HomoEconomus

There's been a lot of discussion lately of whether employment is a leading, lagging or coincident indicator of economic recovery.

Without a doubt, Payroll Employment carries substantial weight in the National Bureau of Economic Research (NBER) Business Cycle Dating Committee’s demarcation of cycle peaks and troughs; that payroll employment factors so significantly in the NBER’s decision process muddies the waters.

In the current recession, the decline in employment was so substantial and prolonged that it, along with Industrial Production, formed the foundation for the Committee’s judgment, making both of these series coincident indicators for the current recession beginning in January 2007 (Chart 1).


Chart 1.

The NBER Business Cycle Dating Committee "maintains a chronology of the beginning and ending dates (months and quarters) of U.S. recessions." The NBER Committee defines a recession as:

"a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators. A recession begins when the economy reaches a peak of activity and ends when the economy reaches its trough. Between trough and peak, the economy is in an expansion."

The Committee goes on to say:

Because a recession is a broad contraction of the economy, not confined to one sector, the committee emphasizes economy-wide measures of economic activity. The committee believes that domestic production and employment are the primary conceptual measures of economic activity." [Emphasis added.]

In these statements, the Committee makes clear what it believes constitutes a recession or recovery, and what measures of economic activity it considers crucial to identifying significant downturns and upswings in the U.S. economy.

In identifying the current recession, the Committee stated in its December 1, 2008 announcement:

"The committee views the payroll employment measure, which is based on a large survey of employers, as the most reliable comprehensive estimate of employment. This series reached a peak in December 2007 and has declined every month since then."

Based on the payroll employment data, the Federal Reserve Board’s Index of Industrial Production and other economic indicators:

"The committee identified December 2007 as the peak month, after determining that the subsequent decline in economic activity was large enough to qualify as a recession."

Of course, the Committee uses a number of indicators, any one of which could be dominant at any given time. So, in the past, other economic indicators may have taken prominence as coincident indicators of recession. One of these candidates is the Federal Reserve Board’s Capacity Utilization Index, which measures the percentage of estimated total capacity of U.S. domestic industries utilized in production. What is striking about this index is that, at least since 1967, its decline tends to uniformly lead NBER designated recessions, but its upswings are coincident with recoveries (Chart 2).

Chart 2.

Of interest currently is that the Total Industry Capacity Utilization rate -- at 68.3% for May -- is at its lowest point of any recession since 1967. (For manufacturing, it is an even lower 65.1%.)

As for employment, its behavior in recent recessions and recoveries is as a coincident indicator, not uniformly lagging as is popularly assumed. This divergence between fact and popular opinion is reminiscent of the commonly definition of recession as two successive quarterly declines in real GDP. Nothing could be farther from the truth. --GAHsr, GAHjr

This past week, Treasury Secretary Tim Geithner released details of the Public-Private Investment Program, his plan to clear devalued, illiquid assets from troubled banks. As outlined in the program, Treasury co-invests with private investors, who bid on bank assets through Public-Private Investment Funds (PPIFs). The PPIFs' purchases are financed -- and levered, up to 6-to-1 -- using Fed- and FDIC-guaranteed debt. The financing is non-recourse, meaning that, if the assets' value declines, the private investor can hand over the paper to the Fed or FDIC and walk away.

Three stated goals of the program are:

• Maximizing the Impact of Each Taxpayer Dollar
• Shared Risk and Profits With Private Sector Participants
• Private Sector Price Discovery

It is the last goal -- price discovery -- that raises red flags.

The price "discovered" in the PPIF bidding process is actually the sum of several different prices. One, clearly, is the market value of the asset. Another, not so obvious, is the value of the option the investor has to put the assets back to the government. (Yet another is the value of below-market financing, but that is small potatoes compared to the value of the put option.)

Under current market conditions, the value of such a put option could be upwards of 20% of the market value of the asset. Therefore, the PPIF price could be 20% higher than the fair market value of the asset.

Now for the red flags:

1. The option premium paid by the investors -- and co-paid by the Treasury -- goes directly to the banks, not the option writer (the Fed or FDIC). In that sense, the PPIF is a hidden transfer from the government to the banks, amounting to perhaps 20% or more of the fair market value of the banks' assets.


2. Banks will inevitably use the PPIF prices to mark to market related assets retained on their balance sheets. Since the banks don't own the put, generally accepted accounting principles suggest the banks should have to mark their retained assets to a lower price -- one that excludes the value of the put. That said, it's not at all clear that the banks will be forced to do this, making the PPIF an accounting sham that will inflate the book value of bank assets.

Let's hope the mainstream press catches up with the government on this one. That giant PPIFing sound is the money getting hoovered out of our pockets. --GAHjr

Many observers -- including recently the editors of Scientific American -- have argued that the financial and economic crisis the world faces today was caused by "quants" who miscalculated rare events, ignored correlations and fundamentally misunderstood "fat-tailed" distributions.

