises

2012-08-31T08:50:00.003-05:00

Interview with James Hamilton (published on Oilprice.com on Aug. 28, 2012).

James Stafford: Oil prices have shot up in the last month. What range do you see oil prices trading in over the next 12 months?

James Hamilton: Oil prices have always been very volatile. If you look at 12-month logarithmic changes in WTI going back to 1947, you come up with a standard deviation of 0.27. In other words, 25% moves up or down within a year are fairly common, and 50% moves or greater have also been seen on a number of occasions. If you look at options prices at the moment, they imply the same level of uncertainty looking forward. For example, somebody today is willing to pay $2.90/barrel for a NYMEX option to buy oil in September 2013 at $120/barrel, consistent with a standard deviation of annual log changes of 0.26. The market is saying that prices that high or higher are not that remote a possibility. And if you look at current fundamentals, it’s not hard to imagine big moves in either direction coming fairly quickly. The price of oil would surely collapse if we saw a significant economic downturn in China (something nobody can rule out) or if Iraq succeeds in producing even half of its ambitious production targets (though I personally consider the latter unlikely). On the other hand, a military confrontation with Iran could produce a pretty spectacular price spike. If the Strait of Hormuz were to close, for example, it would represent a shock to world production that in percentage terms would be 3 times as big as the 1973-74 OPEC embargo. Because the demand for oil is so insensitive to the price over the short run, and because there is little excess capacity in the world at the moment, even small disruptions or additions could produce big price changes. For this reason, I do not have a lot of confidence in anybody’s near-term oil-price forecasts. On the other hand, I think we understand pretty clearly the main factors behind the overall increase in oil prices since 2005. Demand for oil, particularly from the emerging economies, has grown significantly, and we have had a hard time increasing global production. The single most likely outcome is that both conditions will continue to be with us. The most likely scenario is that the next decade will look something like the last, with oil prices volatile but exhibiting an upward trend.

James Stafford: For the past century or so, economies have generally been built upon energy. The economies with access to plentiful, cheap energy have developed the most. With the stagnation of oil production growth, how do you suggest economies could continue to grow from here? Should we stop expecting to see constant economic growth as the norm?

James Hamilton: I think this has put a significant burden on the oil-consuming countries. These economic problems have been compounded by the fact that some of the key manufacturing that once came out of countries like the United States and Japan has now been taken over by the emerging Asian economies. But there is still a strategy for trying to take advantage of the resources we do have. The United States has had astonishing success in producing natural gas. This could be the basis for a renewed manufacturing advantage, a new source of U.S. exports, or an alternative transportation fuel. We should be looking for regulatory reform and infrastructure investment to encourage consumers and entrepreneurs to adopt alternatives to conventional gasoline-powered vehicles.

James Stafford: Apart from the Iran and Syria situations – are there any other geopolitical risks that could lead to increased volatility in the energy markets?

James Hamilton: The list of oil-producing countries is almost a Who’s Who of world trouble spots. There is ongoing unrest in Sudan and Nigeria, and it wouldn’t take much to see a major turn of events in Venezuela and Kazakhstan. Iraq, a key hope for future increases in production, has been a place of conflict for most of the last three decades. The same forces that disrupted production in Egypt and Libya last year could easily return. And the key worry about Syria and Iran is the possibility that instability there could spill over into other nations of the region.

James Stafford: Even though many Asian nations have found a way to continue trading with Iran, its economy is still suffering from high inflation and high unemployment. Do you believe that the US Sanctions are having enough of an impact on the Gulf state’s economy to force them into a deal over their nuclear program?

James Hamilton: I was surprised that the sanctions were as effective as they were in preventing Iran from selling all the oil it wanted. But the other key element of that diplomatic strategy is the assumption that Iran will respond to economic pressure by acceding to U.S. demands. The other possibility is that, if significantly wounded, the regime would lash out more desperately. This looks to me like a scary situation.

James Stafford: Whenever oil prices spike politicians are quick to blame speculators and oil companies for manipulating the markets. Are you in agreement with this – are speculators and oil companies to blame? Or are there other factors that are overlooked deliberately or otherwise by the mainstream media?

James Hamilton: The story is pretty simple, and even though politicians may try to distort it, you’d hope that the media would do a better job of reporting the truth than they have. World oil production was basically stagnant between 2005 and 2008, even though world GDP was up 17%. With economic growth like that you’d normally expect increased demand, particularly from the rapidly growing emerging economies, and in fact China did increase its consumption by a million barrels a day over these 3 years. But with no more oil being produced, that meant that the rest of us-- the U.S., Europe, Japan-- had to reduce our consumption. It took a pretty big price run-up before that happened. To those claiming the price is too high, I would ask, how high do you think the price had to go to persuade Americans to reduce oil consumption by a million barrels a day?

James Stafford: Could you let us know your thoughts on the shale revolution. How do you see it playing out and do you think we have been oversold on shale’s potential?

James Hamilton: This is a real success story, and a primary reason that U.S. production is now rising rather than falling. But there are several key points to keep in mind. First, it is not cheap to produce oil with these methods-- tight oil is never going to be the reason we get back to $50/barrel. Second, we’re likely to face much steeper production decline rates from individual wells than was the case for conventional oil production. The same also applies to deepwater production. So those who think these new technologies will put us back in the world we once knew are in my opinion missing the big picture.

James Stafford: Drilling technology advances, new oil finds and now all the hoopla over shale oil – one would assume we are swimming in the black stuff, yet we have seen no material increase in global annual crude oil production for six straight years. Have we reached a period of peak oil? Or is Daniel Yergin correct in saying that we have decades of further growth in production before flattening out into a plateau?

James Hamilton: I do not think the expression “peak oil” is the most helpful way to frame the question. Too many people have a knee-jerk reaction as soon as they hear the phrase. I can’t tell you how many times I’ve seen people assume that it means that we’re “running out of oil”, which straw man they then try to debunk. I would instead call attention to the basic fact that the annual production flow from any given field shows an initial period of increase followed by subsequent decline. Anyone who tries to deny that has a serious lack of grip on reality. Production from the original Oil Creek District in Pennsylvania peaked in 1873, and from the state of Pennsylvania as a whole in 1891. There’s a long, long list of areas that have exhibited declining production rates for a long, long time. Global production nonetheless continued to increase for a century and a half, not so much because we got more out of the old fields, old states, old countries, but because we turned to new ones. But that game is obviously not one we can continue to play forever. Yes, Yergin today is optimistic about the future. But I remember that Yergin was also very optimistic in 2005, and the last 7 years have not looked at all like he was predicting they would. We’ve increased production only a little bit since 2005, despite tremendous incentives to do more. I think many people are making a mistake if they assume that world oil production is always going to increase, year after year.

James Stafford: What are your thoughts on the Keystone XL Pipeline – is it something that needs to be pushed through after the presidential elections? Or something the country can live without?

James Hamilton: It is ridiculous to see oil selling in Cushing at a $20 discount to the world price and oil in North Dakota selling at a $20 discount to WTI. Since the 1860s we understood that pipelines were the logical way to transport oil. Somehow the Keystone pipeline became a symbol of some bigger controversies that in my opinion should be completely separate from the question of the most economically efficient (and for that matter, the most environmentally friendly) way to transport oil. There are several work-arounds in progress, such as reversal of the Seaway Pipeline and plans to build just the Gulf Coast portion of Keystone. But I think that given the magnitude of the drop in U.S. demand and success of North American production, we’ll need additional measures.

James Stafford: How would you see energy production changing in the U.S. under a Romney Administration?

James Hamilton: Romney wants to be more aggressive in approving oil exploration and development, and that should make a difference. But it’s easy for the politicians to overstate how much they can change. The U.S. is moving ahead with tight oil production, and is going to do so no matter who is the president, because the economic incentives are just too powerful for anybody to stop it. On the other hand, it’s a big world out there, and anyone who thinks that U.S. production alone is going to make up for declines from mature fields and burgeoning consumption of emerging economies is in my opinion way too optimistic. The world faces a huge challenge, and I think we need to take that challenge very seriously.

James Stafford: James, thank you for taking the time to speak with us. For those of you who haven’t seen Professor Hamilton's site please take a moment to visit Econbrowser.

Earnings as leading indicator

2012-02-07T10:58:00.000-06:00

U.S. equity earnings appear to have declined, if ever so slightly, in 2011:Q4 from 2011:Q3. (Click on "Index earnings" to see the data, in xls format.)

I was curious to see whether stock earnings are leading, lagging, or coincident with the business cycle, so I put together some data. Below are the dates for the cyclical peaks of the economy, as determined by the NBER, the peak of the inflation-adjusted Shiller earnings, and the lead or lag between earnings and the economy:

Economy peak	Real earnings peak	Lead (+) / Lag (-), in months
Oct. 1873	Nov. 1873	-1
Mar. 1882	Jan. 1881	14
Mar. 1887	Dec. 1886	3
Jul. 1890	Jan. 1890	6
Jan. 1893	Jun. 1892	7
Dec. 1895	Jan. 1896	-1
Jun. 1899	Dec. 1899	-6
Sep. 1902	Dec. 1902	-3
May. 1907	Jul. 1906	10
Jan. 1910	Jan. 1910	0
Jan. 1913	Dec. 1912	1
Aug. 1918	Dec. 1916	20
Jan. 1920	Dec. 1916
May. 1923	Dec. 1923	-7
Oct. 1926	Aug. 1926	2
Aug. 1929	Dec. 1929	-4
May. 1937	Sep. 1937	-5
Feb. 1945	Jun. 1945	-4
Nov. 1948	Jul. 1949	-8
Jul. 1953	Sep. 1953	-2
Aug. 1957	Mar. 1956	17
Apr. 1960	Aug. 1959	8
Dec. 1969	Jan. 1969	11
Nov. 1973	Dec. 1973	-1
Jan. 1980	Sep. 1979	4
Jul. 1981	Sep. 1979
Jul. 1990	Mar. 1989	16
Mar. 2001	Sep. 2000	6
Dec. 2007	Jun. 2007	6
	Avg.	3.3
	Median	2.0

The average lead time is 3.3 months, and the median lead is 2 months. There is substantial dispersion, though: from a maximum of 20 months, to a minimum of -6 (i.e. the earnings peak occurred six months after the economy peaked). For the last three recessions, earnings crested before the economy did.

That is not to say, of course, that every earnings peak is a foreboding of recession. In part the trick lies in defining a "peak" for earnings. There have been multiple local maximums over the decades, with no ensuing recession. Still, a possible peak in earnings adds to the body of evidence that suggests that the odds of a recession in the near term are high.

A composite of leading indices

2012-01-31T11:05:00.000-06:00

Following up on yesterday's post, here's a chart of a composite of leading indices for the U.S.:

When the super-index is below zero, there is a high probability that the economy enters a recession within three to six months. The lowest value of the super-index with a false positive signal of recession since 1967 has been -3.3 (in 2002). As of November 2011, the super-index was at -5.7. November was the fourth month in a row with a negative value. All three components of the super-index were negative as of November.(By the way, I’m using the brand new, improved index from the Conference Board, not the old, useless one.)

The December’11 value for the OECD index is not available yet. The other two indices were higher in December than in November, indicating a weaker signal of recession than in November. However, in all likelihood the super-index will still be around -5.

Statistical models like this do not “guarantee” anything. It’s still possible that a recession doesn’t happen.

One of two things may be happening:
1) The model is correctly pointing to a recession.
2) The model is “breaking down”: it is not able to capture the leading business cycle dynamics at present.

In the absence of any arguments supporting #2, and in light of the broad evidence from domestic and international macro data, it is prudent to say that the risk of recession is high.

It is also prudent considering the large divergence of outcomes. If the model is wrong, and no recession occurs, the best we can hope for is a mediocre recovery. This is what the stock market seems to be pricing in at present. If the model is right, and we do have a recession, sales and earnings will fall way short of “consensus expectations,” macro data will surprise on the downside, and risk-aversion will kick in, in which case stock prices are likely to dip. This is definitely not priced in by the market at present.

Construction of the super-index:

1. Calculate the three-month moving average of each of the following indices: the Conference Board’s Leading Economic Indicator (LEI) index, the OECD composite of leading indicators, and the ECRI weekly leading index. (For the latter, I start with the monthly figure, which is itself a monthly average of the weekly values.)

2. Calculate the six-month % change, at an annual rate, of each of the moving averages from step 1.

3. Average the three % changes.

A less-brave, new LEI

2012-01-30T11:00:00.000-06:00

The Conference Board updated this month the composition of its Leading Economic Indicators index. The most important change was the substitution of M2 for a proprietary index of credit conditions. Over the last year, especially, it had become embarrassingly evident that M2 was pushing the LEI up, and that this was not justified by economic conditions. M2 accounts for almost a quarter of the index. Now that the Conference Board has replaced M2 with a more appropriate proxy for credit conditions, the LEI is a lot closer to pointing to a near-term recession than it was before.

Source: John Hussman.

It is not yet clear whether the LEI has reached a cyclical peak, or whether it's just taking a breather. (I, of course, think it's the former.) The six-month change of the index, for instance, is now in negative territory. Historically recessions have always been preceded by a negative six-month change of the index, although there have been instances where such negative change has not been followed by a recession. I have taken the three-month moving average of the LEI (LEI-3MA), in order to remove some of the short-term noise, and then calculated the six-month percent change, annualized, of that moving average. These are the true and false positives of this signal:

Aug. 69: True positive. Recession started in Jan. 70. Avg. value in the three months before recession start: -4.2%

Aug. 73: True positive. Recession started in Dec. 73. Avg. value in the three months before recession start: -5.1%

Mar. 79: True positive. Recession started in Feb. 80. Avg. value in the three months before recession start: -8.2%

Mar. 81: True positive. Recession started in Aug. 81. Avg. value in the three months before recession start: -4.3%

May. 89: True positive. Recession started in Aug. 90. Avg. value in the three months before recession start: -1.7%

Mar. 96: False positive. Recession did not occur. (Only one month when signal was present. Value = -0.77%)

Nov. 98: False positive. Recession did not occur. (Three consecutive months when the signal was present. Values: -0.53%, -0.30%, -0.15%)

Sep. 00: True positive. Recession started in Apr. 01. Avg. value in the three months before recession start: -8.9%

Jul. 06: True positive. Recession started in Jan. 08. Avg. value in the three months before recession start: -5.5% (Warning: in this instance, the six-month change of the LEI-3MA was negative between Jul. 2006 and Feb. 2007, then turned positive for five months, till Jul. 07, and dipped again below zero from Aug. 07 on. In those five months, the six-month percent change of the LEI-MA stayed below 1%.)

Nov. 11: ??? The six-month change of the LEI-3MA was -0.64%, and then it December it was -0.14%. The LEI-3MA does not offer strong-enough evidence, yet, of an upcoming recession.

Which EM economies are most likely to be in trouble?