Of course, mainstream econometrics and mathematical finance have addressed these issues for generations. Undergraduate statistics textbooks routinely devote several pages to sample size, covariance and kurtosis. Graduate texts go further, covering topics such as non-stationary processes, time-varying distributions and cointegration; statistical tests for normality, heteroskedasticity, leptokurtosis, serial correlation.

Such subjects were all the rage in econometrics and math finance in the mid 1980s, when ARCH and GARCH hit the scene.

Any quant in the credit field has studied a "jump-to-default" model or two. Robert Merton introduced jump-diffusions to mainstream mathematical finance in the mid 1970s, and in 1993, Stephen Heston gave the world a closed-form model for option pricing under stochastic volatility.

In short, there is a solid understanding of fat tails and black swans among quants. The foundational material has been studied in great depth by all mathematical finance doctoral students in the last 20 years. Believe me.

So what drove the recent bubble and the ensuing crisis?

The reasons for today's situation go much deeper than quants choosing the wrong distribution. It is due to something far more nefarious.

First, we must accept that the bubble, and its collapse, was endogenous -- it was created within the system itself -- as opposed to exogenous (as in an asteroid striking the Earth).

The financial system amplified its own problems in a feedback loop. Leverage begat more leverage, assets became intertwined, and the system became unstable.

Second, the financial system -- politically and structurally -- operated on the myth that no single participant could significantly influence the market, that market frictions were few, and that information was readily availabie. Economists would describe such a system as perfectly competitive.

Of course, the economic and political reality is that the system is imperfectly competitive. The global economy is oligopolistic. A small number of firms are so large that their very existence (or extinction) affects markets: e.g., Countrywide, Fannie Mae, Freddie Mac, Northern Rock, Reserve Fund, Lehman Brothers, Citigroup, AIG, General Motors... The notion is ensconced in the Federal Reserve's policy of "too big to fail." Government itself influences the marketplace, through monetary, fiscal, banking, housing and industrial policy, as monopsonist as well as monopolist. To top it off, the crisis has clearly demonstrated that markets can seize up (e.g., credit and housing) and that information can be painfully asymmetric (cf. TARP).

Along with imperfect competition comes a plethora of issues surrounding incentives and equilibrium. One truth seems to prevail: market participants -- large and small -- can be expected to act more or less in their own best interest.

That truth is the foundation of game theory. The theory has created powerful tools for studying the oligopolistic competition, principal-agency problems and asymmetric information that characterize today's financial system. In particular, game-theoretic models explicitly allow for a single participant to affect the market, as one would expect under oligopolistic competition where firms are "too big to fail."

Game theory also sheds light on the often perverse nature of economic equilibria. It doesn't take much of a stretch to argue that the world fell into a great Prisoner's Dilemma equilbrium. Everyone from Citi's Chuck Prince -- who had to keep on dancing -- to the first-time homebuyer in Las Vegas who took out a no-doc option ARM with a piggyback loan -- acted in his or her own best interest at the time, without realizing that if everyone acted in his or her own best interest, the worst possible outcome would be realized for all.

Few mathematical financial models in common use today are game theoretic. Few allow market participants to single-handedly affect the markets. Indeed, they typically assume near-perfect competition with minimal market frictions. As an example, the widely used copula CDO pricing models do not consider the effect of large positions on systemic liquidity. Of course, that is exactly the kind of analysis needed under a policy of "too big to fail".

If mathematical financial theory is to keep up with the demands of the financial industry, it needs to progress rapidly into the realm of oligopolostic competition, principal-agency issues, market frictions and asymmetric information.

This requires mathematical finance to augment its physical-science roots with traditional economic theory and game theory. Valiant researchers have established beachheads in these areas, but the practical results are few, limiting the adoption of these models by industry. Hopefully, this crisis will be a valuable lesson, and spur further research and study in these areas. --GAHjr

Car czars forcing auto lending? Treasury coercing "patriotic" bank mergers? Unfettered TARP and TALF dole outs? Congress dictating executive pay? Bad banks?

Consider those government activities as you read the following excerpt on fascism from The Concise Encyclopedia of Economics:

Where socialism sought totalitarian control of a society’s economic processes through direct state operation of the means of production, fascism sought that control indirectly, through domination of nominally private owners. Where socialism nationalized property explicitly, fascism did so implicitly, by requiring owners to use their property in the "national interest" — that is, as the autocratic authority conceived it. (Nevertheless, a few industries were operated by the state.) Where socialism abolished all market relations outright, fascism left the appearance of market relations while planning all economic activities. Where socialism abolished money and prices, fascism controlled the monetary system and set all prices and wages politically. In doing all this, fascism denatured the marketplace. Entrepreneurship was abolished. State ministries, rather than consumers, determined what was produced and under what conditions.