2012-01-27T09:08:00.001-06:00

The Economist has constructed a policy room index. It is intended to measure how much monetary and fiscal space economies have to conduct policy. The index has six components: inflation, excess credit (the growth in bank lending minus the growth in nominal GDP), real interest rates, currency movements, current-account balances, and a "fiscal flexibility index." The combine those inputs to produce an overall "wiggle-room index."

This reminds me a lot of another index The Economist put together a few months ago: the overheading index.

I combined the two indices to find which countries are in "most trouble" (i.e. high risk of overheating and little wiggle room). I set the threshold at 70, for both indices. I find that the trouble spots are: Brazil, Argentina, India, Vietnam, and Turkey.

Accelerating, or decelerating? GDP, or GDI?

2011-12-29T14:34:00.001-06:00

We have had evidence for quite some time that "GDP(I) growth is better than GDP(E) growth at tracking fluctuations in true output growth." GDP(I) is commonly called Gross Domestic Income, and GDP(E) is Gross Domestic Product. Conceptually, both GDP(I) and GDP(E) measure the exact same thing, using different methodologies. The main reason, I think, why GDP(E) gets all the attention is that it is released one month earlier than GDP(I). It's also possible that a lot of people still don't know why and how GDP(I) is useful.

In 2011:Q3 GDP(I) grew just 0.22%. Perhaps more importantly for the short-term outlook, the q/q growth rate of GDP(I) has been diminishing during 2011: 2.68% in Q1, 0.26% in Q2, 0.22% in Q3. Far from improving, the U.S. economy seems to have been slowing down.

The growth rate of GDP(E), on the other hand, has been increasing: 0.36% in Q1, 1.33% in Q2, 1.81% in Q3. I do not know of any theory of why the path of the two growth rates is diverging. Nonetheless, an implication of the research mentioned above, by economist Jeremy Nalewaik at the Federal Reserve, is that output growth is more likely to have decelerated than to have accelerated through 2011:Q3. The naive approach of averaging the two measures yields the conclusion that output growth accelerated from 0.8% to 1.01% between Q2 and Q3. Still, a growth rate of 1.01% is nothing to be too cheerful about.

How fast is the economy really growing? We may not know till March 2012 (for Q4 the estimate for GDP(I) will probably be released with a three-month lag, rather than the customary two-month lag).

Fitch downgrades Spain

2011-10-07T13:23:00.001-05:00

Fitch just downgraded Spain, from AA+ to AA-. Fitch's rating is now one notch below S&P's and Moody's. The outlook for the rating is negative, meaning that on its current path Spain would be downgraded again in the short to medium term (this interpretation of "negative outlook" is mine, not Fitch's).

(If you don't have an account at Fitch's website, you can read the press release below, which I pasted from the Wall Street Journal.)

Highlights from Fitch's report:

1) Two factors triggered the downgrade: intensification of the euro crisis, and the budget outlook for Spain's regions.

2) "A credible and comprehensive solution to the crisis is politically and technically complex and will take to put in place and to earn the trust of investors."

3) Spain is too large to fail, and will eventually be bailed out if necessary: "Spain’s ‘AA-’ rating incorporates Fitch’s judgement that as a solvent and systemically important sovereign, in extremis, the ECB and/or EFSF/IMF will provide support to prevent a self-fulfilling liquidity crisis."

4) The negative outlook reflects, among other things, contingent liabilities from the financial sector.

The point that concerns me most is the fourth one. Spain has already spent about 17-18bn. euros in 2011 rescuing (or rather, nationalizing) financial institutions. Two more entities are expected to be nationalized within months. Fitch expects the additional cost of shoring up Spain's banks to be 30bn. euros. Other observers put the bill at 40-100bn, i.e. 4%-10% of Spain's GDP.

Fitch's press release:

Fitch Ratings has downgraded Spain’s Long-term foreign and local currency Issuer Default Ratings (IDRs) to ‘AA-’ from ’AA+’. The rating Outlook is Negative. Fitch has simultaneously affirmed Spain’s Short-term rating at ‘F1+’ and the Country Ceiling at ‘AAA’.

The downgrade primarily reflects two factors: the intensification of the euro area crisis and secondly, risks to the fiscal consolidation effort arising from the budgetary performance of some regions and downward revision by Fitch of Spain’s medium-term growth prospects.

As Fitch has previously cautioned, a credible and comprehensive solution to the crisis is politically and technically complex and will take time to put in place and to earn the trust of investors. In the meantime, the crisis has adversely impacted financial stability and growth prospects across the region.

However, the still sizeable structural budget deficit, high level of net (although not gross) external debt and the fragility of the economic recovery as the process of deleveraging and rebalancing continues render Spain especially vulnerable to such an external shock.
While gross external debt (169% of GDP in 2010) is not high by euro area comparison, the net external debt of the economy (91% of GDP in 2010) is one of the highest in the world, reflecting a relative lack of Spanish foreign financial assets. This leaves the Spanish external finances sensitive to interest rate increases. While the current account adjustment has been significant, falling from 10% of GDP in 2007 to 4.5% of GDP in 2010 and a forecast 3.2% in 2011, further adjustment over the medium is necessary to improve the external balance sheet.

The intensification of the euro area crisis was identified as a negative rating trigger on 4 March 2011 when Spain’s rating Outlook was revised to Negative. With large fiscal and external financing needs, heightened volatility has adversely impacted market financing conditions for Spain as illustrated by the Eurosystem’s intervention in the secondary market. However, Spain’s ‘AA-’ rating incorporates Fitch’s judgement that as a solvent and systemically important sovereign, in extremis, the ECB and/or EFSF/IMF will provide support to prevent a self-fulfilling liquidity crisis.

The second principal driver of the downgrade of Spain’s sovereign ratings is the budgetary performance of some regional governments, which in Fitch’s opinion, poses a risk to fiscal consolidation. In September 2011, the agency downgraded five autonomous communities and maintains a Negative Outlook on the sector reflecting the still difficult fiscal and economic environment and the execution risks in implementing some of the cost cutting measures announced.

While the sub-national sector’s debt was only 11.1% of GDP in 2010, it accounts for roughly one-third of total expenditure, making it a vital part of the necessary correction in the public finances to restore confidence and public debt sustainability.

The process of rebalancing the Spanish economy is well underway but is not yet complete and Fitch expects it to weigh more heavily on economic growth over the medium term. The agency projects annual economic growth to remain below 2% through to 2015 and unemployment to remain high. Despite the important measures already adopted by the government, further structural reform will be necessary to further enhance the competitiveness and productivity of the economy. The fundamental weakness of the labour market, as underscored by an unemployment rate in excess of 20%, is a material rating weakness relative to European and high-grade peers. Nonetheless, while the recovery over the medium term will be lacklustre, Fitch expects the long-term (ie, post-2015) potential growth rate to exceed the average for the euro area as a whole.

Despite the weakened risk profile, Fitch views Spanish sovereign solvency as secure. Under the agency’s baseline scenario, the debt to GDP ratio will peak at 72% of GDP in 2013, well below the forecast euro area average of 89% in 2013.

Spain’s ‘AA-’ rating reflects strong fundamentals: a diversified, high-value-added economy and strong governance. The government’s policy response has been credible and aggressive.
The Negative Outlook reflects the risks associated with a further intensification of the euro area financial crisis, as well as possible material fiscal slippage and to a lesser extent contingent liabilities from the financial sector. A material deviation from the government’s fiscal targets and failure to stabilise the government debt to GDP ratio from 2013 would place negative pressure on the rating. Substantial progress has been made in the restructuring of the banking sector and Fitch has not revised its estimate of the ultimate fiscal cost which is moderate and is consistent with the current rating.

The amount disbursed by the Fund for Orderly Bank Restructuring (FROB) is estimated at EUR17.3bn by end-2011. Under Fitch’s baseline scenario, Fitch assumes that a further EUR30bn (2.8% of GDP) of capital is required from 2012 based on the agency’s stress-test exercise. This is to cover additional losses while maintaining a strong core capital ratio of 10% for the system. Fitch views the costs as manageable. Should recapitalisation costs be significantly higher than this figure, the rating could move into the ‘A’-range.

On a wide range of economic and fiscal indicators Spain has underlying fundamentals consistent with maintaining its sovereign rating in the ‘AA’ category. Success in meeting its fiscal targets and progress on structural reform that would further enhance competitiveness and growth prospects would stabilise the rating, as would resolution of the euro area crisis.

The change in payrolls actually decreased from August to September

2011-10-07T09:11:00.000-05:00

The payrolls number today was deceiving. Taken at face value, it implies an increase in job creation between August and September, from the (revised) 57k in August to 103k in September.

But there was a strike in August., which involved 45k workers. Employees in strike are not counted in the payrolls by the Bureau of Labor Statistics, because they are not paid while they are in strike. I would argue that those employees should be counted in if they are expected to return to the payrolls in the short term. I'm not criticizing the BLS's methodology, but rather trying to capture the underlying trend of employment. If we add those 45k to the change in payrolls in August we get a change of 102k (57k + 45k), and if we subtract those 45k from the change in September, we get a corrected change of 58k (103k - 45k). Job creation, therefore, weakened from August to September.

In addition, keep in mind that the threshold for statistical significance of the change in payrolls is 96.4k. So the change in payrolls in August was not different from zero, from a statistical standpoint, and the change in payrolls in September was only barely significant.

The three month average of payroll changes, as of September, increased to 96k, from 68k in August. Over the last 12 months, nonfarm payrolls increased 1.01%.

Global manufacturing PMI

2011-10-04T09:02:00.000-05:00

In addition to the individual country manufacturing PMI's, on which I commented yesterday, JPMorgan/Markit produce a "global" PMI, which is the a weighted average of the country PMI's. They released this Global PMI for the month of September yesterday as well, showing that world manufacturing activity weakened further.

The composite index reached a level of 49.9, down from 50.2 in August. September is the seventh month in a row in which global manufacturing activity has weakened. Granted, the change is minimal, but it is pointing in the wrong direction (or in the right direction, if you are predicting a recession).

From August to September, the new orders component weakened from 49.4 to 48.5. The employment and output components improved slightly (51 to 51.3, and 49.8 to 50, respectively), and the input price component saw no change.

Next I am eagerly awaiting the release of the non-manufacturing PMI. So far economic activity has deteriorated consistently in the manufacturing industries, but more hesitantly in the services industries. A decline of the services PMI would add another drop to the recession bucket.

Manufacturing PMI by country

2011-10-03T10:24:00.002-05:00

The Wall Street Journal has a convenient summary of manufacturing PMI reports, by country. See table below.

My highlights:

-As of September, manufacturing activity is contracting in 13 countries, out of 24 countries. (I do not include the eurozone as a whole, so as not to avoid double-counting country members of the currency union.) Activity is contracting in: Austria, Australia, Brazil, France, Greece, Ireland, Italy, Japan, Netherlands, Spain, Switzerland, and Taiwan. Activity is expanding in: Canada, China, Czech Republic, Germany, Hungary, India, Poland, Saudi Arabia, Turkey, U.K., and U.S.

-From August to September, activity deteriorated in 17 out of 24 countries. A deterioration can be either a slowdown in the rate of expansion, or an acceleration in the rate of contraction. Activity deteriorated in: Austria, Australia, Brazil, Czech Republic, France, Germany, India, Ireland, Japan, Netherlands, Poland, Saudi Arabia, Spain, Switzerland, and Taiwan. Activity improved in: Canada, China, Hungary, Italy, Russia, Turkey, U.K., and U.S.

Country	Sep.	Aug.	Change
Austria	48.7	50.1	-1.4	Contracting
Australia	42.3	43.3	-1.0	Contracting Faster
Brazil	45.5	46.0	-0.5	Contracting Faster
Canada	55.0	54.9	0.1	Expanding Faster
China	51.2	50.9	0.3	Expanding Faster
Czech Republic	52.3	53.4	-1.1	Expanding Slower
Euro Zone	48.5	49.0	-0.5	Contracting Faster
France	48.2	49.1	-0.9	Contracting Faster
Germany	50.3	50.9	-0.6	Expanding Slower
Greece	43.2	43.3	-0.1	Contracting Faster
Hungary	50.8	50.1	0.7	Expanding Faster
India	50.4	52.6	-2.2	Expanding Slower
Ireland	47.3	49.7	-2.4	Contracting Faster
Italy	48.3	47.0	1.3	Contracting Slower
Japan	49.3	51.9	-2.6	Contracting
Netherlands	48.9	50.7	-1.8	Contracting
Poland	50.2	51.8	-1.6	Expanding Slower
Russia	50.0	49.9	0.1	No Change
Saudi Arabia	54.5	57.9	-3.4	Expanding Slower
Spain	43.7	45.3	-1.6	Contracting Faster
Switzerland	48.2	51.7	-3.5	Contracting
Taiwan	44.5	45.2	-0.7	Contracting Faster
Turkey	51.5	48.8	2.7	Expanding
U.K.	51.1	49.4	1.7	Expanding
U.S.	51.6	50.6	1.0	Expanding Faster

ECRI says that U.S. economy faces new recession

2011-10-01T17:21:00.003-05:00

From the Wall Street Journal:

SAN FRANCISCO (MarketWatch) — The U.S. economy is headed for another recession that government intervention cannot prevent, and such downturns will occur more often, the Economic Cycle Research Institute said Friday.
“This is a new recession; it’s not a double dip recession,” said Lakshman Achuthan, co-founder of ECRI, in a telephone interview. “We can’t avert it.”
ECRI’s Weekly Leading Index (WLI) growth indicator, reported Friday, showed U.S. economic growth sliding to negative 7.2% for the week ended Sept. 23 from negative 6.7% the week before, continuing a trend that began in August. U.S. economic strength has been declining since May, according to the WLI. Based on WLI and other indicators, ECRI has correctly called the last three recessions and recoveries without triggering any false alarms.

“We are seeing the weakness spread widely,” Achuthan said. “There’s a contagion, like a wildfire among the forward-looking indicators that’s not going to be snuffed out. The nature of a recession is not a statistic. It’s a vicious feedback loop. Sales fall, production falls, income falls and that depresses sales. We’re in that and it’s going to run its course.”

Government’s effort to stimulate the economy, coming from both the Federal Reserve and the Obama administration, is a case of too little, too late, Achuthan observed. Politicians and central bankers simply can’t move as fast as the business cycle, he said.