Although the article is describing fascism in its heyday of the early 20th century, the parallels to U.S. governmental policy of the early 21st century are truly frightening: Are we hurtling down the road to neo-fascism in America? --GAHjr

According to the Mortgage Bankers Association, over a quarter of all mortgages originated from 2005 to 2007 were interest only. Freddie Mac estimated that about 15% of the mortgages in its portfolio on Sept. 30, 2007, had loan-to-value ratios above 90%.

Of course, these so-called "homeowners" don't own their homes at all. Typically, these borrowers took interest-only, piggyback and adjustable-rate mortgages so they could "buy" larger homes than they could otherwise afford.

Moreover, there are three important distinctions between low-equity mortgagers and renters:

1) The mortgager receives a government subsidy on his "rent" through mortgage interest deductions. The renter gets nothing.

2) The mortgager profits handsomely if the property appreciates, and can even escape capital gains taxes if the profits are rolled into a new residence.

3) In the event property values fall, the low-equity mortgager gets forbearance, a long foreclosure period, at the end of which he hands over the keys to the lender and walks away after months or even years of free rent, nothing lost, free and clear. The renter who falls behind in his rent, on the other hand, will be out on the street within weeks or months, and dogged by the landlord's attorneys for years to come.

In summary, the game is rigged in favor of the riskiest borrower -- the low-equity interest-only mortgager -- who gets all the upside potential, with little downside risk.

Yet today, the entire machine of government is revving up "to keep current homeowners facing unaffordable resets at the starter rates to help them stay in their homes." Will renters facing eviction get a government bailout? (Laugh -- that was a joke.)

The roots of the subprime problem trace back at least to the mid 1990s when the Clinton administration and Congress (including Representative Barney Frank) began a push to expand home ownership, particularly among lower income Americans. Gretchen Morgenson documents this in "Building Flawed American Dreams" (New York Times, 10/18/2008), an article and series well worth reading.

Unfortunately, the Tax Foundation reports that 36% of home-mortgage interest deductions were claimed by taxpayers whose adjusted gross income was greater than $100,000, even though those taxpayers accounted for fewer than 10% of tax returns. The bulk of the tax subsidy goes to wealthiest Americans.

Alan Greenspan rang the alarum, albeit quietly, in his June 9, 2005, testimony to Congress:

"The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is beginning to add to the pressures in the marketplace."

While many real-estate experts and economists warned of the dangers of these loans, Congress, the GSEs and the Federal Reserve chose a Panglossian optimism that at the time seemed wishful thinking, and in hindsight would be laughable if not so tragic. Alan Greenspan summed it up in his 2005 testimony:

Although we certainly cannot rule out home price declines, especially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications. Nationwide banking and widespread securitization of mortgages make it less likely that financial intermediation would be impaired than was the case in prior episodes of regional house price corrections. Moreover, a substantial rise in bankruptcies would require a quite-significant overall reduction in the national housing price level because the vast majority of homeowners have built up substantial equity in their homes despite large home equity withdrawals in recent years financed by the mortgage market.

They tell us the TARP will work, too. Keep laughing, folks. Otherwise you'll start crying. And it only gets worse from here.
--GAHjr

Germany's chancellor, Angela Merkel, called for a European ratings agency to counter, in her words, "a strongly Anglo-Saxon dominated system" of credit ratings, referring to Standard and Poor's and Moody's. (We'll leave aside for the moment that the Anglo-Saxons were in fact German.)

She went on to say that "in the medium term Europe will need a working ratings agency because the robust currency system of the euro has not yet secured sufficient influence over the rules governing financial markets."

Ms. Merkel need look no further for a partner in her new Eurozone ratings agency than neighboring France. As it turns out, French conglomerate Fimalac SA is majority owner of Fitch Ratings, which, according to Fimalac's website, is "la 3ème agence mondiale du secteur [the world's third largest ratings agency]."

If Ms. Merkel's nationalistic fingerwagging is taken at face value, we may soon witness the transformation of Fitch into a Franco-Prussian credit ratings empire, the likes of which the world has never seen.

However, don't expect a triple-A credit rating to be any more credible just because it's written in Blackletter Gothic script. --GAHjr

On the same day that Hillary Clinton announced her withdrawal from the presidential campaign, Bloomberg News reports that Obama's campaign may help Hillary's campaign pay off its $20+ million of debt.

According to the article, Hillary has until the Democratic convention to pay herself back the $11 million she lent to her campaign; otherwise, it becomes a campaign contribution, and she can only recoup $250,000.

All becomes clear.