“Even in the best of times, government intervention is too small; it’s dwarfed by the business cycle,” Achuthan said. “Earlier this year these leading indicators were turning down and starting to weaken. Maybe there was a slim chance back then. Today it’s water under the bridge.”
A second recession in as many years will lead to higher unemployment, lower tax revenue, and poses obvious challenges for stocks, but investors should get used to more frequent up-and-down cycles, Achuthan said.
“We are in an era of more frequent recessions,” Achuthan noted. The long, benevolent expansions of the 1980s and 1990s that created a generation of stock investors and an equity culture in the U.S. are relics of the past, he said. Going forward, he added, business cycles will be shorter and sharper — as was true in the 1970s and in fact for much of the country’s history.
Accordingly, since economic recoveries will be more fragile and easily derailed, investors should expect continued heightened volatility for stocks, he explained, “If you have a big negative shock it can take a mild- or even medium- intense recession and make it really bad,” Achuthan said.
That said, no indicators currently are suggesting the economy faces a Great Recession comparable to 2008, Achuthan added. “But I can’t rule it out either,” he said, “because the Great Recession was great in part because of the shocks” including the failure of Lehman Brothers in September 2008 that froze the financial markets.
Nowadays, Achuthan said, the debt crisis in Europe is the most obvious potential trigger for a protracted breakdown in the global economy. Still, he said, “If that crisis is somehow averted, it doesn’t mean were OK. We’re still going to have a recession. If that crisis is not averted, that recession has a likelihood of being worse.”
Investors, meanwhile, will have to adjust their thinking about how they buy and sell stocks, he added.
“Bear markets are associated with recession,” Achuthan said. “If you have frequent recessions the equity risk premium gets elevated and can’t come down.” In that scenario, stocks tend to trade in a range and investors have to be more nimble and more watchful. It’s an environment not unlike the sideways market of 1966-1982. In those years, said Achuthan, “You could make a fortune if you weren’t buying and holding.”

Robert Reich on "How to attack America's job depression"

2011-09-08T10:25:00.001-05:00

Visit the original op-ed here (gated page of the Financial Times):

Barack Obama will unveil his plan for US jobs on Thursday evening. Some of the president’s advisors have been urging what might be termed Plan A. Others insist on Plan B. We will soon know which prevails – but my betting, unfortunately, is on B.

Plan A would be big enough to restart the economy and reduce unemployment. That means the government should spend another $1,000bn over the next two years – rebuilding the nation’s worn out infrastructure, creating a Works Progress Administration and Civilian Conservation Corps (modelled after the Depression-era agencies that put jobless Americans directly to work), lending money to cash-starved states and cities, and exchanging mortgage debt for equity stakes in people’s homes when they are eventually resold.

Republicans will oppose such a plan, of course. They will say the original stimulus didn’t work. They are wrong about this: it saved 3m jobs. But it was far too small given the drop in consumer spending and the substantial budget cuts by states and cities.

Republicans will also argue that the nation cannot afford Plan A. They’re wrong again. The yield on 10-year Treasury bills is now 2 per cent, making this an excellent time to borrow. Moreover, if growth is not restored soon, the ratio of public debt to gross domestic product will balloon.

A cynic would suspect the real motivation of Republicans was to keep the economy anaemic up to election day 2012 so voters send Mr Obama home. Whatever their motive, the result is the same: if the president presents Plan A he will have to fight for it. He will have to barnstorm the country, demanding Republican votes. And if he fails to attract enough votes, he will have to build his 2012 presidential campaign around it, attacking the Republican “do nothing” Congress, as did “Give ‘em hell” Harry Truman in the election of 1948.

Plan B would be a bunch of policy miniatures. They would all be worthy initiatives: they would include extending unemployment benefits and last year’s Social Security tax cut, reauthorising the highway building trust fund, giving employers a small tax incentive to hire the long-term unemployed, and ratifying trade agreements that are languishing.

The president would present each of his policy miniatures as a separate piece of legislation hoping to attract enough Republican votes to get something – anything – enacted and declare a victory. He would then campaign as a leader who can “get things done,” even though the US economy is still a basket case.

These small-bore initiatives would not revive the economy, however, because they would not come close to making up for the shortfall in demand. The latest official data show that the US economy generated no net new jobs in August, and fewer than previously thought in June and July. At least 125,000 are needed each month merely to match population growth. So the hole continues to deepen.

Since the jobs depression began at the end of 2007, the nation’s potential labour force – working-age people who want jobs – has grown by over 7m but the number of Americans with jobs has shrunk by more than 300,000. The problem is clearly on the demand side.

Republicans claim businesses are not hiring because they are uncertain about regulatory costs or cannot find the skilled workers they need. Yet, if these were the reasons – and if demand were growing – we would expect companies to make more use of their current employees, with average working hours increasing. In fact, the opposite has been occurring. In August, the length of the average working week declined for the third month in a row, to 34.2 hours – barely longer than at its shortest point two years ago, in June 2009.

Plan B is not even wise politics. The night before Mr Obama lays out his jobs plan Republican presidential hopefuls were holding their first big debate. The winner this week will be the one who comes off as the toughest fighter for average Americans, almost regardless of the soundness of his or her economic plans. Similarly, the winner of the 2012 presidential election will almost certainly be the person who comes off as the toughest fighter for average Americans.

The writer is a professor of public policy at the University of California at Berkeley, and former US secretary of labour under president Bill Clinton. His latest book is ‘Aftershock: The Next Economy and America’s Future’

August BLS employment report

2011-09-02T07:36:00.005-05:00

The Bureau of Labor Statistic released the monthly employment report for the month of August. Highlights:

Nonfarm payroll employment was unchanged (0) in August, and the unemployment rate held at 9.1 percent. (...) Health care continued to add jobs, and a decline in information employment reflected a strike. Government employment continued to trend down, despite the return of workers from a partial government shutdown in Minnesota.

The change in total nonfarm payroll employment for June was revised from +46,000 to +20,000, and the change for July was revised from +117,000 to +85,000.

Both the civilian labor force participation rate, at 64.0 percent, and the employment-population ratio, at 58.2 percent, were little changed.

The average workweek for all employees on private nonfarm payrolls edged down by 0.1 hour over the month to 34.2 hours.

In August, average hourly earnings for all employees on private nonfarm payrolls decreased by 3 cents, or 0.1 percent, to $23.09. This decline followed an 11-cent gain in July.

There is nothing positive in this employment report. Granted, it could have been worse: the participation rate could have decreased, the change in payrolls could have been negative. Some will dismiss the news as temporary: a result of the extreme negative sentiment during the first half of August, and the Verizon strike. But the payrolls number for both June and July were revised down as well, and both are now well below 100k.

ADDENDUM (8:15AM):

Private employers added 17k jobs, whereas the government cut 17k jobs. The ADP survey yesterday showed a 91k increase in private payrolls. Payrolls changes were minuscule across industries, so it is hard to highlight anything. The largest gain was for healthcare and social assistance (35.5k). Professional and business services added 28k, and information subtracted 48k, no doubt influenced by the strike of Verizon's employees.

Average hours and average hourly earnings were both down, which is not a good omen for future months. The declines were too small to be alarmed yet, however. And, as always, a month does not make a trend.

From the household survey, the number of people working part-time for economic reasons (i.e., they could not find a full-time job) increased 430k. The number of jobless who were unemployed because they re-entered the labor force increased 122k. I consider this a good thing: more people entering the workforce means confidence that they can find a job. But that was pretty much the only crumb of good news I could find in this report.

Overall, as I wrote before, a very negative employment report.

Why the U.S. is very close to a recession (if not in one already)

2011-08-30T16:57:00.004-05:00

A set of economic and financial market conditions indicate that the U.S. economy is either in a recession, or very likely to enter one within months. My post last week already touched on the topic of whether the economy is closer to a recession now or in August of 2010. Here I explain why I think the economy is within inches of a recession.

As mentioned in the previous post, Hussman’s set of warning signs is currently at a level of 3 (4 being the highest risk, 0 being the lowest). When the index switches from a value of less than 4 to 4, it indicates that we are in a recession or that we will shortly be in one. (The “Hussman index” I am referring to is explained in this link, and it is a set of four conditions that John Hussman came up with.)

Given current conditions in the stock market, treasuries market, and corporate debt market, it is extremely likely that the index will reach a level of 4 on September 1, and if not, on September 2. (The manufacturing PMI index for August will be released on Sep. 1, and the employment report for August will be released on Sep. 2.)

The consensus forecast for the PMI index is 48.5, which is below 50 and would put the "Hussman index" at 4. The PMI in July was 50.9, and has been falling since February 2011. Regardless, the PMI index will be below 54 almost certainly, in which case employment conditions kick in in the index. One-year growth of payroll has been below the critical value of 1.3% since 2007. For that number to be above 1.3% as of August 2011, the change in payroll from July to August would have to be 431k. Not gonna happen. In fact, consider this: the payrolls number to be released on Sep. 2 takes as reference period “the pay period ending on the 12th day of the month.” That would be, approx., the first two weeks of July. If you remember, in early August the markets were in a wild rollercoaster, so I doubt that employers had much confidence to add to their payrolls. The Philly, Empire State, Richmond, and the rest of manufacturing surveys are coherent with my suspicion.

In other words, there is a 99.99% chance that the index will reach the scary value of 4 by September 2.

Does the “Hussman index” produce false positives? Yes, it has produced false positives in the past. To find out, I gathered the necessary data, at the weekly frequency, going back to 1963. Since then, the index has produced three false positives: one in 1967, one in 1998 (Long-term Capital crisis?), and one in 2002. In each case, the index went from 3 to 4, stayed at 4 for 1-3 months, then fell to 3. No recession ensued.

(I added a 5th condition to “Hussman’s index,” to see if I could refine the index further and avoid some false positives. The 5th condition is that the ECRI Weekly Leading Index is below its value six months prior. This condition, however, did not add anything to Hussman’s index, in the sense that the augmented index is equal to 5 every time that the original Hussman’s index is equal to 4.)

However, even when a value of 4 of the “Hussman index” is not followed by a recession, such value is associated with negative one-month returns of the S&P500, high or rising corporate spreads, and low or falling Treasury term spreads, especially during the first 3-5 weeks after the index’s transitioning from a 3 to a 4.

Are we there yet? Are we there?

2011-08-22T15:38:00.005-05:00

John Hussman posts his list of warning signs of a recession:

#1: Widening credit spreads: An increase over the past six months in either the spread between commercial paper and three-month Treasury yields, or between the Dow Corporate Bond Index yield and ten-year Treasury yield.

#2: Falling stock prices: S&P 500 below its level of six months earlier.

#3: Weak ISM PMI: Manufacturing PMI below 50.

#3a (alternate to condition #3): Weak PMI, and weak employment growth: Manufacturing PMI below 54, together with either
i) nonfarm payrolls below 1.3% the level of the preceding year, or
ii) an unemployment rate 0.4 percentage points (or more) above its 12-month low.

#4: Moderate or flat yield spread: Yield spread (ten-year minus three-month) below 2.5%, if condition #3 is in effect, or yield spread below 3.1% if condition #3a is in effect.

According to Hussman,

"the components of our recession warning composite might be called "weak learners" in that none of them, individually, has a particularly notable record in anticipating recessions. The full syndrome of conditions, however, captures a critical "signature" of recessions. That signature of "early warning" conditions is based on financial market indicators including credit spreads, equity prices and yield curve behavior, coupled with slowing in measures of employment and business activity. Every historical instance of this full syndrome has been associated with an ongoing or immediately impending recession."

I was intrigued by this list of "warning signs," so I put them to a test. Would these variables have predicted a recession in the summer of 2010, when the U.S. economy was on the brink of a recession-cum-deflation, but a recession did not actually ensue? The following table details whether each of the four "Hussman signs" are in effect now and last summer:

	Summer 2010	Summer 2011
#1	Yes. The credit spread (measured by the Moody's seasoned BAA yield minus the 10-year Treasury yield) was above its level six months prior between June 2010 and December 2010. The credit spread reached its maximum in November 2010.	Yes. The credit spread has been higher than its level six months prior since 6/24/2010. The spread is still rising.
#2	Yes. The six-month price change turned negative in late May 2010. It was persistently negative from 8/20/2010 through 10/29/2010. The minimum that summer was in late August.	Yes. The six-month price change turned negative in early August and is still negative.
#3	Nope, not even close. The minimum that summer was 55.10, reached in July.	No (but almost). The PMI reached a new low of 50.9, just a hair away from 50, which indicates a contraction of manufacturing activity. The PMI has been declining every month since February 2011.
#3a	No.	Yes. This condition was fulfilled in May, when the PMI dipped below 54, and again in July. Annual payroll growth has been below 1.3% since March 2007. Over the 12 months to July 2011, the most recent month with available data, payroll growth was 0.97%.
#4	No. Since neither condition #3 nor #3a were in effect, condition #4 was not in effect either. In any case, the spread reached a low of 2.3% in October.	Yes. The spread has been below 3.1% since May, and is now below 2.5% (and falling).

This summer, it appears, it is much more likely that a recession occurs within the next few months that it was last summer. In fact, all four of Hussman's warning signs are in effect.

What do other leading indicators say? I take a look at three widely-followed leading indices of economic activity:

	Summer 2010	Summer 2011
ECRI WLI leading index	The growth index turned negative in early June 2010. It had been declining since October 2009. In the summer of 2010 the WLI reached a low of -10.9, in July. In the 40+ year history of this index, the economy had never avoided a recession when the index reached such a low value.	The growth index turned negative on the week ending in August 12, with a value of -0.1. It has been declining since April 2011.
Conference Board's leading economic index	The LEI fell slightly between May and June of 2010. The growth rate slowed down significantly as the summer proceeded.	The LEI has not ceased to increase at all. The growth rate has not slowed down, as of July 2011.
Philadelphia Fed's leading index	The index declined persistently from May 2010 through September 2010, although it did not turn negative.	The index has declined persistently since April 2011.

All signs point to a continuing slowdown of economic activity, not to rebound. The odds of a recession are high, are arguably higher than last summer. The discordant indicator is the Conference Board's leading economic index, which is not showing signs of a slowdown.

Market update: what is happening in the stock market?

2011-08-09T08:54:00.006-05:00

In my opinion the equity market sell-off over the last week—and rise of Treasury debt prices–is a reaction to three negative events: the debt-ceiling agreement reached by Congress on August 1, the failure of the U.S. economy to leave behind the economic “soft patch,” and the debt crisis in Europe. These three factors have done two things. First, they have elevated uncertainty. Second, they have darkened the economic and market outlook. And none of these things are ever well received in the stock market. In this note I take on each of these events, one at a time, and try to explain how they have affected the stock market, and what they imply for the future.

It’s not S&P

The S&P downgrade per se did not have, in our opinion, any meaningful impact on asset prices. U.S. treasuries were as creditworthy last week as they are today. Not only that, but the S&P decision did not unveil any news that the markets did not already know. S&P relies on public, freely available data, all of which was known by the markets.

S&P’s decision is newsworthy only in that it is the opinion of an official sanctioner of credit quality. It has a direct impact in that some investors, notably some insurance companies, are required to hold AAA-rated securities, and those investors are forced to sell treasuries. But they are a small minority, especially because the two other leading rating agencies have kept the AAA. Money market funds, for instance, are allowed to hold AA-rated debt.

If you are not convinced, look at the yields. Treasuries --the very instruments which were just downgraded — are up, with the 10-year bond yielding 2.31% as of today’s closing [August 8], 72 basis points lower than two weeks ago.

The debt ceiling agreement, on the other hand, was bad news in the short term. The agreement is supposed to reduce the deficit by $2.5tn over the next ten years. A fiscal contraction of that amount spread over such a long period of time, should not by itself have moved the market in a normal economic environment. The problem, of course, is that we do not live in a normal economic environment. Since the end of the recession in 2009, the economy has posted unusually weak rates of growth. In fact, we are barely growing at all. In that environment, a fiscal contraction of modest size can easily result in recession.

It’s the economy, stupid

Adding to the bad news is that we are not leaving the “soft patch” behind. Many economists, including myself, believed that the slowdown that started in March was the product of the supply-chain disruptions triggered by the disasters in Japan and the lagged effect of oil prices. “As soon as we get through this,” the consensus was, “the economy will start doing better.” Up until June, I would say, the consensus was that the U.S. economy would resuscitate in the second half of 2011. So far we have been proven wrong. I would not say that the economy is definitely tanking, but it is definitely not bouncing back either. The downward revision of past GDP numbers, added to the mediocre PMI and jobs numbers reported last week, in a climate of unusual uncertainty about the economic outlook, have prompted people to revise up their subjective estimates of another recession. And recessions are very bad for equity prices.

Eurotrouble

Finally, having put behind its own debt crisis, the U.S. markets have started to pay due attention to the debt crisis in the eurozone. The suspicion that Italy –the third largest issuer of debt in the world— and Spain might default, brings the world to uncharted territory. If we learned one thing from our own financial crisis in 2008 is that market exposure is like an iceberg: much more is hidden below the surface than above. Indirect exposure through bank liabilities and derivatives markets transmits local financial shocks far away, and makes the entire banking system surprisingly fragile.

And, above all regarding the situation in Europe, there is uncertainty. What are the implications of an Italian default? We don’t know. How will the eurozone respond to a debt crisis, in a context of independent fiscal policies of its member countries? We don’t know (although we do know that fiscal stimulus is not an option, as it was in the United States in 2008). Has the European Central Bank the same power (and bravado) to conduct unconventional monetary policy as the Federal Reserve once had? We don’t know. But the uncertainty is killing the market.

What do we know?

What do we know, then? Not much with certainty. But I can offer you my reasonable conjectures. First of all, the equity markets probably overreacted. U.S. stocks are not worth 20% less than they were at the market highs around 1,370, last May. A recession is not a certain event just yet. A partial counter-reaction of the stock market is likely in the short term, even if we do not return to pre-crisis levels. Second, a default by Spain or Italy is likely, but not immediately. Those two countries face almost insurmountable debt dynamics that, realistically, can be solved only by either partial default or by leaving the currency union. There is strong resistance from European leaders to either defaults or union dismemberment, which will result in a protracted drama. Eventually, I would say, there is no escape. Third, the Federal Reserve is now more likely to announce another round of asset purchases (a.k.a. QE3) than it was a month ago. If the economic outlook continues to deteriorate, I predict that QE3 will be announced by the FOMC meeting on September 20, if not earlier.

NABE's economic measurement seminar

2011-07-25T11:57:00.003-05:00

Today and tomorrow I am attending NABE's Economic Measurement Seminar.

You can download pdf files of the presentations here.

So far it's been a great seminar. The presenters are incredibly knowledgeable about their topics. The organizers have split the seminar into Track A (for "beginners") and Track B (for "experts"), although attendees are allowed to mix session from the two tracks. I highly recommend the seminar to economists in the private sector who have been in this business less than, say, five years.

Economic forecasts update

2011-05-18T09:19:00.004-05:00

The FRB of Philadelphia released on May 13 the results of the Q2 Survey of Professional Forecasters (SPF).

Growth over the next two years is expected to be in the 3%-3.5% range. The participants in the survey have revised down their real GDP growth forecasts for Q2, and up for Q3 and Q4. Forecasts for 2012 and 2013 are a tad lower than at the Q1 survey (the column labelled "Previous"):

	Real GDP (%)		Unemployment Rate (%)		Payrolls (000s/month)
	Previous	New	Previous	New	Previous	New
Quarterly data:
2011:Q2	3.5	3.2	9.2	8.9	188.3	191.1
2011:Q3	3.1	3.4	9.0	8.7	201.1	194.5
2011:Q4	3.4	3.5	8.8	8.5	213.1	173.9
2012:Q1	3.1	2.9	8.7	8.4	201.4	219.4
2012:Q2	N.A.	2.5	N.A.	8.2	N.A.	182.0
Annual data (projections are based on annual-average levels):
2011	3.2	2.7	9.1	8.7	134.9	130.4
2012	3.1	3.0	8.5	8.1	226.1	194.8
2013	3.0	2.8	7.8	7.5	N.A.	N.A.
2014	3.4	3.3	7.3	7.0	N.A.	N.A.

The unemployment rate is expected to gradually fall as well, and the new forecasts are more optimistic than the ones released in Q1 (perhaps in light of the developments in the job market between February and April of 2011?).

The commentary on the FRB Philadelphia website:

Growth in the U.S. economy looks a little slower now than it did three months ago, according to 44 forecasters surveyed by the Federal Reserve Bank of Philadelphia. Our panelists expect real GDP to grow at an annual rate of 3.2 percent this quarter, down from the previous estimate of 3.5 percent. On an annual-average over annual-average basis, the forecasters also predict slower real GDP growth over the next four years. The forecasters see real GDP growing 2.7 percent in 2011, down from their prediction of 3.2 percent in the last survey. The forecasters predict real GDP will grow 3.0 percent in 2012, 2.8 percent in 2013, and 3.3 percent in 2014, each somewhat lower than their respective predictions in the last survey.

The outlook for the labor market is mixed. The forecasters see a brighter picture for the unemployment rate over the next four years. Unemployment is projected to be an annual average of 8.7 percent in 2011, 8.1 percent in 2012, 7.5 percent in 2013, and 7.0 percent in 2014. On the jobs front, the forecasters see slower growth in jobs in 2011 and 2012 than they predicted in the last survey. The forecasters see nonfarm payroll employment growing at a rate of 191,100 jobs per month this quarter and 194,500 jobs per month next quarter. The forecasters' projections for the annual-average level of nonfarm payroll employment suggest job gains at a monthly rate of 130,400 in 2011 and 194,800 in 2012, as the table below shows. (These annual-average estimates are computed as the year-to-year change in the annual-average level of nonfarm payroll employment, converted to a monthly rate.)

The inflation rate experienced the sharpest revision among the economic variables considered. The Q2 forecast was raised from (and admittedly too low) 1.3% to 3.5%. Inflation is expected to cool down to 2%-2.3% over the year and a half after Q2.

	Headline CPI		Core CPI		Headline PCE		Core PCE
	Previous	Current	Previous	Current	Previous	Current	Previous	Current
Quarterly
2011:Q2	1.3	3.5	1.2	1.7	1.3	2.7	1.3	1.5
2011:Q3	1.8	2.2	1.3	1.6	1.5	2.2	1.3	1.4
2011:Q4	1.8	2.0	1.4	1.6	1.5	1.8	1.4	1.5
2012:Q1	2.0	2.3	1.6	1.9	1.8	1.7	1.5	1.6
2012:Q2	N.A.	2.1	N.A.	1.9	N.A.	1.8	N.A.	1.6
Q4/Q4 Annual Averages
2011	1.7	3.1	1.3	1.6	1.6	2.6	1.3	1.5
2012	2.0	2.2	1.7	1.9	1.8	1.9	1.6	1.6
2013	2.1	2.3	1.9	2.0	1.9	2.1	1.7	1.8
Long-Term Annual Averages
2011-2015	2.10	2.35	N.A.	N.A.	1.91	2.20	N.A.	N.A.
2011-2020	2.30	2.40	N.A.	N.A.	2.10	2.27	N.A.	N.A.

Long-term (10-year) inflation expectations are a tad higher now, but still below 2.5%.

The commentary on the FRB Philadelphia website:

The forecasters predict higher inflation, both in the short run and over the long run, for the survey's four measures of inflation. The forecasters expect current-quarter headline CPI inflation to average 3.5 percent, up from the last survey's estimate of 1.3 percent. The forecasters predict a higher current-quarter headline PCE inflation of 2.7 percent, up from the last survey's estimate of 1.3 percent.

Measured on a fourth-quarter over fourth-quarter basis, headline CPI inflation is expected to average 3.1 percent in 2011, 2.2 percent in 2012, and 2.3 percent in 2013, higher than the forecasts of 1.7 percent, 2.0 percent, and 2.1 percent, respectively, in the last survey.

Over the next 10 years, 2011 to 2020, the forecasters expect headline CPI inflation to average 2.4 percent at an annual rate. This estimate is up slightly from 2.3 percent in the last survey.

The results are roughly in line with the Wall Street Journal's May survey of forecasters.

Final GDP numbers for 2010:Q4

2011-03-25T09:45:00.003-05:00

Today the BEA released the third and final estimate for GDP growth in 2010:Q4. The revision from the first estimate (the "advance" estimate) to the final estimate was small: the growth rate was revised down from 3.2% to 3.1%. The "advance" estimate is published about one month after the end of the quarter, the "preliminary" estimate is released two months after the end of the quarter, and the "final" estimate, you guessed right, is published approximately three months after the quarter's end.

By components, the largest revision in absolute terms was for the change in inventories, whose negative contribution shrunk from 3.7% to 3.42%. In relative terms the largest revision was for for nonresidential investment, whose positive contribution went up from 0.43% to 0.73%.

2010:Q4 was characterized by a very large negative contribution of the change in inventories, and a large positive contribution of imports (which means that imports shrunk with respect to the previous quarter). I expect a reversal of both in 2011:Q1.

Excessive optimism of small businesses

2011-03-08T08:39:00.006-06:00

The National Federation of Independent Businesses released today the results of the February survey of small businesses. You can read a summary here, or the original release here.

Among other things, the survey reports the net percentage of businesses that expect higher sales over the next three months--that is the percentage of businesses that expect higher sales minus the percentage of businesses that expect lower sales. The survey shows the same statistics regarding actual sales. I could not resist comparing actual versus expected sales. See the chart below. I present expected sales with a three-month lead, so that both actual and expected correspond to the same three-month period.

Click on the chart to enlarge it.

There is a positive correlation between the two, showing that, generally, higher expectations are followed by higher sales. However, the percentage reporting higher actual sales is almost always lower than the percentage reporting higher expected sales. On the chart, most of the data points fall below the NE-SW diagonal line.

Moreover, the slope of the linear relationship between actual and expected sales growth is far below 1 (0.75, with data between Feb. 1981 and Feb. 2011). For each additional 1% of managers expecting higher sales over the next three months, on net, the net percentage of businesses with actually rising sales is only 0.75%.

Why are small businesses biased about sales growth?

This is not the same as saying that actual sales always falls short of expected sales. I am using a binary variable here, not dollar sales. It is possible that the businesses that get their optimistic forecast right, regarding sales increases, experience a deviation of actual versus expected sales big enough to make up for the shortfall of businesses that get the forecast wrong. But I'm skeptical.

A word of caution is in order: self-reported sales forecasts of small businesses are probably a bit too rosy.

The recent decline of the labor force participation rate

2011-02-14T14:27:00.010-06:00

A striking feature of the last recession and present recovery has been the decline of the labor force participation (LFP). In January 2008, at the beginning of the recession, the LFP in the United States was 65.7%. By January 2011 it had dropped to 63.9%. That is the sharpest three-year decline ever observed in the history of this time series. The LFP is now at levels not seen since 1984. In this post I show that changes in the age distribution of the US population have been responsible for one third of the fall of the LFP; other factors (business cycle, structural forces) explain the remaining two thirds.

The LFP is the proportion of the population who is either working or looking for a job, relative to the size of the population eligible to work. More specifically, the numerator is the number of non-institutionalized civilians, ages 16 and older, who is either employed or looking for work. The denominator is the total civilian non-institutionalized population, ages 16 and older. The difference between numerator and denominator is the number of people who are not looking for work, either because they are in school, retired, staying at home as homemakers, or physically unable to work, for example.

Two groups of forces are responsible for the drop of the LFP. First, demographics. Different age groups have different LFP’s. People younger than 25 or older than 65, especially, are much less likely to participate in the labor market than the rest of the population. As the age distribution of the population changes, the total LFP also changes, even if the within-group LFP remains unchanged. Because the first baby boomers turned 65 in 2010, some observers may be wondering the new retirees are responsible for the precipitous decline of the LFP.

Second, structural and cyclical factors. When job opportunities become scarcer, two things happen. New entrants in the labor market (recent graduates, for example) put off their job search. Also, former unemployed persons stop looking for work. In both cases, they are excluded from the ranks of the “active population,” depressing the LFP.

Whether the recent drop in the LFP is due to demographics or to structural/cyclical reasons is relevant because it will affect the future path of the unemployment rate. If the LFP has fallen so much over the last three years because of demographic factors, we should expect the LFP to continue declining at about the same rate, without affecting much the unemployment rate. If the crash of the LFP is due to structural/cyclical factors, many of those who are currently out of the labor force may come back to the job market at some point, raising the LFP. This phenomenon will also keep the unemployment rate elevated even if the economy is creating jobs, as those who were formerly out of the labor force join the ranks of the unemployed. In other words, a low LFP may be hiding a large “shadow army” of labor, waiting to join the labor force.

In reality, a combination of demographic and cyclical/structural factors is at work. I did the legwork to find out what fraction of the LFP crash is attributable to each.

My calculations reflect two simple counter-factual experiments. First, suppose that the LFP within each age group did not change, but the age structure of the population changed as it actually did. What would the LFP be now? Second, suppose that the age structure of the US population had not changed between 2008 and 2011, but the LFP within each group changed as it did. What aggregate LFP would we be observing now? The following chart shows the answer:

The LFP fell 1.8 percentage points between January 2008 and January 2011. Using the first experiment, we see demographic factors would have lowered the LFP by 0.6 percentage points. The second experiment tells us that factors other than demographic forces cut the LFP by 1.2 percentage points.

The table below shows a breakdown of by age group (NSA data, corresponding to the month of January):

	Share of civilian population		LFP		Contribution to total LFP
Age group	2008	2011	2008	2011	2008	2011
16-24	0.161	0.160	57.2	53.3	9.2	8.5
25-34	0.171	0.172	83.3	81.5	14.2	14.0
35-44	0.180	0.166	83.7	82.8	15.1	13.7
45-54	0.188	0.184	82.3	81.0	15.5	14.9
55-64	0.142	0.153	64.5	64.2	9.2	9.8
65+	0.158	0.165	16.2	17.5	2.6	2.9
					65.7	63.9

Notice that the LFP rose within the 65+ age group, that it fell for all the other age groups, and that the population share of those older than 54 rose substantially, whereas the population share of the 34-44 groups declined significantly.

To make a long story short: the large drop in the LFP during 2008-2010 is mostly due to a collection of cyclical and structural factors, not to demographics.

Update (March 24, 2011): The Congressional Budget Office published their labor force participation projections through 2021. They estimate that between 2007 and 2010 demographic effects reduced the LFP by 0.5 percentage points (p. 10 of the report, last paragraph). My estimate between Jan. 2008 and Jan. 2011 was 0.6%. A very interesting feature of this study is that the CBO projects the within-group LFP, something which I did not even try to explain.